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Hedging A Transitory Rise In Inflation

Jul. 18, 2020 2:10 PM ET5 Comments
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Eric Basmajian is an economic cycle analyst and the Founder of EPB Macro Research, an economics-based research firm focusing on inflection points in economic growth and the impact on asset prices.

Prior to EPB Macro Research, Eric worked on the buy-side of the financial sector as an analyst at Panorama Partners, a quantitative hedge fund specializing in equity derivatives. 

Eric holds a Bachelor’s degree in economics from New York University.

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  • The economy continues to recover from the forced shutdowns earlier in the year.
  • Both growth and inflation indicators are rising in the short-run.
  • The rise in growth and inflation will soon collide with the long-term forces that are keeping a lid on growth and inflation, but the transitory rise should be respected nonetheless.
  • It is most probable given the long-term forces that the current rise in growth and inflation expectations proves short-lived and entirely correlated to an expected pent-up demand rebound from the forced shutdowns.

[Weekend Dashboard] Hedging A Transitory Rise In Inflation

Despite the temporary rise in growth and inflation indicators, the rates market is projecting that the Fed funds rate will remain at or below the current 0.10% for the next three years.

This partially explains the lack of volatility in the belly of the Treasury curve. Regardless of short-term fluctuations in growth around temporary stimulus bills, the overnight policy rate will remain firm at the zero-lower-bound "ZLB."

Forward Market Implied Policy Rates:Source: Bloomberg

The same situation is forecast by the rates market in most developed economies such as Europe, the United Kingdom, Switzerland, Japan, and more.

Developed economies are too overindebted at both the public and private levels to sustain interest rates above the ZLB, and the market is coming to grips with that reality.

After the 2008 crisis, it took almost nine years to close the deflationary output gap and seven years for the overnight rate to lift off the ZLB. Overnight interest rates did not move above 1% for 8.5 years, and the return trip from 0%, up to 2.25%, and back to 0% took roughly 4.25 years.

With an economy significantly more overindebted, a base case assumption is that policymakers will have to take a less aggressive, not more aggressive, schedule in moving overnight interest rates.

This assumption suggests a decade or more at the ZLB is a distinct possibility, an outcome that is being priced in through the belly of the Treasury curve.

International 5Y5Y Forward Inflation Swap:Source: Bloomberg, EPB Macro Research

As a result, despite a rise in inflation expectations seen across most regions, government bond yields remain depressed and rangebound.

Globally, government bond markets are starting to look more and more like Japan as the market comes to realize that moving off the ZLB is a low probability outcome.

Real GDP growth is a proxy on the average rate of return in the economy for your mid-range risk. If the overnight policy rate is 0% and expected to be 0% for the next 5-years, and the annualized rate of real GDP growth is roughly 1%, the real risk-free rate must be lower than the mid-range risk on an economic investment. Thus, negative real interest rates prevail across the entire curve.

The risk for real interest rates is that inflation expectations turn back lower as the economic improvements run into the structural ceiling of debt and productivity. Nominal interest rates have little room to fall without piercing the ZLB before a decline in inflation expectations starts to put upward pressure on the real rate.

US Treasury Rates

After topping out in June, the Treasury curve has started to flatten again over the past month, with long-term rates falling roughly 20bps.

Monthly Change In Treasury Yields:Source: Bloomberg, EPB Macro Research

In line with commodity prices rising, inflation expectations have ticked up across the Treasury curve. Real rates have been the dominant force keeping Treasury rates down over the past month.

Monthly Change In Treasury Yields Breakdown:Source: Bloomberg, EPB Macro Research

As it becomes increasingly certain that overnight interest rates will not rise, a more significant portion of the Treasury curve loses all volatility and starts to look like short-term rates. In Japan, this has occurred virtually across the entire curve though 30-year rates.

Treasury Rates (%):Source: Bloomberg, EPB Macro Research

Treasury volatility is below 2% through 5-years, proxied via ETFs, in the four-pane chart below.

Treasury Volatility (%):Source: Bloomberg, EPB Macro Research

Heavily indebted economies typically see interest rate volatility decline as the entire curve flattens around the ZLB.

Treasury bonds at the long-end remain an attractive investment because the opportunity for capital gains still exists if long-term rates do compress to 0%. Double-digit capital gains with declining volatility is an attractive risk-reward.

All investments involve risk, and a continued increase in inflation expectations could weigh on bond prices. As noted above, increasing commodity exposure at this juncture, or adding higher beta metals or metal proxies such as gold miners or silver are all reasonable ways to hedge a continued rise in inflation expectations. I would be quick to remove such additions should the trends in inflation expectations reverse.


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