Inflation Expectations and the Price of Hedges

Gold briefly traded over $1,000 an ounce, while CPI inflation as embedded in the spread between TIPS and Treasury coupons actually fell slightly. Why should there be a divergence between two measures that in one way or another reflect inflation expectations?

TIPS-Coupons Spread for 5 Year Constant Maturity

Source: St. Louis Fed

The answer is that gold and TIPS play very different functions. Gold is an end of the world hedge; as a portfolio asset it costs money to own (vault storage, insurance) and has no legal standing. It only comes into play as an asset in the still-unlikely event that the dollar breaks down as a reserve currency and no combination of other currencies can be found that can substitute for the dollar.

Its peak in real terms came with the Soviet invasion Afghanistan over Christmas 1979, when the world considered the possibility that American power would collapse and with it the reserve role of the dollar.

I just spent two weeks in the Far East talking to a variety of financial types (although the main purpose of my trip was unrelated to finance). Everyone is sick of the dollar as a reserve currency; everyone foresees a diminution of American power under the Obama administration; and no-one has a clue what alternative might present itself to the dollar.

As I indicated in my last post before leaving, the desirability of American assets depends on their price in a basket of other currencies. A cheaper dollar reprices domestic tradeable assets, e.g., equities, to a world level which no longer is measured in dollars. There is a nearly one-for-one relationship between the value of the dollar index and the price of the US equities index. That, as I observed earlier, is how a banana republic equity market trades.

That does not necessarily imply a great deal of domestic inflation in CPI terms. Most US prices are non-tradeables and reflect first of all the cost of labor. Given 10% (in fact much higher) unemployment as well as the likely increase in the labor force participation rate due to seniors who find themselves unable to retire, labor costs are likely to remain subdued. Higher prices for international tradables won’t have quite the same impact on the CPI index.

That is why five-year CPI inflation embodied in TIPS-Coupon spreads is hovering just over 1% despite the devaluation of the dollar and the corresponding rise in commodity prices. As I have been saying for months, the best inflation hedges are international tradeables rather than TIPS. Gold is a particularly volatile hedge, because it reflects not only the value of the dollar, but the price of insurance against the prospect that the dollar reserve arrangement will collapse.

That is unlikely, to be sure, but if it were to happen, there is no reason why the gold price might not rise by some arbitrarily large margin. That is why the gold price, strictly speaking, is reckoned as an option against the end of the world.

Over time, China will attempt to trade $2 trillion worth of Treasury securities for $2 trillion of production inputs. In this order, China’s priorities are food, food, food, energy, food, iron ore, food, copper, food, and food again.

As an Asian growth play, I continue to look at production inputs into food. That probably explains why fertilizer companies are among the year’s best performers.

Comments

[User 143167:]

In a slavery economic system, you can keep the labor cost low and stable almost for ever as long as slaves are enough. So according to your logic, its government will never face the problem of inflation right? However, the history never suggested so.
So I think inflation or even hyperinflaiton can actually emerge with labors negotiation power being very low.

Sep 10 01:33 PM

[donbruce:]

Tips i can see are not ideal, what about the WIP option...?

Sep 11 07:13 PM