Thoughts through the cycle: W1 August ’20

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Inflation – what does the market see that the Fed doesn’t?

  • The New York Federal Reserve seems to have a habit of using the Wall Street Journal to ‘float’ policy changes or at least give hints about the direction of Fed policy. During the Q&A following the Fed’s FOMC meeting on the 29th July, Chairman Powell mentioned that the Fed’s 2% inflation target is under review. This is not new – the Fed’s Brainard amongst others has mentioned on a number of occasions the desire to ‘run policy hot’ in terms of inflation going above target.
  • To the backdrop, an article in the Wall Street Journal on the 2 August entitled ‘Fed Weighs Abandoning Pre-Emptive Rate Moves to Curb Inflation’ ought not to come as much of a surprise. In his press conference last week, Powell also suggested the main problem that the US faces is a deflationary one. Now is probably a good time therefore to have a look at where inflation expectations are, and where they might be heading.
  • The graph below shows US core CPI (yellow) and the Fed’s favoured measure of core inflation, the PCE deflator (blue). There are various criticisms of how the PCE deflator accounts for certain inputs, notably health-care costs. In any case, even a cursory glance at the graph below would justify Powell’s assertion that deflation or disinflation is the current problem.

Source: Bloomberg, 3rd August 2020

  • What is perhaps more interesting is that more ‘market’ based measures of inflation are starting to show a different story. The graph below shows the inflation breakeven level on the 10yr US inflation-adjusted Treasury (TIPS). This is almost back to pre-Covid levels. It must be remembered that TIPS break-evens are highly correlated to oil – oil has bounced from the $20’s to settle around $40 so this may explain much of the rally. Nonetheless, it also reflects investors’ appetite for inflation bonds. The question is whether the market senses inflation coming even before the forward indicators show it.

Source: Bloomberg, 3rd August 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • Why would the market be sniffing out inflation in the middle of a recession? The Fed’s balance sheet has gone from $4.2 trillion (year end 2019) to $6.95 trillion as of 29 July. The US primary deficit may hit the mid-20s in The current round of Congressional deliberations on further stimulus has got to the stage where $1 trillion is seen as ‘not enough’. If ever you needed a set up which would end up with inflation, aggressive deficit financing with a compliant (or complicit) central bank is a good starting point – the current US scenario is an extreme example of this.
  • Outside the statistics like CPI or the PCE deflator, hints of inflation can be spotted in areas of the market which can be seen either as less controlled by the central banks (based on the logic that they now control the yield curve for example), or where price moves are in fact the product (or consequence) of fiscal and monetary policy. The two areas of focus here are commodities and currencies.
  • The graph below shows US core CPI (white) plotted against lumber futures (magenta). As a measure of economic activity (especially housebuilding in the US), lumber clearly acts as a leading indicator. Part of the sharpness of the spike here could be pent-up demand from lockdown, or unusual demand from the leisure industry (restaurants rushing to build outside dining-areas and the like). Pending home sales for June were up 16.6% following a 44% rise in May. One wonders whether this new demand is from those looking to relocate out of the cities in the US. Regardless of the causality, ostensibly lumber is saying there is inflation coming.

Source: Bloomberg, 3rd August 2020

  • In that grey area between commodities and currencies lies the precious metals, silver and gold. While industrial uses account for less than 10% of annual gold production, up to 40% of silver is used in manufacturing, and therefore of the two, silver has a more pro-cyclical bias. While many crow on about the gold standard and Bretton Woods, it was silver which was actually used as money in the US – it was only in 1965 that the silver dollar was officially withdrawn from circulation and replaced with the now ubiquitous dollar bill.
  • The graph below shows the precipitous rise of silver following the March crash, with the metal up over 100% from the lows. There have been supply issues due to Covid-related mine closures in South America, but this cannot alone explain the rapid price increase. Part of the move is silver ‘catching up’ with gold – the ratio of the metal prices got to an unprecedented 124x in March, and has since mean-reverted to the current levels of 81x (the 200-day average is 94x).

Source: Bloomberg, 3rd August 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • Gold is often seen as an inflation hedge, but in reality, its role is a far more complex one, given its sometimes vacillating relationship with the US dollar and US real interest rates as well its periodic use as the ultimate safe-haven asset. At present, it seems that gold is showing an extremely strong relationship to US long-end rates. The graph below shows gold (yellow, inverted) against US 30yr real rates (red). The correlation is evident. All else equal, lower real rates reflect falling economic growth potential – deeply negative real rates suggest long-term capital destruction.

Source: Bloomberg, 3rd August 2020

  • Back in the day, the venerable James Pierpoint Morgan (of J.P. Morgan fame) is reported to have said, ‘Gold is money, everything else is credit’. When one sees gold rising in a period of aggressive central bank money creation and large fiscals deficits, there is a sense that its price action is more a measure of the debasement of fiat currency than anything else – the idea being the price of gold goes up because the purchasing power of fiat currencies is falling. There is much to be said for this argument, especially if one asks whether central banks and governments can actually exit their current policies. One way of looking at the falling 30yr real yields in the US is that the market is pricing an extended period of financial repression (central banks keeping rates low through extraordinary monetary policy) and governments running up large, deflation-inducing debts in the meantime.
  • One could argue that for political and social reasons, governments and central banks are bound into this cycle of printing and spending. One could add that the massive global stock of debt means that aside from any political considerations, it is in fact debt itself that makes the demand that it be serviced, forcing the authorities to act in the current manner, more as a matter of necessity than one of choice.
  • Perhaps hints of the future can also be seen within the commodity market itself. There is a certain type of market analyst who loves to talk about what ‘Dr Copper’ is saying. Rising copper prices suggest growing global demand and growth. The graph below shows the ratio of gold to copper. After what looks like a reflationary bounce in May and June, the gold/copper ratio is rolling over. This is a bad indicator for real GDP growth prospects.

Source: Bloomberg, 3rd August 2020

  • What does this all add up to? Clearly the pandemic and lockdown were huge deflationary shocks. The splurge of government and corporate borrowing that followed was also deflationary. Real rates at the long end of the US yield curve are suggesting that the ensuing recovery will be weak and elongated. Copper’s underperformance against gold seems to be hinting that the hoped-for V-shaped recovery is foundering. Yet there are spots of inflation appearing in the commodity market. The experience of the 1970s was also one of low growth, low real interest rates, and high inflation – if these indicators are tallied up, it may well be that a period of deflation leads to a subsequent one of stagflation.

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