One recurring theme in my analysis of recent Fed and ECB policy has been that investors should begin positioning for rising inflation expectations by allocating a greater percentage of their portfolios to gold. As noted by economist William White in the context of the Fed's asset purchases and by Goldman Sachs in a discussion of TARGET2 and its effect on the collective psychology of the German public, people's inflation expectations can become self-fulfilling if they begin to influence economic decisions.
Now, with many market participants expecting the Fed to announce a third round of easing either this week or at the latest, in December, inflation expectations are indeed climbing. In August, the University of Michigan's consumer sentiment survey showed both short and long term inflation expectations rising -- one-year inflation expectations hit a 5 month high of 3.6.
Similarly, the 10-year breakeven rate (the difference between nominal 10-year Treasury bonds and 10-year TIPS) rose to a 5 month high of 2.40% this week, signaling that traders believe prices are set to increase. Similarly, the 5-year breakeven rate rose to a 3 month high this week at 2.02%. Investors may recall that on August 23, an auction of 5-year Treasury Inflation Protected Securities drew a record low yield of -1.286% signaling voracious appetite for the securities whose holders enjoy a principal adjustment inline with the rise in the Consumer Price Index (CPI). All of this adds up to one thing according to an interest rate strategist quoted by Reuters:
"Of the possible consequences of what the Fed could do, the market is focusing only on the most negative one. The prospect of increasing inflation expectations."
For its part, Citigroup notes that in contrast to the environment that existed when previous iterations of QE were announced, there are few attractive options in terms of investment currently. The bank notes that emerging markets are far less attractive now and predicts that
"...new liquidity [will] slosh around the banking system rather than being used for investment abroad."
This prediction, combined with the bank's observation that persistent asset purchases are succumbing to the law of marginal utility, leads the bank to recommend that investors position in
"...assets that [are] sensitive to liquidity, such as money substitutes and Treasuries, rather than assets that are sensitive to real business cycle expansion."
Of course, by 'money substitutes' the bank means gold. I am inclined to agree. Investors should heed Citi's advice and read the writing on the wall in terms of rising inflation expectations. I recommend adding to holdings of gold to hedge against the risk that people's expectations do indeed become self-fulfilling causing prices to rise.