The focus of this article is inflation and its role as a determinant to the ending of quantitative easing (QE). The Federal Reserve has been running its QE programs for the past five years and interest rates have been near zero for the past four years. The latest round of QE has the Federal Reserve buying $85 billion in bonds every month. The Federal Reserve cannot support the economy forever through monetary easing though, and interest rates will eventually have to rise.
On June 19, 2013, Federal Reserve chairman, Ben Bernanke, announced a possible slow down to the quantitative easing program as well as plans to end the bond-buying program in September 2014. The exact timing will be determined by the state of the economy. Before completely ending the program, the Federal Reserve set targets for unemployment (6.5%) and inflation (2-2.5%). Interestingly, we've been in a disinflationary period. Inflation peaked at 3.9% in 2011, but has been trending downward since. As of May 2013, the inflation rate is at 1.4%. It makes sense that the economy is at a safe point before ending QE, as the next step would be to raise interest rates. The Fed does not want to be in a situation in which they are raising interest rates while going through disinflation, or worst, deflation. That could be cataclysmic for the economy and markets.
The Fed's announcement of their plans to slowdown the bond-buying program has made markets uneasy. Gold (GLD), oil (USO) (UCO), and Treasury securities (TIP) have all been in play. A lot of this is tied to the end of QE. The long-term trend in each of these assets will be tied to the direction of inflation. Each one historically has a strong relationship with inflation.
First, let us take a look at gold. Gold has always been seen as an inflation hedge and a safe haven asset. Historically, investors will buy gold whenever there is instability in the market or economy. More specifically, whenever there is a banking crisis, investors lose trust in currencies and stocks and prefer to own gold. Gold is used and accepted globally as storage of value especially in times of crisis, since it provides investors a real asset with real value, to protect their wealth. Gold is a hedge against inflation; it does not lose its purchasing power as inflation climbs. When inflation rises, the purchasing power of the dollar decreases, having a negative impact on the economy.
Over the past several years, gold has been a great performer, due to the financial crisis and European Debt Crisis. Gold has gone from roughly $700/oz., at the beginning of the financial crisis in 2007, and peaked at $1,911.40 /oz. in October of 2011. Since then, gold has been on a steep decline, most recently trading at $1,222 on July 6, 2013. All of this is leaving many people asking what exactly happened to the price of gold in recent times. Concurrently, inflation also peaked in October of 2011 at 3.9% and as mentioned prior, the inflation rate has been on the gradual decline. Below are charts on gold and the inflation rate dating back to January 2011.
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Oil is a leading indicator for inflation. The relationship between the two stems from oil being such a large input in the economy. As oil prices increase, we can expect inflation to follow the same trend. Below we have two interesting charts on oil. The first is a 1-year daily chart on oil. We can see that oil has been trading between $83 and $100 per barrel since last July. Oil prices recently broke out of this range because of the political events in Egypt. Investors are worried that the crisis in Egypt can have an effect on the Suez Canal, one of the world's largest shipping lanes, which is located in eastern Egypt. Roughly 2 million barrels of oil is shipped daily into the rest of the world through the Suez Canal. A disruption in the Suez Canal could slow down the transportation of oil from the Middle East. The second chart shows us the relationship between oil and inflation dating back to 1997. We can see inflation moves in tandem with oil, but last month the prices have started to diverge. Since June, oil prices have been increasing and inflation has been trending the opposite direction. This economic dissonance exposes an obvious mispricing in the market, making for a profitable opportunity. Based on the historical relationship of oil and inflation, we can assume inflation would have to reverse its trend to increase alongside oil.
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Lastly, I want to touch upon a special type of Treasury security called TIPS (Treasury inflation protected securities). In 1997, the government responded to investors who wanted an inflation-protected security and designed TIPS. A rise in inflation has a negative effect on bonds, so investors were looking for an alternative. TIPS are exactly like bonds except its value is tied to the Consumer Price Index (CPI). If the CPI increases by 2%, the value of TIPS increases by 2%, and vice versa. This is a great tool for investors seeking a pure inflation hedge.
I believe we are in a macro environment. This is not a market to focus on picking stocks, but rather on assets that are being affected by events at a macro-economic level. Traders and investors from around the world are anticipating what the Fed's next move will be. For certain we know the next move will be ending QE, but how fast it is executed is going to be based heavily on inflation rates. I'm sure there are other ways to play inflation, but gold, oil, and TIPS have a strong relationship with inflation and we can expect to see aggressive price movements in each of these markets.
Going forward you want to mark your calendar for these dates
• Friday August 2, 8:30 am - Core Personal Consumer Expenditures
• Wednesday August 14, 8:30 am - Core Producer Price Index
• Thursday August 15, 8:30 am - Core Consumer Price Index
• Friday August 30, 8:30 am - Core Personal Consumer Expenditures
These are the dates for inflation numbers before the Federal Reserve meeting and announcement on September 17-18.
Rising inflation rates should have a negative effect on the market (SPY). As the Fed moves closer to its target, they will be getting closer to ending QE. Falling inflation rates will signal the Fed to continue QE, having a positive impact on the market. Each of the assets discussed above should move with the inflation rate except for oil. Short term, the political unrest in the Middle East could possibly send oil in a different direction than expected. Be sure to pay close attention to the numbers going forward and good luck with the market.