Pig in the Python: The Growing Threat of Inflation
In our 7/17/2020 weekly update (contact 3D if you’d like to be added to the distribution list), we noted a shift in Federal Reserve policy concerning its dual mandate of maintaining full employment while keeping a lid on inflation. So far, we’ve witnessed the Fed’s aggressive response to the economic contraction and capital markets meltdown back in March-May that has resulted in a ballooning of its balance sheet to nearly $7 trillion and unprecedented policy measures to support the capital lending markets for U.S. corporations and municipalities. The Fed’s actions have clearly solved the ‘liquidity’ problem as corporate and municipal bond spreads to safe-haven U.S. Treasuries have narrowed quite a bit from their mid-March panic levels (the ‘solvency’ issue remains to be seen although bankruptcy filings have been mostly limited to the weakest link borrowers across consumer retail and energy).
The Fed’s aggressive policy actions have not gone unnoticed by certain asset classes that tend to track real rates (interest rates adjusted for inflation), such as Treasury Inflation-Protected Securities (TIPS) and precious metals/commodities. We are now witnessing a major breakout of these real rate asset indicators (Figure 1) as real rates get driven further into negative territory (Figure 2).
Figure 1 – Precious Metals and TIPS Responding to Negative Real Interest Rates
Source: Wall Street Journal Daily Shot (7/21/2020)
Figure 2 – Long-Term U.S. Inflation-Adjusted (Real) Rates Driven Further Into Negative Territory
Source: Bloomberg (Federal Reserve US Treasury H15 Constant 10-Year Real Rate)
The general consensus among economists and Wall Street strategists is for inflation remain moribund and not surface as a problem as global demand remains weighed down by the COVID-19 pandemic (not to mention long-term demographic trends of high debt levels and declining labor replacement ratios due to low birth rates). This outlook remains a reasonable baseline scenario as one need only observe the juxtaposition of a plunging money supply velocity rate (Figure 3) against the exponential increase in broad money supply (M2) as all that money printing remains stuck with the major money center banks in the form of excess reserves held with the Fed.
Figure 3 – Plunging Money Velocity Juxtaposed Against Accelerating Money Supply (M2) Suggests the Inflation ‘Pig’ Is Expected to Remain Inside the Fed ‘Python’
However, as consensus opinion coalesces around this viewpoint that inflation will not likely rear its ugly head anytime soon, an inflationary breakout ‘reflexively’ can turn into a greater ‘tail’ risk for investors. Readers of this blog article may want to check out the Bear Trap’s post on this topic (see “The Cobra Effect”) for further color on the potential unforeseen consequences of monetary and fiscal policy seeking to solve both economic and social output gaps. For now, the Fed’s desired policy goal is not only for inflation to come back but for it to become enough of a noticeable societal-wide problem affording the Fed justification to enact tighter policies to address it. In our 7/17/2020 update, we highlighted this excerpt from Fed Governor Lael Brainard’s July 14 speech:
“…[The Fed] will be guided not only by the exigencies of the COVID crisis, but also by our evolving understanding of the key longer-run features of the economy, so as to avoid the premature withdrawal of necessary support (underline emphasis 3D).”
In other words, the Fed will not only wait to see the ‘whites of inflationary eyes’ before raising rates, but they’ll wait to see inflation face-to-face before raising rates (and maybe even wait some more). Hence, we are now beginning to see global asset prices reflect this ‘lower-for-much-longer’ Fed policy where the Fed is less likely to preemptively respond to inflationary pressures with tighter policies.
But wouldn’t nominal interest rates rise with inflation? U.S. Treasury rates reached a near-term low of 0.61% this past Friday reflecting a seemingly contradictory outlook of both disinflation / preference for safe haven assets (hence demand for long duration sovereign debt) versus cyclical risk appetite as reflected by recent U.S. dollar weakness and commodity strength. BCA strategist Jim Mylonas makes an interesting point about this dichotomy where he observes, “The stronger signal from the bond market regards [central bank] policy rather than the economy. The Fed (or the Fed’s view on its mandates) drives real rates…Investors have been adjusting to a new and more-dovish reaction function over past months/years which is pushing real rates lower.” In other words, the bond market is reflecting the Fed’s attempt to push its thumb on the rate scale in order to keep real rates negative for the foreseeable future. U.S. Treasury rates may be more influenced by central bank policy preferences over the short term, and then it becomes a game of ‘who is stronger?’ – the Fed or capital markets.
For now, commodity price action, following a heavy sell-off in response to the global pandemic, have mostly recovered those losses, especially copper prices (Figure 4), while precious metals, such as gold and silver, continue to rally in response to lower negative real rates.
Figure 4 – Copper and Gold Respond to Negative Real Rates, Anticipating an Inflation Problem Few Seem to Be Expect
Investors may complain about the nosebleed valuations of global equities with forward price/earnings multiples (based on expected 12-months earnings) at or exceeding 10-year highs, but equities can still capture upside increases in underlying cash-flows, whether driven by real revenue growth or by inflation. Fixed income faces an increasingly asymmetric risk profile as interest payments remain largely fixed (except for floating rate debt). The U.S. Aggregate Bond Index has performed tremendously well as long-term interest rates have plummeted this year in response to the global pandemic. However, the option-adjusted duration of the index is approximately six years – a 1% increase in longer-term rates would roughly translate into a 6% loss, more than wiping out six years’ worth of interest income based on prevailing rates. Inflation may not be a problem now for investors, nor it seems less likely to become a problem over the near term as the world tries to recover from the coronavirus pandemic. But cyclical assets that track real rates are starting to price in a higher probability that inflation will eventually become an issue – an achieved policy goal that the Fed may not want to see.
The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate however 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete.
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By: Benjamin Lavine