Deflation Trading Strategy (Backtest And Example)

Last Updated on January 11, 2023

Deflation is considered bad news for any country’s economy, and it’s generally not good for the financial markets, as prices of goods and services fall and companies’ profitability decline. However, periods of deflation may actually present an excellent opportunity for savvy traders and investors to snap the best investments. What is your deflation trading strategy?

A deflation trading strategy refers to the methods and techniques you can use to invest and make money during a period of deflation. This includes how to spot the asset to trade, the direction to trade, and how to spread your investments. Examples of deflation trading strategies include buying real assets, like real estate, short-selling stocks, buying cash-rich stocks, and investing in Treasury bonds.

In this post, we answer some questions about the deflation trading strategy and we end the article with a backtest.

What is deflation, and how does it affect trading strategies?

Deflation refers to a general decrease in the prices of goods and services in an economy. It is the inverse of inflation — which refers to a general increase in the prices of goods and services in an economy. Essentially, deflation is said to occur when consumer and asset prices fall over time while buying power rises.

In other words, with the same amount of money you have today, you can buy more products or services tomorrow. As a result, consumers tend to delay spending, with the hope that they would buy the same item at a cheaper price in the future. While deflation may appear to be a beneficial thing, it might indicate an imminent recession and difficult economic circumstances, and here’s why:

Reduced spending means less income for producers, which can lead to unemployment and higher interest rates. In other words, deflation breeds more deflation and might lead to a recession or even a depression. Historically, periods of deflation have been associated with significant economic and stock market downturns. As such, deflationary periods tend to favor short-selling strategies in stocks.

What is a deflation trading strategy?

A deflation trading strategy refers to the methods and techniques you can use to invest and make money during a period of deflation. This includes how to spot the asset to trade, the direction to trade, and how to spread your investments.

In a deflationary economy, the general stock market is usually bearish, as companies’ profitability is reduced. For an experienced trader, the strategy could be to short-sell stocks of companies that are hit the hardest. Another strategy could be to invest in stocks of companies that have lots of cash on hand, as such companies are in a better position to take advantage of the lower prices and make investments that could increase the value of their stocks.

A good deflation strategy is to invest in tangible assets, such as real estate, gold, and silver. Such assets can often be purchased at a discount, but they usually hold their value well during deflationary periods. In some cases, prices may increase as investors rush to those assets to protect their wealth.

Another deflation trading strategy is to invest in Treasury bills and notes. Contrary to what happens to stocks and corporate bonds during deflation, Treasury bonds tend to do well in such situations, as investors consider them safe-haven assets. You may also buy a foreign currency and probably use it to buy the country’s government bonds.

How do you identify deflationary trends in the market?

Often referred to as negative inflation, deflation occurs when the annual inflation rate falls below 0% (inflation turns negative). Such an event is usually brought about by a reduction in the money supply, an increase in the productivity of goods and services, declining confidence among consumers and businesses, a decrease in the demand for goods and services, or a combination of these factors.

As with inflation, deflation is measured using economic indicators like the Consumer Price Index (CPI), which tracks the prices of a group of commonly purchased goods and services and publishes the changes every month. When the prices measured in aggregate by the CPI are lower in one period than they were in the period before, the economy is said to be experiencing deflation.

Another measure of deflation is the personal consumption expenditures price index (PCE) — a measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services.

What types of assets perform well during deflationary periods?

Generally, during deflation, asset prices go down, but there are a few assets that tend to perform well during deflationary periods, such as:

  • Real assets: These include real estate, gold, and silver.
  • Treasury bonds: Unlike corporate bonds, which are very risky investments during deflationary periods, investors consider Treasury bonds a safe-haven asset and tend to buy them.
  • Stocks of cash-rich companies: Companies with huge cash reserves during deflation can make shrewd investments that can increase the value of their stocks.

How do you adjust your portfolio to prepare for deflation?

There are a few ways to go about it. First, you have to move away from risky assets, such as stocks, corporate bonds, and cryptocurrencies. It is much better to stay in cash during such periods than to have a huge allocation in risky assets. The reason is that such assets tend to decline in price, while the purchasing power of your cash increases.

A better way is to move to safe-haven assets, such as gold, silver, and most importantly, Treasury bonds. The good thing about Treasury bonds is that they offer you some returns and might also increase in value. You can also buy some real estate, as the asset tends to do well in such times.

What are some specific trading strategies for profiting from deflation?

Here are a few of them:

  • Investing in tangible assets: You can invest in tangible assets, such as real estate, gold, and silver. Such assets can often be purchased at a discount, but they usually hold their value well during deflationary periods. In some cases, prices may increase as investors rush to those assets to protect their wealth.
  • Investing in Treasury instruments: Unlike what happens to stocks and corporate bonds during deflation, Treasury bonds tend to do well in such situations, as investors consider it a safe-haven asset.
  • Short-selling stocks: If you are an experienced stock trader, a good strategy during deflation is to short-sell stocks of companies that are hit the hardest.
  • Investing in cash-rich stocks: A long-term play could be to invest in stocks of companies that have lots of cash on hand, as such companies are in a better position to take advantage of the lower prices and make investments that could increase the value of their stocks
  • Buying foreign currency: You may also buy foreign currency and probably use it to buy the country’s government bonds.

How do you manage risk when implementing deflationary trading strategies?

A good way to manage risk when implementing deflationary trading strategies is to diversify your investments into different assets and strategies. Use a combination of all the strategies mentioned above if you have the capacity to do so. That way, if one is not doing so well, the others would offset the losses.

For example, if your play in buying cash-rich stocks seems too early and the overall market is too bearish for those stocks to perform, the profits from the stocks you short-sold would offset the temporary losses in the stocks you bought.

How do central bank policies impact deflationary trends and trading strategies?

One of the causes of deflation is a reduction in the money supply and the consequent decrease in demand. Money supply reductions often arise when central banks raise interest rates too high to discourage easy access to credit facilities.

When deflation strikes, central banks fight it by adopting an expansionary monetary policy, which often includes reducing interest rates to zero or near-zero levels, buying back treasury instruments, and quantitative easing.

How do you adjust your strategy as deflationary trends change?

You do that by monitoring deflationary trends to know when they are changing. If the economy is about to go into a deflationary period, you can offset most of your risky assets to stay in cash. With enough cash, you can look for good deals in real estate and other tangible assets or invest in treasury bonds.

If the market is moving from a deflationary to an inflationary environment, you can gradually rebalance your portfolio to include risky assets like stocks and corporate bonds.

How do you monitor economic indicators related to deflation?

In the US, the two key economic indicators for assessing deflation are the CPI, which is released by the Bureau of Labor Statistics (BLS), and the PCE, which is released by the Bureau of Economic Analysis (BEA). Both data are released monthly, and the release schedule is available on the website of the respective agencies. You can also monitor both data from the economic calendars of any investing website.

How do you determine the appropriate level of leverage to use in deflationary trades?

It may be appropriate not to use any leverage at all if you can because the market is usually highly unpredictable in such moments. Even though the market tends to generally decline and you may be tempted to go very big on the short side, a huge government intervention can swing the market back in no time. Minimize leverage to reduce risk.

How does deflation impact the value of debt?

During deflation, a unit of a dollar has more value than it did in the past, so the value of debt increases. The value of the money you use to repay debt becomes higher than what you borrowed.

As debt becomes more expensive with deflation, people and businesses tend to avoid taking loans and struggle to pay the debts they already owe.

How do changes in the supply and demand for money affect deflationary trends?

When there is a reduction in the supply of money, people tend to save their cash instead of spending it. As a result, the demand for goods and services declines, while the supply probably remains the same. This creates a sort of supply surplus, leading to declining prices.

How do changes in consumer and business confidence impact deflationary trends?

Changes in consumer and business confidence are one of the factors that cause deflation. The reason is that if people are worried about the economy or unemployment, they tend to spend less so they can save more money. As spending reduces, the demand for goods and services declines, leading to more supply than demand, which forces producers to reduce prices.

How do changes in global economic conditions affect deflationary trends in a particular market or country?

The world has become increasingly connected such that people refer to our planet as a global village. An economic mishap in one part of the world can have a ripple effect in other parts of the world, as information is easily disseminated and people can easily move funds from one region to another. Global economic conditions tend to affect all countries because the markets are connected via trade and investments.

How do you differentiate between temporary deflation and sustained deflationary cycles?

Temporary deflation refers to deflation that is short lived, often lasting within one business quarter. This sort of deflation is beneficial to consumers as prices for goods and services fall and their purchasing power increases. And it may also encourage investment, as investors can purchase more assets with the same amount of money.

Sustained deflation, on the other hand, refers to deflation that lasts two or more consecutive quarters. This kind of deflation can lead to recession and have damaging effects on the economy.

How do you anticipate and respond to potential deflationary spirals?

You can monitor economic data like the CPI and PCE, which are published every month by the relevant agencies. You can get the data from the websites of the agencies that publish them or from the economic calendar of any financial website.

The “All Weather Portfolio” does it hedge against deflation?

The “All Weather Portfolio” is a diversified asset mix developed by hedge fund manager Ray Dalio. Its asset allocation formula is as follows:

  • 40% long-term bonds
  • 30% stocks
  • 15% intermediate-term bonds
  • 7.5% gold
  • 7.5% commodities

Historically, the “All Weather Portfolio” tends to fair better than most other asset allocation methods during periods of deflation.

Deflation trading strategy backtest

A complete backtest of a deflation trading strategy with strict trading rules and settings is coming shortly.

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