The Way Out: Why Inflation Will Be Higher Than Market Expects

|
 |  Includes: TBT, TIP, TLT
by: Jonathan Tunney, CFA

For a corporation, there is a financial condition which is quite simply the “point of no return.” This is the point where existing liabilities become so large that the service of these liabilities overwhelms the income statement and the entity enters into a downward spiral of even greater liabilities. Eventually, the entity has no choice but to stop servicing its liabilities and enter into the inevitable default.

This, in fact, is the conundrum with which the federal government will have to contend in the not-too-distant future as it faces unprecedented deficits. The increase in the debt of the US as a percentage of GDP over the last few years is alarming, however it is nowhere near as alarming as what is to come. But as bleak as the fiscal future of the world’s largest economy may seem, there are simple ways to hedge against and/or profit from an inflationary resurgence which, while inevitable over the long term, is largely unpredicted by current financial markets.

UNSUSTAINABLE EXPENDITURES

Even before the passage of the most recent healthcare legislation, the amount of GDP spent on entitlement programs is forecast to increase from 15% today to over 80% of GDP by the year 2060 (90% of this spending will be on health care).

This level of expenditure is simply unsustainable. And when something simply cannot be sustained, it isn’t. What are the policy options with which the US may address this problem? Quite simply there are three:

1) Raise taxes

2) Reduce spending

3) Default

4) Monetize its liabilities

Let's address each possibility individually

The prospect of raising taxes – while there is a small minority of those in government who truly understand this dynamic, higher tax rates do NOT equate to high revenue for the government. At the margin this may be true but raise tax rates to high enough marginal levels, and the incentive to work is diminished more than the incremental tax rates achieve in revenue.

During the Reagan administration, the most substantial change was in the tax code, where the top marginal individual income tax rate fell from 70% to 28%. But federal receipts actually grew at an average rate of 8.2% (2.5% attributed to higher Social Security receipts) during Reaganomics, while outlays grew at an annual rate of 7.1%. Quite simply, raising taxes will address the deficit problem only marginally.

The prospect of reducing spending – the unfortunate reality of today’s political landscape is that nobody wants to make the tough choices. It is far easier to simply kick the can down the road and leave it to be addressed by someone else. Only by a major crisis will the type of spending reform necessary be brought to pass. While long term this remains the only true viable option, in the medium and short term the prospect of addressing government spending is simply not feasible.

The prospect of default – the sovereign defaults that have been a part of our recent history, Russia, Argentina, etc. arose from countries who had borrowed in a currency that was not their own (US dollars). This is because there was no international market for debt denominated in their own currency so they borrowed in dollars and were unable to pay it back. It is an entirely different situation when you own the right to print money to service your debts, such as the United States does. The only reason for a default would be that you couldn’t afford the ink and paper to print more money.

The prospect of monetizing our debt – “monetizing” debt is just a fancy term for reducing our debt burden, in real terms, by introducing inflation into the economy. Without question this is the only viable method of addressing our debt burden longer term. For every year during which inflation runs at 10%, the real value of our liabilities is reduced by the equivalent amount. Ben Bernake knows this as well any anyone. He also knows that the mistake made by his predecessors during the Great Depression is that they raised interest rates too early. Japan also made the mistake of raising rates too early in the aftermath of its 1990 depression. There is not an example in modern history of when an industrialized nation in our situation has kept rates too low for too long from which Mr. Bernanke can draw his conclusions. Given the positive effect of inflation on the US debt, the Fed will effectively address two issues by not raising rates. In fact, inflation, in and of itself is not an unmanageable aspect of economic growth. The reality is that unexpected inflation is far more harmful to businesses because it introduces uncertainly into the business planning process. If business can count on a period of inflation being 10% per year for a certain period of time, they can address spending, pricing and other processes to address this.

THE WAY OUT FROM HERE

If you agree with our conclusions, what is the most effective inflation trade to take advantage of this?

First let’s look at what is currently priced in for inflation today:

click to enlarge

TIPS breakevens and implied inflation rates. source: BloombergClick to enlarge

This chart shows the difference in yields between nominal government bonds and inflation-protected government bonds by maturity. The difference between the two yields represents the market's estimation of annualized inflation over that time period (or a “breakeven,” in market lingo). By using simple bond math, one can deduce the spot rate of inflation over the given time period. The conclusion of this exercise is that the market does not predict inflation at any elevated levels over this time period. This may be correct on the short end, but not on the long end.

What is inflation? Far too many people take “inflation” as simply a face value number without understanding the mechanics behind it. Inflation (as measured by the ‘Consumer Price Index’ or ‘CPI’) is the price of a basket of goods that can be measured and priced in different areas of the country. Most people don’t realize that the single biggest “item” in the inflation calculation is something called “owner equivalent rent” at 25.2% of the calculation. This measure is largely a measure of, you guessed it, housing prices. So while the continued malaise in the housing market may keep down the CPI number for a certain period of time, the recovery of the housing market is inevitable in the 10-20 year timeframe, if not sooner. However, the level of inflation is actually forecast to decrease in 20-30 years.

There are lots of folks that would recommend foreign currencies, commodities, real estate, etc as the ‘trade’ to address the coming inflationary environment, but there is a much simpler (and more cost-effective) approach. The most simple and relevant “breakeven” trade would involve overlaying the timing of the liabilities for the United States and its entitlement programs vs. the implied inflation rates on the chart above, noting that the biggest gap is on the far end of the curve. Simply purchase the 20 – 30 year government inflation-protected security and “short” the nominal government bond with treasury futures contracts, capturing the economics of a mispriced 30-year inflation spot rate of 2.91%.

There are plenty of people in the financial services industry who will attempt to “dress up” this trade into something that they can make a killing on (performance fee, hidden management fee) but the trade ultimately comes down to the relatively simple transaction described above.

Disclosure: Long TIPS, short Treasuries