Of Smart Funds and Long Bonds

Further to my last post which shows that smart funds are long the commodity trade (inflation) and long the US long bond trade (dis-inflation), a further word of explanation seems to be in order. I believe that the key macro view underpinning this position is:

• The secular trend is for more inflation and official inflation rate is understated
• The cyclical trend is for inflation to fall, setting up for a rally in the bond market

Official inflation rate understated

The Fed focuses on core inflation and that statistic has been consistently lower than the other measures of inflation. The chart below shows the progression of headline CPI, core CPI, or CPI ex-food and energy, and PPI.

As the chart shows, core CPI is consistently lower than the other measures of inflation. PPI, or one, is more sensitive to commodity prices, which has been rising. Moreover, PPI has none of the hedonic and other adjustments that the CPI has from the recomendations of the Boskin Commission. Others have also commented that even the headline CPI has problems and doesn’t reflect true changes in the cost of living.

Even if you were to focus on one of Greenspan’s favorite indicators of inflation, PCE, the Dallas Fed’s measure of trimmed mean PCE seems to be consistently higher than core PCE.

Inflationary pressures cyclically easing
Recently, there have been abundant signs that the economy is weakening. The latest Beige Book report indicates sluggish growth. Reconstituted M3 growth is falling off a cliff. Various Fed officials have been signaling that inflationary pressures are easing and therefore the pressure to hike interest rates are lessening. In response to these signals the bond market has responded and the spread between TIPS and the 10-year Treasury are in retreat.

What does an investor do?

Mutual funds tend to have longer term time horizons than the average swing trader. Smart funds have been saying: “We are not fooled by the official inflation rate and our long term view is for inflation to stay high. In the short term, however, the weak economy is going result in a bond market rally.”

One of the keys to spotting a bottom to the US equity market will be to watch for smart funds to switch their stance on the long bond.

Comments

[User 143167:]

Inflation is not dying, we are in another 1974 when everyone thought the Fed should lower the rates with the inflation going down to save the economy, however, you know what they ended up with.

2008 Sep 08 12:24 PM

[whidbey:]

Surely you know that the little bail out we saw over the week end is inflationary? If not, think it over again since inflation is inevitable given the money that must be printed to fix/fund the options given the miscreants. I like tips here since the inflation comes before the deflation, which is Act 3. I think bonds is where the action will be for some time, after we short this fall decline in equities.

2008 Sep 08 05:29 PM

[nym:]

There are 5-year cyclical trends and there are longer ones. As 'user' points out, in the 70's we had 'stagnation' and inflation simultaneous. One factor was a large increase in the price of petroleum. Another was LBJ's 'guns' AND 'butter' policy of deficit spending, reminiscent of what we have had since the Reagan era. One solution is indeed inflation, which is a net transfer of wealth from savers to borrowers. I hope you enjoyed your tax rebate: where do you think the money came from?

2008 Sep 10 10:43 AM