Bernanke's Choices On Friday - Inflation Or Recession

Includes: IEF, TIP, XLB, XLE, XLI
by: Option Millionaires

This week, investors are eagerly, and nervously awaiting Ben Bernanke's speech in Jackson Hole, Wyoming on Friday. With the market continuing its slow crawl up, it seems that investors are expecting some sort of further easing. Last week, markets focused on a letter from Bernanke to Congressman Darrell Issa. Specifically the quote:

"There is scope for further action by the Federal Reserve to ease financial conditions and strengthen the recovery."

That was following the news from two days earlier from the FOMC minutes that suggested that if the economy continues to slow, the Fed will take further action. However, what would the effect of further easing be?

In a past article, I mentioned that the Fed, while not blatantly stating it to the public, had limited options. This was due to the fact that expected inflation was relatively high. I used this chart of the TIP ETF (NYSEARCA:TIP) divided by the 10 year Treasury ETF (NYSEARCA:IEF).

(Click to enlarge)

Since then, thanks to a combination of Iranian turmoil, national drought, and further speculation of monetary easing, expected inflation is even higher now; specifically about 1% higher measured by this metric. To make matters worse, indicators are also beginning to show the U.S. economy slowing.

For the technicians out there, there is another indicator that shows that inflation expectations are high and real inflation may soon follow. Here I plot the 8 week momentum of both expected inflation (5 yr. Treasury - 5 yr. TIP yield) in blue and the inflation rate as measured by the CPI in purple.

(Click to enlarge)

Things to note

  • Momentum of inflation expectations bottoms first, therefore actual inflation is a lagging measure.
  • Inflation tends to bottom around a -0.02 momentum value and tops around 0.02. It has just bounced off the lower 0.02 level.
  • Expectations just crossed the 0 level, meaning that inflation expectations are now on the rise.

Therefore, I emphasize the same warning as the past article. At this point, Bernanke has two choices, inflation or recession. The current market sees inflation as a threat and inflation expectations can eventually create real inflation, especially if given another inflationary policy. A new easing program, if initiated now, would have to either be of a very short duration or be accompanied by a higher inflation target range.

Unfortunately, inflation, if history has taught us anything, eventually slaughters any bull market, but not immediately. Initially, an easing program would raise stock prices, however, only due to inflationary growth and not earnings growth. Which sectors would be the winners of a last, inflationary bull surge? Materials (NYSEARCA:XLB), energy (NYSEARCA:XLE), industrials (NYSEARCA:XLI), and perhaps mining. After that, bad news bulls.

Disclosure: I am short XLB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.