There is a new trade developing in bond and equity markets: the deflation trade.

Today, deflation is coming to the forefront thanks to bond market activity and what the New York Times had to say about it this weekend. The mood of both the Street and among individual investors often mimics the coverage that’s given to issues by the media, and deflation was written about by Elliott wave theorist and Times writer Robert Prechter.

For us the concern isn’t his specific forecast or opinion, but rather that the article appeared in the Times at all. Deflation was also a 15-minute discussion this morning on CNBC in primetime — and that too is something that would not have happened just six months ago.

Short-term Market Outlook

The technical trend is down, -4.5% last week and -8% during the past two weeks, and we seeing in oversold conditions. This may produce a week with a temporary bias to the upside. However, the multi-week trend is still strongly to the downside.

This momentum will run into the Street’s reaction to earnings in the coming days. The consensus is for strong second-quarter earnings, while those same people are fearful of weak top-line forecasts for the rest of the year.

Countering all of this mixed sentiment is the continuing power of the 0% interest rate/dollar/commodities trade, i.e., the dollar carry trade, which often dominates day-to-day trading.

The bottom line is that the downward trend will continue as earnings come out and we near critical support levels at S&P 500 (SPX) 985.

The Deflationary Threat

What is deflation and how do we play it?

The opposite of inflation, Investorwords.com defines deflation as, “A decline in general price levels, often caused by a reduction in the supply of money or credit. Deflation can also be brought about by direct contractions in spending, either in the form of a reduction in government spending, personal spending or investment spending. Deflation has often had the side effect of increasing unemployment in an economy, since the process often leads to a lower level of demand in the economy.”

Just about any way you cut it, deflation is much more harmful and a tougher problem to control than inflation.

* Psychologically deflation makes people feel poorer.

* Deflation increases the cost of existing debt. In constant dollars, a $100,000 loan is a reduced burden of $98,000 after one year if the inflation rate is 2%. On the other hand, $100,000 is an increased burden of $102,000 in constant dollars if there is a 2% deflation rate.

* From mortgage loans to regulatory oversight, our financial system is designed to deal with an inflationary environment. It is poorly suited to fight deflation. For example, the Fed has, in effect, created more than a $1.5 trillion in new money since the crisis began, yet the money supply has contracted during that same time.

Are we experiencing deflation?

* The largest chunk of wealth for the average American is their home and, nationally, home values are down by more than a third during the past three years — that’s definitely asset deflation.

* The value of equities is still down roughly 27% since the start of the Great Recession, and the average portfolio of individuals has fallen even more — more asset deflation.

* Since Lehman went under in September 2008, oil has fallen by more than 33%.

* Wages have been stagnant for several years, and take-home income after taxes and healthcare costs have actually fallen.

* Consumer prices are stable or falling across the board with two major exceptions: health care and higher education. These prices continue to climb because they are supported and inflation-driven by federal spending and guarantees.

What becomes more valuable in periods of deflation?

* Bonds, specifically Treasury bills. The 10-year Treasury bill now yields less than 3%, having yielded almost 4% less than a year ago.

* Currencies backed by political confidence and bonds that are increasing in value — and that means the U.S. dollar.

* Gold — a “flight to” commodity seen as being impervious to deflation.

* Human and investment capital that are involved in areas of inflation such as health care.

How to Play Deflation

In my Short-Side Trader service, we currently have a long-side play on the board in the PowerShares DB US Dollar Index Bullish ETF (NYSE: UUP) with the UUP Sept 27 Calls.

Triple-Digit Profits No Matter What the Market Does — You are not at the mercy of the markets. You can start adding triple-digit winners to your portfolio now if you’re ready to embrace the new rules of investing. Here’s how to make money every day in up markets AND down.