economy Markets

‘Raise Inflation Hedges Big Time’: Is The Genie Already Out Of The Bottle?

Who’s concerned about inflation on the heels of the biggest global demand shock in at least a century?

Quite a few market participants, actually. I often speak of the pandemic’s “Harvey Dent character” – the biggest demand shock since the Great Depression is a deflationary supernova by definition, but the virus was also a supply shock in many respects. The risks associated with far-flung supply chains were suddenly laid bare, and with populism/nationalism still ascendant, you can expect more on-shoring/protectionism and less globalization going forward.

On top of that, the policy response to the crisis — the marriage of fiscal generosity and monetary largesse, as central banks accommodate government spending — is seen by many as inflationary by definition. Much of the above is captured in the responses to BofA’s Global Fund Manager survey (figure below).

In the latest edition of his weekly “Flow Show” series, the bank’s Michael Hartnett says there are “secular reasons to raise inflation hedges big-time heading into 2021”.

He cites July’s hot core CPI reading in the US, which is receiving quite a bit of attention despite the “noisy” nature of the data in the wake of the pandemic.

“In one month, core prices rose by as much as the 10-year nominal yield”, Hartnett writes. That’s one way to look at it, I suppose.

Hartnett continues, citing a series of factors including “bigger government (the expansion of a monopolistic public sector), a smaller world (the breakdown of global supply chains), and dollar debasement (inflation solves excess indebtedness)” among myriad “secular reasons to raise inflation hedges”.

As discussed here at length this week, both market-based measures of inflation expectations and consumer expectations for prices have moved higher. 10-year breakevens, for example, have erased the entirety of their pandemic plunge, alongside stocks and crude, with the latter having basically doubled from the lows (and I’m stripping out the anomalous plunge into negative territory for WTI).

This should all be considered in conjunction with the distinct possibility that a vaccine is discovered and widely disseminated by the end of Q1 2021.

It all plays into a reversal of the themes which have dominated in rates and equities for years.

“The trick will continue to be about what happens in the fall with potential for further PMI rebound [as the] base effect ‘impulse turn’ still matters, issuance spigots open in size as expected post-Labor Day, pro-cyclical seasonality kicks into gear, and we get further COVID-19 vaccine progress”, Nomura’s Charlie McElligott said Friday. All of that, he remarked, is “a strong recipe for more [curve] steepening”.

McElligott’s view on this is tactical, although his daily missives are always infused with, and informed by, bigger picture macro trends.

BofA’s Hartnett sees “no new lows in bond yields”. Treasury yields are up 20 bps while bund and JGB yields have risen 20-45 bps from recent lows, he writes.

When you consider all of this, remember that while fiscal-monetary “partnerships” could conceivably be a catalyst for inflation, you need the fiscal side. As we’ve seen over the last dozen years, central bank asset purchases are most assuredly not sufficient to create inflation by themselves.

“[If the] extra money just sits in the banking system and doesn’t result in any extra economic output, then by definition the velocity of money falls”, Kevin Muir, former head of equity derivatives at RBC, wrote in a Thursday note.

“Although there are other factors that affect velocity, the main reason for its recent plunge is the fact that quantitative easing does not cause inflation (or economic growth)”, Muir added.

In the same vein (and as documented here last week), those looking for a real “reflation signal” should watch for signs that the surge in the M2 stock is abating. A decline would mean “money is put back to work on the corporate and individual levels as risk aversion and focus on savings turns into a more opportunistic outlook”, Nomura’s McElligott said, in an August 5 note.

With that in mind, the latest update from the Fed shows the M2 stock fell a third week.

It’s going to take more than that to trigger the snowball effect, but this is something to keep an eye on as the recovery continues — or doesn’t continue, whichever the case may be.


5 comments on “‘Raise Inflation Hedges Big Time’: Is The Genie Already Out Of The Bottle?

  1. I see little reference to the difference policies make for the Federal government as an income taxing authority. If you give a poor person money they spend it quickly and it gets spent by others quickly to replenish stock. However give a tax cut then it sits in someones bank for generations. In the first case the federal government gets most (how much?) of the money back in taxation in the latter the treasury is starved. I would like to see more public acceptance of this basic principle.

    Thank you for the daily education. I read all the articles. Some more than once.

  2. Kevin Muir has started his sequence of articles on inflation; what causes it and what assets do well in a high(er) inflation environment. I do not know if we will have inflation or deflation in the future but Muir offers an interesting point of view; personally I think the probability of higher inflation is somewhat high (0.5? 0.6?). Of course, we have had asset inflation for ten years.

    Before Keven goes too far down the rabbit hole, what do you, Professor Heisenberg, think are assets that will do well in a high inflation environment under the current conditions (e.g. QE, low bond yields, large federal deficits, political chaos, King Trump?, etc)?

    Some things come to mind.
    Utilities? State regulators will keep utility rates in step with inflation and utilities are not optional.
    Large Cap Tech? The answer to every equity question?
    Commodities? We could have inflation and a recession; my guess is commodities are not the answer.

  3. payshunt says:

    Interesting call on the low in yields. Let’s see the range when the fed makes an effort.

  4. Ria says:

    A curve steepener is an indicator the market thinks growth will pick up. Things are going to be dicey for awhile. Wait until the end of August and see how the consumer is reacting when the spigot gets shut off – even if it is for a couple of weeks. While I am cautious for the next 3-4 quarters we will come out of this and get some growth back eventually- the world will not end. After a borrowing binge there is usually a hangover, and this will lower long run growth. Not saying it is not worth the trade off- better that than homelessness and even more breadlines, but there will be a price to be paid later. Lower long run nominal growth, lower population growth and aging demographics usually do not lead to longer term higher interest rates.

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