Approximately nine years ago, I founded a company specializing in developing new ways to invest in and hedge against inflation. I originally had two partners; one left after a few months and the other lasted a year before heading back to a Wall Street job. (I think leaving after 3 months of trying a startup was a little sporty, but I don’t begrudge the partner who stuck it out for a full calendar turn and then some.)
The last nine years have been a difficult time to be developing and marketing inflation expertise. While we conceived the firm as having strategic positioning on inflation protection – whether inflation is going up or down, inflation risk is always there to be managed…and we are all born inflation-exposed, and remain so unless we do something about it – I confess that I underestimated how hard of a pitch that would be to investors who haven’t seen core inflation above 3% for two decades. Unless you have a certain amount of grey hair, you think 3% is high inflation, but that’s not really high enough to damage most asset markets. So why bother?
But times, they are a changin’ back (as Bob Roberts famously sang). Average core inflation around the world is near the highest levels since the 1990s. The chart below shows the unweighted average of the US, Europe, Japan, the UK, and Chinese core inflation (using median for the US, which is a better measure). While the average of 1.7% or so is nothing to be terrified about, it also should be noted that there is nothing evident on the horizon that would tend to arrest this rising trend.
While money supply growth has been slowing gradually around the world, monetary conditions are not likely to seriously tighten until banks are no longer sitting on a mountain of excess reserves. In the meantime, higher interest rates will tend to cause money velocity to rise because velocity is the inverse of the demand for real cash balances – in English, that means that when interest rates are low, you’re happy to hold cash balances but when interest rates rise, cash becomes a hot potato to be invested, spent, or lent rather than sitting in cash.
It is no coincidence that both global money velocity and global interest rates are both at or near all-time lows. However, interest rates seem to be going higher – seemingly nowhere faster than in the US, where the 5-year Treasury rate has risen about 80bps in the last five months and is at 8-year highs. In turn, that means money velocity is very likely to rise, and any rise at all makes it harder to have an agreeable mix of growth and inflation.
You can subscribe to my live tweets on the monthly CPI day and see why, but not only is domestic inflation rising but the optics this year are going to be much worse for policymakers and investors focused on core inflation. In 2015-16, core inflation accelerated about ¾% to catch up with median CPI; this year the rise is going to be at least that much just from the effect of cell phones and cars.
My point forecast for median CPI in 2018 – I hate point forecasts, but to illustrate that I’m mainly talking about optics in 2018 – is for an 0.25% acceleration in median CPI. But core CPI may rise a full percent because of the transitional pieces that are falling out of the y/y number. And that assumes that protectionist rumblings don’t get any louder than they currently are.
In 2015-16, breakevens actually didn’t respond much because investors didn’t believe in the underlying dynamics. They do today, as global inflation swaps (see chart below) are on the rise everywhere except in the UK, where the post-Brexit spike is fading some. Even in Japan!
I don’t know where the flows will take us, but the combination of the general inflation uptrend, the optics, the flows, the fact that TIPS are still about 35bps cheap compared to nominal bonds (although down from about 100bps cheap 18 months ago), and the fact that gasoline prices are probably going to make headline inflation look even worse than core all come together to create the possibility of a pretty unfortunate spike in inflation markets. Unfortunate, that is, for owners of stocks and bonds.
Over the last nine years, I have spent a lot of time watchfully waiting, working on product development (this index launched last year by S&P, representing a tuition tracking strategy that we hope will result in new college tuition hedging products, is going to be one of our biggest successes), nurturing the slow growth of the firm, and positioning it to be relevant when inflation heads higher. As the years have passed, I have written less frequently because there wasn’t much to say.
There is, now, starting to be more to say. Inflation is headed higher at least for now, and I am seeing more inquiry from investors curious about how to play it. You can expect to hear more from me, because what I am saying is more urgent than it was. And I’d like to hear from you, too.
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