Inflation Risk Is Underpriced

One of the many unusual things in the financial markets these days is the relationship between the growth in the money supply and inflation expectations. At the same time as unprecedented growth in the balance sheet of the Federal Reserve is taking place, inflation expectations, as witnessed by the narrow yield spreads between inflation indexed treasuries and regular treasuries, are extremely low.

Low inflation expectations

Inflation expectations for the coming 12 months, as measured by a University of Michigan survey of consumers, have been coming down rapidly, from 5.1% last July to 1.7% in December. Given the current weakness in the economy and falling commodity prices, it is perhaps not surprising that people are expecting low inflation in the near term (although deflation fears seem to have diminished recently).

For inflation expectations further into the future, my preferred measure is the spread between Treasury Inflation-Protected Securities (TIPS) and regular, unindexed Treasuries. Currently, 5-year TIPS are yielding 1.44%, only a quarter of a percentage point lower than regular Treasuries. 30- year Treasuries are yielding 3.4%. Unfortunately, TIPS are no longer issued in maturities longer than 20 years, but the 20-year inflation-indexed yield of 2.5% indicates that long-term inflation expectations are quite low.

One argument I have seen against using this spread as an indication of inflation expectations is that in times of financial crisis, investors seek liquidity as well as certainty of repayment. As TIPS are less liquid than regular Treasuries, a small spread may say more about a preference for liquidity rather than low expectations for inflation. I would dismiss this argument for the following reason: TIPS have only been available since 1998. The only financial crises since TIPS were first issued are the collapse of Long-Term Capital management in 1998, and arguably the stock market bust of 2001-2002. These are not enough data points to base generalizations on. Besides, trading volumes in TIPS have not remained constant during this period. In 1998 the average daily trading volume of TIPS was USD 900 million. In 2008 it was 8.7 billion, having risen every year in between. The discount on TIPS, for this reason, should be steadily diminishing.

In any case, inflation expectations appear to be low in the short-term as well as the long-term. Recent developments in the money supply make those expectations implausible.

The money supply

For those of us who agree with Milton Friedman’s statement that “inflation is always and everywhere a monetary phenomenon,” recent growth of the money supply suggests unequivocally that it is only a matter of time until inflation will start to kick in. M1 (see Wikipedia entry for further explanation of terminology) has grown by 17% in the last twelve months and almost 40% in the last three months (on an annualized basis) and M2 has grown by 9.9% and 18.4% by the same measures, respectively. However, it is not until we get to the narrowest measure of the money supply, M0 or the monetary base, that things get really crazy.

From September to December of 2008 the monetary base expanded from USD 905 billion to USD 1.65 trillion. This is mostly due to banks accumulating excess reserves with the Fed, where they can earn an interest rate equal to the fed funds target rate. Of course, there is little reason for banks to lend to each other when they can more safely lend to the Fed at the same rate. This has served to more than double the Fed’s balance sheet in the last year (for a more thorough discussion of this, see this article). Given current economic conditions, it seems likely that sooner or later banks will be discouraged from hoarding their cash with the Federal Reserve (for instance by not paying interest on those reserves).

Flight to safety…but safety from what?

It is clear that aversion to risk is currently very high and risky assets are being sold in favor of those that are perceived as being safe, such as cash and Treasury securities. These assets are safe, if safety is measured in terms of avoiding large, negative numbers in one’s account statement.

However, the fear of losing money can quickly be replaced by the fear of money losing purchasing power. If, and I consider this scenario very likely, inflation sets in, yields on Treasuries can be expected to rise quickly. The same is true for the inflation premium on TIPS. Mispricings in the markets should not be seen as intellectually irritating, but rather as a profit opportunity. In this case, shorting unindexed Treasuries, buying TIPS, or both, could be appealing.

This is all easy to do with ETFs. For TIPS, there is iShares Barclays TIPS Bond (TIP), which has a duration between 6.5 and 7.25 years. For shorting non-indexed Treasuries, Proshares has ultrashort funds for intermediate (7- to 10-year) treasuries (PST), and for long (20+ year) treasuries (TBT). As is often the case, timing is tricky and I would advise caution with the ultrashort funds.

Disclosure: No position in securities mentioned in this post.

Comments

[Daniel Braun:]

good article thanks

Jan 27 08:29 AM

[cma:]

Good article on the fundamentals but absurd conclusion to use the Pro-shares ultra-short treasuries. These Proshares ETFs only produce the required return on a daily basis, not over any longer time frame.

Jan 27 10:08 AM

[Arnbjorn In...:]

cma,

You are right about the ultrashorts -- they are only good for short-trem positions. The flaws of ultrashort (and ultralong) funds hvave been brought up in many articles, so I did not see a reason to explain it here. Therefore I just mentioned that timing was important and advised caution. For longer term positions, other ways of shorting treasuries would be preferable.

Arnbjorn

Jan 27 10:17 AM

[garyholl:]

I keep seeing that ultrashort are only good in the short run. Would someone explain this for me?

Thanks

Jan 27 11:02 AM

[kelm:]

Good article. It is surprising to me the resistance that the inflation argument receives from so many commentators when the relationship between money supply and inflation is so fundamental.I think it may be because relatively few people commenting here and elsewhere actually have experienced inflation. All they really here is the deflation stories brought to us by the Fed and CNBC.

Jan 27 11:07 AM

[nym:]

It might help if you would expand on 'flight to safety'. When that flow is reversed, there will be too much 'money' chasing limited supplies, for oil, as example.

Jan 27 11:29 AM

[Arnbjorn In...:]

Thank you for your comments.

The basic reason ultrashort funds are dangerous over long periods of time is that they amplify daily moves. Therefore, if you suffer a large down move, it will take more than a corresponding move in the opposite direction to break even.

seekingalpha.com/artic...

This is a link to an article written by Marc Gerstein in defense of leveraged ETFs. It has links to other articles so you can see both sides of the story and decide whether leveraged ETFs are for you or whether you would be safer staying away from them.

Jan 27 11:36 AM

[Chris B:]

Arnbjorn,

I'm glad you understand that the growth in M0 and M1 has come largely at the expense of M2 and the now uncalculated M3. I had to argue yesterday with a SA article that said that because banks were hoarding their cash in their federal reserve accounts (MO increasing exponentially), hyperinflation was imminent. I suppose to a person who doesn't understand the definition of these terms, and the fact that dollars can move from one type of asset to another, it could seem like the chicken littles are right and 100% or higher inflation was imminent.

However, I think I agree with you that moderate to high (5-10%) inflation is in our future. It amazes me to see so many investors plowing into treasuries at record high prices when those notes and bonds, especially the long term bonds, could lose double-digit percentages of their value in an inflationary environment or in the case of a buyer shortage. I suspect that is why the banks are sitting in their federal reserve accounts rather than playing the long treasury market. The treasury bubble consists of foreign investors who lack access to accounts backed by the US govt. or FDIC and have no other good, liquid options for storing USD. I'm worried that the treasury bubble could unwind rapidly (within a day or two) at the first sign of recovery, driving treasuries and the dollar down by double-digit percentages.

In such an environment, certain forex contracts and the double-short ETF's you mentioned might be the only winners, despite their flaws. Perhaps you could add a dollar-bearish or a basket of foreign currency ETFs to the mix (e.g. UDN, DBV, FXE, FXA, FXC, FXS, FXM).

Jan 27 11:43 AM

[Arnbjorn In...:]

nym: I wanted to focus on the money supply and inflation expectations in the bond market in this article. I do agree that once inflation expectations increase, investors will again look to commodities and I can see commodity prices rising sharply again in the not too distant future. I will probably write a separate post on this later.

Chris B: Thanks for a thoughtful comment and the ETF suggestions.

Jan 27 12:13 PM

[Karl Glazier:]

In the current environment, increasing the money supply does not lead to inflation.
There is worldwide overcapacity in everything leading to sinking or at least stable prices.
The money supply cannot even be defined properly, that's why you have M0, M1, M2 etc.
It is an absurd concept.
It is Friedman's pet theory, which is just as wrong as his market fundamentalism, which brought us to the current crisis (lack of regulation).
Prices can only rise if there is more demand than supply of goods.
Where is the demand supposed to come from?
Consumers either don't want or can't get more loans to increase consumption.
Only when the economy is booming again, do we have to watch inflation, and then it is easy for the Fed to sell the securities they have bought and thereby decrease the money supply, if needed.
That may not happen for years.

Jan 28 01:53 AM

[Arnbjorn In...:]

Karl, I think you are doing yourself a disservice by dismissing everything associated with Friedman out of contempt for his political views. Even if the real world applications of monetary economics are more complicated than the neat MV = PY equation you will see in textbooks, the concept of money supply is hardly an absurd one.

Surely you would agree that if every household were sent a million dollars in the mail, inflation would be unavoidable. Hypothetical examples aside, if you think inflation can only occur during boom times, you need look no further back than to the 70s for an example to the contrary.

Jan 28 10:48 AM

[Msoane:]

i agree with Arnbjorn's argument for inflation and the subsequent impact on bond prices but I think he understates the case. A looming $1.3 trillion deficit and the concomitant need to issue debt and increasingly weak demand from Japan, China and the Gulf countries is going to drive down bond prices regardless of the current relationship between aggregate supply and demand.

Feb 06 04:44 PM

[guymar:]

If you bought a neutral position on the 10th of August 2007 for 10 000 usd DXD (Dow Ultrashort 2x) and 10 000 usd DDM (Dow Ultra (long) 2x) you would have 17952 USD today, that is a lot of slippage and commissions on 20 months. On the 6th of March 2009, your DXD traded at 90 vs 53.28 now. But it went up only by 4 dollars between the october 2008 low and the march 6 low. Perhaps it should be considered a swing-trader tool.


On Jan 27 11:02 AM garyholl wrote:

> I keep seeing that ultrashort are only good in the short run. Would
> someone explain this for me?
>
> Thanks

Apr 29 11:22 AM

[GotLife:]

"By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."

-- John Maynard Keynes

No wonder our politicians love Keynes. Taxes without consequences -
Priceless!

Aug 04 09:53 AM