Harley Bassman’s Trades For An Inflationary World

The preponderance of evidence suggests inflation is not transitory, the rub is that interest rates may no longer be correlated with inflation. What is indisputable is that Implied Volatility is way too low since the range of outcomes is now much wider.

“A Cheerful Sisyphus”

A Commentary by Harley Bassman

Over the course of a dozen years and the terms of three Fed Chairpersons, the FED has been working dutifully to create inflation in the US economy.

Seemingly at odds with their Congressional mandate to “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” the FED is well aware that inflation is the only solution to unravel our problem of excessive debt, both public and private.

As a reminder, there are only two ways out of a debt crisis — either default or inflate with the caveat that inflation is simply a slow-motion default.

Now let us consider the implications of what might occur if the FED, with the unanticipated support of COVID, has finally achieved its goal.

While it may be a reach to claim “it takes a village” to crash the economy, there was certainly no lack of bad actors and actions that precipitated the Great Financial Crisis (GFC) of 2007-09.

But regardless of blame, at the end of the day there was not only too much debt, but also much of this debt was of poor quality.

At a similar time at the onset of the Great Depression, Treasury Secretary Andrew Mellon advised President Herbert Hoover to “Liquidate labor, liquidate stocks, liquidate farmers…it will purge the rottenness out of the system.”

If this path was unacceptable during the harsh times before FDR’s introduction of Social Security and LBJs creation of the Great Society, it was certainly out of bounds for our modern day FED.

Thus, the FED’s clever idea, which I still support, relied upon Milton Friedman’s observation that “inflation is always and everywhere a monetary phenomenon.”

GDP = Money * Velocity = Price * Quantity

Via a process most civilians would call “money printing,” but what the FED coyly dubs Quantitative Easing (QE), the money supply expanded.

The FED injected this money into the economy via its Large-Scale Asset Purchase (LSAP) program. Here the FED went into the open market and purchased from Wall Street banks Treasury and Mortgage securities and placed them on their balance sheet.

The (not) unreasonable notion was that, per Friedman’s monetary policy equation, an increase in Money would force an increase in Price (inflation), assuming Quantity and Velocity remained relatively constant.

It was an unexpected bother for policymakers that Velocity collapsed, muting the impact of their monetary expansion.

Slightly preceding, but concomitant with the LSAP program, was the FED’s Zero Interest Rate Policy (ZIRP). A 0.25% overnight rate, combined with the LSAP purchase of ultra-safe USTs and MBS, pushed fixed-income (bond) investors into riskier assets to achieve their yield/return targets.

The objective was to force-fund risky ventures, and thus revive Keynes’s so called “animal spirits” to pull the economy out of recession.

Chalk up a success. The junk bond spread has compressed such that the high yield index now barely yields 4%, an oxymoron of sorts.

But let us be clear, it is bogus to say that Western central banks have not created inflation.

It has been an unintended consequence, and a public policy disaster, that instead of increasing wages and reported CPI, their money has fed directly to financial assets.

“Be careful what you wish for” might be timely advice for the FED, since their request for fiscal support was granted by the arrival of COVID.

While the FED could inject money into the system, only the federal government can deliver it directly to the wallets of consumers who will spend it.

Inflation arrived soon after the vaccines were approved, with a third quarter rate of 5.4%, nearly triple the 1.95% average since 2016. Paradoxically, the 10-year interest rate at 1.55% is unchanged from its pre-COVID level creating a negative real rate.

While it is possible inflation is a short-term “transitory” blip related to the rebound from COVID, let us consider investment opportunities if inflation remains elevated well above the FEDs somewhat floating ~2% target.

Buy Equities

In theory, stocks are the Discounted Present Value of a company’s earnings over the life of the firm. For non-financial readers, this means determining the value of a dollar today (current stock price) versus a dollar tomorrow (future earnings).

If we are entering into a period of increased inflation, a company can raise their prices (and earnings) slightly ahead of rising input prices. If interest rates (the discount factor) remain constant, the value of their stock will rise.

However, there is an inflection point where interest rates (usually) catch up to inflation, and this greater discount rate will offset the enhanced earnings.

This raises the question of what might occur if, anomalously, earnings were to inflate while interest rates declined?

There is no reason to guess, as this is precisely what has occurred over the past few years and explains the leadership of the six FAAANMs.

Unless the government (finally) reins in these monopolies, I will stipulate that the FAAANMs will earn oodles of money in the future. So, the only question is what is the value of this pile of cash decades hence?

Trust me on the math, but if the discount factor has followed interest rates, that would explain much of the price movement over the past three years. These stocks are effectively 70-year bonds with massive rate sensitivity.

Not to bury the lede, but if the FED holds rates down (Yield Curve Control – YCC) while inflation runs hot, stocks can explode higher.

In the past, I have offered the many public policy benefits of the FED allowing long-term rates to rise while holding short-term rates low.

But there is an equally compelling case that the FED should model their policy after the Bank of Japan (BoJ) and place an (explicit or implicit) cap on rates.

If you think inflation is not transitory, and a fearful FED will not allow interest rates to rise significantly, buying SPY is a fine idea. A better idea may be to check out some of Simplify Asset Management’s convexity enhanced products.

But the big money idea is to buy long-dated in-the-money call options.

• Current SPY = 450;
• Strike price = 400; (notice it is in-the-money by 50 points)
• Expiry = January 19, 2024 [Listed option]
• Price = 80

This option is 50 points in-the-money, with a “time value” of only 30 points (80 – 50 = 30); thus, the break-even requires a rally of a mere 6.67%.

Using this type of option also offers cheap leverage as one is “borrowing” the strike price until January 2024 at a rate of 0.72%.

Pencil to paper, a 30% rise in SPY would translate into a 69% gain in the option price at expiry. In a 40% rally in SPY, the option would gain 125%.

Be careful though, if SPY is at or below the strike price at expiry, the entire option investment will be worthless.

The interesting strategy is to take your $450 of investment cash, and instead of buying a share of SPY, buy the option at $80. Place the remaining $370 in a safe place.

If the market tumbles hard, your option is worthless, but you still have the $370, which is effectively a “stop out” put option on your nest egg.

In a FED propelled rally, you have positively convex upside; conversely, on the downside your losses are effectively limited to a 17.78% portfolio loss.

If you like this, look at listed call options on the SX5E – the Dow 50 of Europe.

• SX5E Index = 4200;
• Strike price = 4200;
• Expiry = December 19, 2025
• Price = 365 [only an 8.7% breakeven over four years !!]

This option is listed on the EUX exchange, available to many financial “civilians”.

Buy a House

Except for the ultra-rich (who will soon be taxed back to Earth), nobody “buys” a house. Rather, they sign up for a thirty-year payment plan.

The rather daunting table details the math, so take a moment. The old rule was to allocate 28% of income to shelter. Working backwards with the mortgage rate, one can figure out how much can be borrowed assuming a 10% down payment is required. At the macro-level, the median house price must be available to the median income; which creates a type of Affordability Index.

1) The large median house price increase from 2019 to 2021 is mostly due to a declining mortgage rate; 2) With mortgage rates below 3.00%, housing is still “cheap”; 3) FED purchases of MBS (to reduce mortgage rates) is a financial dagger at Millennials who are now forming households and trying to buy a home; 4) If inflation is not transitory, and the FED limits rates via YCC, real assets such as gold, art, jewelry (and maybe crypto) will increase in price.

Buy TIPs (Treasury Inflation Protected Securities)

Please shoot me. You know I hate TIPs. But…

TIPs pay off based upon the Consumer Price Index (CPI), a government manufactured number that intentionally low-balls inflation. Revised in 1998, it includes both “hedonic” as well as “quality” substitutions. Since many government transfer payments have a CPI-based cost of living adjustment (COLA), the government has a vested interest in understating CPI.

Notwithstanding the above, TIPs could still be interesting at the right price, but presently five-year TIPs yield negative 1.75% while ten-year TIPs are posting a forever low of negative 1.02%.

A significant contributor to this rich price is the FED’s purchases of TIPs at a rate greater than their net issuance.

But, as they say, “Don’t fight the FED.” The real yield on TIPs is calculated by the nominal yield of a Treasury security minus the CPI inflation to the same maturity. So, if the 10-year yields 1.5%, and CPI is expected to be 2.5%, the TIPs yield will be negative 1.0%. This “real yield” is what one earns after inflation.

If inflation (CPI) runs hot, say 4.5%, and the FED holds rates at 1.5% via YCC, a 10-year TIP will rally about 11% in price to yield negative 3.0%. Of course, there is also the scenario where inflation runs above the FEDs target, and they allow long-term rates to rise, not Weimar-style, but moderately. The 10-year rate was nearly 200bps higher for most of 2018 and the sky did not fall.

To profit from this view, consider the Simplify Interest Rate Hedge Strategy. Below is a “modeled profile” updated to reflect the current rate and volatility structure. [And be reminded, this is a profile and not a prediction.]

Closing Comments

The preponderance of evidence suggests that inflation is not transitory, the rub is that interest rates may no longer be correlated with inflation.

I appreciate how this can be a short-term financial salve; but let us be clear, it is a long-term public policy blunder. What is indisputable is that Implied Volatility is way too low since the range of outcomes is now much wider.

Remember: For most investments, sizing is more important than entry level.

Harley S. Bassman

November 2, 2021

---