How To Trade Deflation

Several analysts are convinced that hyperinflation is just around the corner, arguing that the vast sums of money printed in response to the recent credit crisis will inevitably lead to rising prices. Others, like NY Times columnists and Nobel Prize winner Paul Krugman, disagrees.

Krugman believes that there is little chance of inflation flaring up anytime soon because the economy is still contracting, and a good chunk of the Fed’s printed money is sitting idle in bank vaults instead of flowing through the economic system. “It’s important to realize that there’s no hint of inflationary pressures in the economy right now," he wrote in May 2009. "Deflation, not inflation, is the clear and present danger."

Here are a few Exchange Traded Funds (ETFs) that may benefit from falling prices, i.e. deflation.

Long-term Treasury Bonds: Falling prices tend to lead to falling interest rates, which is usually a positive development for long-term treasury bonds. Have a look at the iShares Barclays 20+ Year Treasury Bond Fund (TLT), and the Vanguard Total Bond Market ETF (BND), which both track the performance of long-term Treasury bonds.

Investment Grade Corporate Bonds: Deflation tends to occur during times of economic weakness. Investment grade corporate bonds tend to outperform during these difficult times, mainly due to their superior credit quality. To gain exposure to this market, you can use the iShares iBoxx $ Invest Grade Corp Bond Fund (LQD), which tracks the investment grade bond market.

Cash: In a deflationary market, cash is king, because you can buy more as prices fall. Short-term bonds tend to be closely correlated to cash, offering protection against deflation. Have a look at the Vanguard Short-Term Bond ETF (BSV) and SPDR Barclays Capital 1-3 Month T-Bill (BIL), which both track the performance of short-term bonds.

Sell Commodities: Commodities tend to be closely correlated to inflation, which means that they will fall in value if prices start declining. One way to profit from such a trend is the ProShares UltraShort Basic Materls ETF (SMN), which increases in value if commodities decline.

Disclosure: I do not own any of the securities mentioned above.

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