Expert Commentary

Deflation to Come Back into Focus

We can use Elliott wave analysis to anticipate changing expectations.

Charles Dow, creator of the Dow Jones stock market averages, founder of the Wall Street Journal and grandfather of what we now know as technical analysis, wrote extensively about market behavior before his death in 1902. His writings became known as Dow’s Theory and, in 1932, Robert Rhea published his book ‘The Dow Theory,’ starting a newsletter at the same time.

Ralph Nelson Elliott was one of the first subscribers to Rhea’s newsletter and so he knew Dow’s Theory inside out. In 1934, Elliott made his discovery that market behavior cycles in repeatable patterns and he wrote to investment advisor Charles Collins in an effort to get his work published. In that letter he wrote that his discovery was a ‘much needed complement to Dow Theory’ that added ‘great forecasting value which it lacks’.

This is exactly why people love the Elliott Wave Principle. It enables us to anticipate future developments based on the current price pattern, something which is impossible by using tools such as moving averages. They’re great at telling us what the trend has been, but useless in telling us what the trend might do tomorrow. Elliott wave can though.

One of the Elliott wave patterns most adept at this forecasting edge is the venerable triangle. Triangles only occur at a few points in a market cycle and so, when one appears, it can give us a strong clue as to what’s coming next. Triangles appear most often as wave 4 of an impulse or as wave B of a correction. We can therefore anticipate that the next wave will either be wave 5 or wave C. In other words, the next wave after a triangle will be a terminating wave, meaning that after a thrust out of the triangle a reversal should occur.

All of which brings us to deflation.

The chart below shows the expectations of U.S. consumer price inflation as measured by the 10-year Treasury Inflation Protected Securities (TIPS) breakeven rate, the difference in yield between a normal 10-year Treasury bond and one protected against price inflation.

As we can see, a clear triangle pattern has been traced out since the August high and it now looks complete. If this is correct, we can forecast two things. Firstly, there should be an upward thrust in price inflation expectations in coming weeks. But secondly, once that thrust is complete, a reversal should occur, putting downward pressure on consumer price expectations. If this triangle is a fourth wave, and the thrust higher is therefore a fifth, the subsequent reversal could be extremely deep, perhaps even down towards the low of 0.50% reached in March of this year.

Thus, using this simple yet powerful Elliott wave analysis allows us to forecast that we can expect some brief elevated chatter about consumer price inflation followed by growing concern about price deflation as we move into 2021.

US Price Inflation Expecations Nov2020