What is the best way to ride the inflation wave?
There are some alternatives to hedge against inflation. The best know are buying TIPS (still a good opportunity but with limited upside and pegged to core inflation – a measure that does not include the ever growing food and gasoline), buying gold, or, even better, buying into timber assets, particularly international ones, as in the U.S timber assets are quite possibly overpriced already (look at the multiples at which Plum Creek Timber (PCL) is trading, for example).
In my view, however, the risk/reward calls for more aggressive action: shorting the ten year (or longer maturity) treasury bonds. This could be done through RYDEX INVERSE GOVT LONG BOND STRAT INV [RYJUX], but if you can, I would recommend actual direct shorting of the T-Bonds.
Marc Faber called it the short of the century.
Yields on treasuries across the maturity curve are substantially below the historical averages and although they have widened slightly in recent weeks, are still close to all time lows; therefore, treasury prices are close to all time highs (as yield and price are inversely related).
Let’s look more closely at the risk/reward profile of this trade, which looks great:
10 year treasury yields are at 4.19% (6/23/98); the “real” interest rate according to the treasury department is 1.75%, based on a core inflation rate of 2.44%. This is really not much of real return, so it can’t go down much further, particularly if one considers that if inflation was appropriately measured (more on that below) it would be much higher than 2.44%; the “real” real return is probably close to zero. So the downside is very limited.
The upside comes from the inflationary ball that is building up around the world for a variety of reasons (fuel prices on the rise, food prices on the rise all sorts of commodity prices on the rise) and which Ben Bernanke has greatly amplified in the U.S. due to (in my view) very misguided monetary policies: lowered interest rates (expanding the monetary mass) and the devalued dollar. The devaluation of the dollar further fuels the commodity price run and has an immediate direct impact has imported goods (denominated in other currencies) comprise an important component of the CPI.
It is not hard to imagine inflation reaching high single digits or even double digits; this would naturally lead to a increase in the return demanded by investors in treasuries just to keep their real return a the same level. A 5% percent increase in the yield (which would require a similar increase in long term inflation rate expectations) would lead to a 30% decrease in the value of the 10 year treasuries (3%x10=30%; the change in the price of a bond is roughly equal to the simetric of the change in yield multiplied by the duration of the bond which in the case of treasuries because of their bullet amortization is the same as the term of the bond). Not bad!
I would not recommend to try this at home, but for traders who can sell futures for the 10 year treasuries, and are putting down perhaps 5% of the notional amount, with that leverage the returns could be 6X (of course the downside here would be more meaningful as well).
Now another way to look at the situation and reach similar results, without requiring the same extent of acceleration in reported inflation, would be for investors to stop looking at the “official” core inflation but to realize that in fact “real” inflation has been and is higher. I read somewhere the following funny but insightful comment stating that the situation with the way inflation is measured in the U.S. currently is a little bit like parents who invent Santa Claus stories for their kids but over time end up believing in them themselves!
Bill Gross’ [PIMCO] June investment outlook newsletter has some interesting insights on inflation figures in the U.S. Some of the key changes that have been made over time on how inflation is measured and monitored in the U.S. which have had a moderating impact including:
- Replacing house purchase prices for owners’ equivalent rent (this got ride of the rampant house price inflation in the last 10 years or so, although current it would have deflationary impact).
- Including adjustments in the weighting of the CPI to take into account substitution effects. i.e. if chicken prices increase and turkey prices don't, I will reduce my consumption of chicken and increase my consumption of turkey.
- Including adjustments to take into account increases in the quality of products overt time. i.e. the computer I bought today may cost the same as the one I bought five years ago, but the cost per MB has decreased a lot. Actually, 46% of the CPI comprises products durable goods and others subject to hedonic adjustments, even textbooks!
- Introduction of a distinct concept of core inflation and headline inflation where the first excludes food and gas. Core inflation is relevant to monetary policy makers in that it excludes items which often have temporary fluctuations.
The slight problem with these is that oil and gas prices have been steadly going up for the last six years, so there is nothing temporary about it. Most other countries do not use these “sophisticated” methods, although one country is now revising its methodology to include some of these - Argentina, whose government is suspected of having manipulated their inflation figures for a while with unofficial estimates of inflation running at about twice the official figures (most forecasters expect inflation in Argentina to raise by 25-30 pct).
Bill Gross estimated a while back in 2005 that without the quality and substitution effect inflation in the last decade or so would have been about 1% higher and real GDP growth 1% lower. Also, consider that headline inflation has been running at least 1% higher than core inflation for several months/years; add these up and you are talking about a real difference!
Disclosure: Author holds short positions in T-Bonds
