The Rise of Inflation Premiums

We are not alone in believing that the seeds of long-term inflation were sown, nicely watered and nurtured by the recent massive cash injection to the US economy.

Others have been quite vocal in declaring that the we are quite wrong; they are certain that deflationary conditions will abound.

We are happy to be proved wrong, but simply cannot see any fundamental or technical deflationary indicators. This article will provide a quick overview of one of our favourite tools used to determine inflation/deflation.

In this exercise we compare the performance of inflation-protected bond mutual funds relative to the US 10 year. The TIPS relative to the US 10 year could also be used. For the purpose of this exercise we have chosed mutal fund performance as this does tend to iron out some volatility. We then compare the results of this test against commodity trends.

What we have below is two of the bigger inflation-protected mutal bond funds relative to the US 10 year, ACITX and VAIPX. If we can see outperformance on the part of the inflation-protected side of things, then we have a reasonably clear indication that there is a rising expectation of inflation, measured by the increasing premium.

Unsuprisingly, the top two charts are almost identical, with both reaching multi-week highs recently. They are also showind a very consistent rising trend as of December last year.

Keep in mind how the bottom chart (GSG) has an almost mirror-like appearance, albeit with an offset of around 3 months. The bond market does tend to be more efficient, so you can use the behaviour of inflation-protected bonds as clues to the likely future commodities performance.

Mr Deflation did pop around for sherry and cake, but it seems the market told him..

"Could you close the door, please? No, from the other side." (Gil Grissom - CSI)

We are listening to the market and have positioned our trades accordingly.

Disclosure: Long TIP, DBC, SLV

Comments

[Steve in TN:]

Please remove Cetin (aka Rhodes Scholar)!

Aug 27 11:41 AM

[Larry House:]

"Expectations" do not prove the point. I agree with your main idea, and I have used ACITX in the past. We don't have the key ingredient for inflation--full employment and rising wage pressures. It is hard to have inflation with 10% unemployment and 20% unused production capacity. Consumers are not ardent at the moment. If they don't like the price, they just won't buy. How many retailers are making huge discounts to get people into the stores to spend a little? We may have an inflation problem down the road (meaning years), but it is not here now. It is okay to hold TIPS, but don't think they are going to pay off right away.

Aug 27 11:50 AM

[squark62:]

larry great points. what is more likely? high inflation as you describe it in your scenario or the U.S. falling into a developing economy (third world) inflation scenario e.g. zimbabwe? more than likely the yours than the latter. however, don't be surprised that many will shout out the zimbabwe boogy man scenario for ratings.


On Aug 27 11:50 AM Larry House wrote:

> "Expectations" do not prove the point. I agree with your main idea,
> and I have used ACITX in the past. We don't have the key ingredient
> for inflation--full employment and rising wage pressures. It is
> hard to have inflation with 10% unemployment and 20% unused production
> capacity. Consumers are not ardent at the moment. If they don't
> like the price, they just won't buy. How many retailers are making
> huge discounts to get people into the stores to spend a little?
> We may have an inflation problem down the road (meaning years), but
> it is not here now. It is okay to hold TIPS, but don't think they
> are going to pay off right away.

Aug 27 12:01 PM

[Erwan Mahe:]

Looking at the TIPS market to predict thoutcome of the inflation/defaltion debate seems to me like the tail chasing the dog ! If that is your only argument to prove your point, it seems a little short. By this method, because TIPS are rising you "position your trades accordingly" ?
That means that you would have sold them short like crazy and loaded instead on 30 Years bonds in december 2008, when these securities were pricing (so anticipating with a high degree of certainty according to dog tail your theory) the imminent manic episode of deflation ?
I am sure and hope you did not do that, as it appears clearly that your belief in the inflation scare is more the consequence of a fondamental-psychological belief (Austrian School maybe ?) than of any clear macroeconomical analysis.
If you have a minute to spare, have a look at my paper on this subject ('What risks are really keeping central bankers up at night?')that should be published later tonight (french time here).
I will kindly take into account any observation you shall make.
Best regards.

Aug 27 01:09 PM

[Andy1234:]

Inflation is just the increase in money supply.

If the economy is contracting in output....and the same amount of money is in the system....the result is further inflation as GDP has contracted.


The best analogy I have heard for inflation goes something like this.


Glass = size of the economy
Water = money in that economy


Let's say you take a snapshot of the economy and at that time the economy is a glass. The glass is half full of water (money).

Now.....let's determine ways to create inflation in this economy.

In order for inflation to be created...only TWO possible things can occur to result in inflation.

1) Water is added to the cup.
2) The size of the glass shrinks.

Vice versa for deflation.
1) Water is taken away from the cup.
2) The size of the glass gets larger.


I think whats happening now....is the government is injecting crap loads of money into banks.....but the money is not being loaned out....and people are paying the debts down....decreasing the real money supply in circulation.


as a result......prices need to come down for the market to clear.

You can also tilt the glass and have money flow from one sector to another....but jobs will be shifted from one sector to another if the shift is large enough. It will not result in higher inflation across the board....because the money supply (water) remained the same.

A lot of people say Higher oil prices create inflation. It does not create inflaton....it simply is a result of money printing....or demand/supply issues. It cannot create inflation. If you think it can....please explain to me...how it can.

Aug 27 01:21 PM

[GMiki1:]

I think inflation will be the eventual outome once the velocity of money increases. That's my best guess. However and regardless, we will get price increases in commodities due to supply issues--we're competing with wealthier countries (China) for supply. The low volume of trading leading to a higher market right now isn't a good sign for sustained market growth.

Aug 27 02:30 PM

[JeffDB:]

From your article, however, seekingalpha.com/insta... it sounds like you think deflation is the biggest threat at the moment, in which case you would be in favor of investing in longer term bonds?

On Aug 27 01:09 PM Erwan Mahe wrote:

> By this method, because TIPS are rising you "position your trades accordingly" ?

That means that you would have sold them short like crazy and loaded instead on 30 Years bonds in december 2008, when these securities were pricing (so anticipating with a high degree of certainty according to dog tail your theory) the imminent manic episode of deflation ?
I am sure and hope you did not do that, as it appears clearly that your belief in the inflation scare is more the consequence of a fondamental-psychological belief (Austrian School maybe ?) than of any clear macroeconomical analysis.?

> If you have a minute to spare, have a look at my paper on this subject
> ('What risks are really keeping central bankers up at night?')that
> should be published later tonight (french time here).
> I will kindly take into account any observation you shall make.

>Best regards.

Aug 27 05:11 PM

[Erwan Mahe:]

yes indeed, structurally, but no so much as a certitude of deflation as a cdertitude of the absence of (hyper) inflation.
Anyway I would really advise, for those who did not buy some bonds earlier these last 2 months, to wait for a pullback.
The persisting rise in risky assets should create some better opportunities (lower bond prices) to enter this asset class...

Aug 27 05:40 PM

[chap08:]

Larry, full employment and wage pressures are not the key ingredients of inflation. They are the key ingredients in causing an inflationary spiral - when they are present, it makes inflation difficult to stop. But their absence does not mean that inflation can't appear. Inflation can and will appear because the Fed will ensure that it does. If the Fed wanted to, it could recreate Zimbabwe. It obviously doesn't want that, but it will give enough of the same (well, very similar) juice to ensure that there is more inflation than deflation.


On Aug 27 11:50 AM Larry House wrote:

> "Expectations" do not prove the point. I agree with your main idea,
> and I have used ACITX in the past. We don't have the key ingredient
> for inflation--full employment and rising wage pressures. It is
> hard to have inflation with 10% unemployment and 20% unused production
> capacity. Consumers are not ardent at the moment. If they don't
> like the price, they just won't buy. How many retailers are making
> huge discounts to get people into the stores to spend a little?
> We may have an inflation problem down the road (meaning years), but
> it is not here now. It is okay to hold TIPS, but don't think they
> are going to pay off right away.

Aug 27 06:58 PM

[JeffDB:]

On Aug 27 05:40 PM Erwan Mahe wrote:

> yes indeed, structurally, but no so much as a certitude of deflation
> as a cdertitude of the absence of (hyper) inflation.
> Anyway I would really advise, for those who did not buy some bonds
> earlier these last 2 months, to wait for a pullback.
> The persisting rise in risky assets should create some better opportunities
> (lower bond prices) to enter this asset class...

But that certitude of the absence of (hyper)inflation is predicated on the current low velocity of money, correct? It would seem to me that if things begin to pick up a little, as seems to be likely, and confidence returns that velocity could pick up rather rapidly.

Were that to happen, would the central banks then not be required to reduce the supply of money rather rapidly? Would that not be a tough thing to do politically, and would it not pose a risk to a nascent recovery?

I believe the U.S. & Great Britain, at least, have some pretty large deficits to contend with which would make reducing the money supply to soak up the excess that has been pumped in more difficult and a lot more painful, or at least it would seem so to me.

P.S. How does "the persisting rise in risky assets" cause a drop in bond prices? Are the risky assets you are speaking of the bonds themselves? Sorry if I'm being a little obtuse here, I'm just not sure of the mechanism of how that would work.

Thank you.

Aug 27 08:28 PM

[Andy1234:]

I personally don't think the fed can raise interest rates because of multiple reasons.

1) The interest on their short term interest rates would be HUGE...this would lead to massive money printing just to cover the interest on the debt.
2) House prices would tank yet again....as interest rates would need to rise in order for the velocity of money to be slowed down and saved.
3) The two above would slow growth of the economy or kill the economy......I don't know how the fed can balance a bubble forever.


We currently have malinvestment everywhere.....at some point these malinvestment need to be cleaned.....and the way the government is choosing technologies to invest in, and what not to invest in, and the rules/regulations they set through policy will create massive distortions....once that low interest rates will not be able to resolve.

What we need to do is deregulate in real terms. Remove all regulations and let companies fail who are incompetant.....that ultimately is the regulation...being able to survive. Remove all government scholarships, grants, etc. Remove regulation and paperwork on the health care side etc. We should see prices come down dramitically. Prices still continue to drop with operations that are selective....like lasic eye surgery and cosmetic surgery.

Central planning does not work.....we need the free market to do it. And we need to slowly get ourselves away from government. Just MO.



On Aug 27 08:28 PM JeffDB wrote:

> On Aug 27 05:40 PM Erwan Mahe wrote:

Aug 28 08:36 AM

[Erwan Mahe:]

dear jeffdb,
if the velocity of money comes back, the central bankers, who did a hard job the last 30 years (FED, BoE and ECB-ex BUBA) to earn their inflation fighter reputation, will be able to reduce the mass of money in circulation rather easily, as it will ab neutral for the economy as a whole. When you follow the M*V=P*Q equation, you can see that we suffered a dramatic fall in V (velocity) because of the "death of the securitisation" (may-june 07 with Bear Stearns CDO HF implosion). This has been automatically followed by a quick drop in Q (industrial orders for example) and P (as described by CPI, PPI and every prices indexes).
Thanks to their knowledge of the mistakes of the Big Depression and of the japanese (2) Lost Decades, the Central banks have violently tried to prevent this phenomenon to transform itself into a deadly deflationist spiral, putting rates to the 0% bound when feasible, and creating money through the Quantitative Easing Process.
If velocity picks up, with a restart of the securitisation, and this is what the ECB intends to do by putting a floor on the Covered Bond markets in Europe, we may see a temporay minimum rise in inflation, waiting for the exit strategies to work their way.
But you may be sure that, and in Europe that is a given knowing the religious anti inflationnist stance of the ECB, that they will not wait for unemployement to come back to more sustainables levels before taking the punch ball away.
But you may notice that there is no real emergency, as we can see in Europe that the M3 index rate of growth is constantly decreasing, to a mere annual 3% last month, so way below the ECB confort zone. And as long as loans growth remains subdued, no velocity on the horizon !
PS : the rose in risky assets I am refering to is the one of equities, commodities, corporate bonds, and this may lessen the attraction of Governments Bonds (safe haven process), because of a typical Panurgian Process. Personally, I will never short Governements bonds as long as the risk of a deflationnist burst is still so present, but everybody is free. cheers.


On Aug 27 08:28 PM JeffDB wrote:

> On Aug 27 05:40 PM Erwan Mahe wrote:

Aug 29 01:21 PM