What's your best guess on how the inflationary/deflationary theme will play out

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Q: What's your best guess on how the inflationary/deflationary theme will play out? The divergent thought between Bill Gross and Jeffrey Gundlach, and now hearing Gross is buying Treasuries is making me a bit nervous.

A: Our view (or best guess) is that the U.S. will avoid a deflationary environment on account of a pickup in the labor market that should support higher levels of aggregate demand which, in turn, will spur increased lending activity and rising wages (for private sector workers anyway).

The $64,000 question is, can the Fed adjust monetary policy at the right time, and in the proper scope, to prevent inflation expectations from becoming unhinged? Thus far, market participants are giving Mr. Bernanke the benefit of the doubt on that front as evidenced by rising, but not alarming, inflation expectations seen in forward breakeven rates.

The deliberate pace of improvement in the labor market is a factor that we think is contributing strongly to the market's current semblance of patience in considering the Fed's ability to hold things in check. That patience will be tested (as would our view) if the Fed doesn't shift to a tightening policy in the face of a quickened pace of hiring and lending activity.

As for the recent strength in the Treasury market, we think it has more to do with the prospect of (a) another flare up in Europe's sovereign debt market and/or (b) worries the first quarter earnings reporting period will be a catalyst for a stock market selloff than it does with the idea that a material slowdown in U.S. economic activity will lead to deflation.

In other words, it looks like a frontrunning of a flight-to-safety trade some might think would occur on either development. We suppose, too, some faith is being placed in the idea that the S&P action yesterday, and the initial reaction to it, will convince Congress to raise the debt limit sooner rather than later.

As an aside, I did see a follow-up report on The Wall Street Journal blog that quoted Bill Gross as saying he is not buying Treasuries again (at least nothing beyond a 1-year maturity). His stance is fairly consistent with our view that it is best to keep duration short when investing in U.S. Treasuries at this juncture.

Patrick J. O'Hare
Chief Market Analyst

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