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I've written many, many, many articles on gold, silver, SPDR Gold Trust (NYSEARCA:GLD) and iShares Silver Trust (NYSEARCA:SLV), and there are common themes that develop in the comments. One of the most persistent themes is that we have inflation, or that the Fed's actions will generate inflation. The evidence provided is that food and gas prices are going higher, gold has gone higher and that the CPI is rigged to understate inflation. People will redefine inflation as simply "printing money," or using alternative measures of inflation to make their case. All those may be true, but they simply don't matter.

I could go into detail about the CPI, PCE and other inflation indexes and write ad nauseam about how poorly constructed they are and the inherent problems of any artificial inflation index, but it simply doesn't matter. We could have debates with panels of experts arguing over the accuracy of the CPI, but none of the information gathered would be worth a hill of beans. All these academic exercises may be fun, they make great cocktail party conversation and fodder for internet discussion boards, but they all totally miss the point. The only measure of inflation, the only definition of inflation, the only important estimate of inflation is the estimate created by the markets. When talking finance and economics, the only value of inflation that matters is that value the markets assign to it.

Market interest rates include an inflation adjustment. Nominal interest rates consist of 5 components:

  1. Real Risk-Free Rate - This assumes no risk or uncertainty, simply reflecting differences in timing: the preference to spend now/pay back later versus lend now/collect later.
  2. Expected Inflation - The market expects aggregate prices to rise, and the currency's purchasing power is reduced by a rate known as the inflation rate. Inflation makes real dollars less valuable in the future and is factored into determining the nominal interest rate (from the economics material: nominal rate = real rate + inflation rate).
  3. Default-Risk Premium - What is the chance that the borrower won't make payments on time, or will be unable to pay what is owed? This component will be high or low depending on the creditworthiness of the person or entity involved.
  4. Liquidity Premium- Some investments are highly liquid, meaning they are easily exchanged for cash (U.S. Treasury debt, for example). Other securities are less liquid, and there may be a certain loss expected if it's an issue that trades infrequently. Holding other factors equal, a less liquid security must compensate the holder by offering a higher interest rate.
  5. Maturity Premium - All else being equal, a bond obligation will be more sensitive to interest rate fluctuations the longer to maturity it is.

If one wants to know what the inflation rate is that is applicable to investing or economics, all one needs to do is study the market interest rates. It is important to note that bonds don't discount an increase in the price of gold or an increase in the price of food and gasoline. Bonds discount inflation, and inflation to the bond market is a sustained increase in aggregate prices. The market estimate of inflation is almost totally oblivious to the price of food going higher due to a drought or ethanol policy, or the higher price of oil due to war or other supply disruptions or the surging gold price due to a highly effective cable TV marketing plan. Those short-term, random and transient phenomenon are insignificant to the market's view of inflation. Gold can go to $10,000 and I would bet interest rates would remain unchanged. I simply doubt that most people that buy long-term bonds purchase bars of gold in their weekly grocery trip.

One popular way to get a market estimate of inflation is to take the difference in yield between 10 year Treasurys and a 10 year TIP. From recent auctions, we can see that on 1/31/2013 a newly issued 10 year TIP had a yield of -0.63% (yes that is a negative yield, TIPs sometimes do that because they are adjusting for the expected CPI adjustment). The 10 year Treasury sold on 2/15/2013 yielded 2.046%.

The Treasury auctioned 10-year inflation-indexed notes at a negative yield for an eighth consecutive time as investors remain skeptical that Federal Reserve measures won't lead to a resurgence in consumer prices.

The difference therefore is 2.046% - -0.63% = 2.676% inflation. Note, the article used different values calculated at different times so their estimate is 2.54%.

The benchmark 10-year yield increased three basis points, or 0.03 percentage point, to 1.94 at 1:08 p.m. New York time, according to Bloomberg Bond Trader prices after climbing six basis points yesterday, the biggest increase since March 7.

The difference in yields between 10-year bonds and TIPS, a gauge of what traders expect for inflation, has risen this year, touching 2.54 percentage points today, up from 2.45 percentage points in January.

That however isn't a market estimate of inflation, that is a market estimate of what the CPI will be. The markets are discounting their expected CPI adjustment, which is different from inflation.

Another way to look at this is by using the Treasury's daily yield curve date. They provide both a nominal and real yield curve. Right now it has the 10 year at 2.13% and the 10 year TIP at -0.07% for an estimated CPI of 2.20%.

Unfortunately there isn't a quick and dirty way to get a clean estimate of the rate the market is discounting for inflation. The problem is there are 5 components of an interest rate, and you have to control for 4 of them in order to get the 5th. To make matters worse, we have the Fed distorting the yield curve with their open market purchases of bonds on the longer end of the yield curve. Because of these complexities, each method has its own problems and errors. Because of this, I tend to define an estimated range of inflation using different methods.

Method #1 is to simply use the TIPs estimate detailed above. Right now the CPI is estimated to be about 2.5%.

Method #2 is to assume 100% of the 10 year Treasury yield is inflation adjustment. That puts the upper end of inflation at about 2.13%. Problem is, we know the Fed is tampering with the 10 year, so another proxy would be the AAA bond yield. The current AAA bond yield is 4.23%, and the historic pre-QE spread between the AAA and the 10 year Treasury is about 1.13%, so the maximum inflation rate using this method is 4.23% - 1.13% = 3.10%.

Method #3, is to work backwards to get inflation using the 5 components listed above. From the yield curve we can see that the nominal 3 month T-Bill risk free rate is 0.05%. The 1 month rate is 0.03%, so on the short end, inflation doesn't seem to factor into the rate, and will be assumed to be 0%. So for component #1, real risk free rate, we will use 0.05%. For component #3 above, default risk, we will assign a 0% because we are using Treasury bonds, leaving us with 0.05% + 0.00% = 0.05%. For component #4, liquidity premium, we will also us 0.00% because we are using Treasury bonds. That results in 0.05% + 0.00% + 0.00% = 0.05%. For component #5, maturity premium, we need to calculate the difference in yields between the years.

Date1 mo3 mo6 mo1 yr2 yr3 yr5 yr7 yr10 yr20 yr30 yr
06/03/130.030.050.080.140.300.501.031.532.132.923.27
1 yr2 yr3 yr5 yr7 yr10 yr20 yr30 yr
0.140.300.501.031.532.132.923.27
Diff0.160.200.530.500.600.790.35
Avg/yr0.160.200.270.250.200.080.04
Step Yrs112231010

The problem this highlights is that the annual steps aren't linear, they are curvilinear, with the steps getting smaller the further out you go on the yield curve. If you sum up all the differences and adjust them for the numbers of years in the steps, you get an average of about 0.096% each year. Because we are dealing with Treasury bonds, that 0.096% includes component # 2, inflation, and #5, maturity premium. The other 3 components have already been accounted for. What that means is that if we take the highest estimate from the above table, and assume a 0% adjustment for maturity premium, then the markets are estimating inflation to be 0.27% at its worst, and will peak sometime between year 3 and year 5.

The table also demonstrates that the markets have very little fear of inflation longer-term, and barely have any adjustment for inflation between years 20 and 30. That doesn't mean inflation won't develop, it only means that right now, the markets simply aren't concerned with inflation, and what inflation they do seem to see is rather mild and in the intermediate term.

In conclusion, there are many ways to measure and define inflation, but there is only one measure that matters to the economy and markets as a whole, that being what the markets expect inflation to be. It is that rate that the "collective mind of the market" uses to value its bonds and other assets. Individual price increases and decreases like what we see in the price of oil are micro issues, and may be relevant to specific industries like trucking and airlines, but are irrelevant on a macro scale as far as the markets are concerned. As the bond prices prove, even with the Fed's distortions, the markets simply don't fear inflation...at least right now.

The broader market, however, is in complete disagreement with the sector of the market that believes gold is the true and only accurate measure of inflation. Gold, at least until it peaked 2 years ago, is/was signaling not only inflation, but high inflation and possible hyperinflation if you watch or listen to Glenn Beck and other cable news channels. The problem is, both can't be right. We will either have inflation or we won't, only time will tell. Personally, while I love Glenn Beck, my money is on the collective mind of the market being correct. The Fed is simply too experienced in fighting inflation, and the markets seem to know that.

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Source: Market Measures Of Inflation And What They Are Saying