#$tip

Is inflation about to make a comeback? When it comes to the Commodities sector, inflation has been absent since the highs back in 2011. When it comes to inflation from a bond market perspective, little inflation has been taking place, since yields have been in a down trend for years and years.

Are bonds getting concerned that inflation might be coming back? Is the long-term bond bull market ending right in front of our eyes? What the inflation indicator does from here, could well answer many key questions about where the macro/global picture is heading.

Below looks at the TIP/TLT ratio, that is often viewed as a good indicator for the prospects of inflation or lack-of

CLICK HERE TO ENLARGE CHART ABOVE

The ratio has been trending down for the past 7-years, creating a series of lower highs and lower lows. Since 2011, each time this indicator has looked like it was heading higher, it ended up peaking and turned south, inside of falling channel (1).

Since July of 2016, the ratio has been rising sharply, causing some to wonder if inflation/global growth theme might be taking place. This sharp rally has taken the ratio back to the top of falling channel (1) at (2). Over and over, this ratio has peaked and ran out of gas inside of this falling channel, suggesting that global growth was peaking again.

Now the ratio is testing falling resistance again, will the results be different this time? If it does breakout at (2), it does something different that it has done for years and years, commodities would like the price message and bonds could be very concerned about it.

Some tools are used to measure inflation or lack of. Some look at the price of Crude Oil, Doc Copper or the Commodities Index (CRB) to determine if inflation or deflation is in play. Since 2011, most commodities have created a series of lower highs and lower lows and for many, it has been easier to make the case of deflation than inflation, is in play.

Below looks at another tool, that is often used to determine if inflation or deflation is in play. This tool we are referring too is the TIPS/TLT ratio-

CLICK HERE TO ENLARGE CHART ABOVE

Since 2011, the TIP/TLT ratio has continue to create a series of lower highs and lower lows. The ratio in July of 2016, hit the same level as the lows, during the 2009 financial crisis. Double bottom?

Since July the TIP/TLT ratio has moved sharply higher. This 4-month rally has not taken the ratio up to test a cluster of resistance at (1).

Janet Yellen’s speech last Friday cast some doubt on current expectations of a December rate hike. The first sentence of her prepared remarks questions analysis based on recent economic history:

“Extreme economic events have often challenged existing views of how the economy works and exposed shortcomings in the collective knowledge of economists.”

It is possible Yellen was implying the call to raise interest rates based on the historical relationship between employment and inflation may be premature given the state of the global economy. From The Wall Street Journal:

“Her speech at a conference held by the Federal Reserve Bank of Boston offered a window into her mind-set and how policy might evolve in the months ahead. She effectively expressed sympathy for the idea of keeping short-term interest rates low to let the economy gather steam and reverse some of the long-run debilitating effects of the slow recovery, such as low labor-force participation and business investment. That implied very gradual rate increases in the months ahead.”

Are Inflation Expectations Taking Off?

If we use the ratio of inflation-protected Treasuries (TIP) to standard Treasuries as a proxy for inflation expectations, it is difficult to say they have reached alarming levels. The TIP/IEF ratio is currently lower than it was in both November 2008 and June 2015.

Other excerpts from Yellen’s prepared remarks lean toward the dovish end of the interest rate spectrum:

“If we assume that hysteresis is in fact present to some degree after deep recessions, the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a ‘high-pressure economy,’ with robust aggregate demand and a tight labor market.”

“For example, hysteresis would seem to make it even more important for policymakers to act quickly and aggressively in response to a recession, because doing so would help to reduce the depth and persistence of the downturn, thereby limiting the supply-side damage that might otherwise ensue. In addition, if strong economic conditions can partially reverse supply-side damage after it has occurred, then policymakers may want to aim at being more accommodative during recoveries than would be called for under the traditional view that supply is largely independent of demand.”

Stocks: Pullback Or New Bear Market?

This week’s stock market video puts numerous present day charts in historical context, allowing us to better understand the risks of a Fed-induced correction relative to the risk of a new long-term bear market.

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.

Market Expectations Did Not Change

Yellen’s remarks did not significantly impact market odds for a December rate hike, meaning the market’s initial reaction did not change perceptions about the probable short-term path of interest rates. Given numerous Fed governors have made the case for a December rate increase, the market remains skeptical relative to the shorter-term message in Yellen’s remarks.

Fischer’s Follow-Up Message

Fed Vice Chair Stanley Fischer spoke to the Economic Club of New York Monday. He said low rates had negative consequences, but raising them was not as simple as it may appear. From MarketWatch:

Market Remains Skeptical Of June Rate Hike

Based on 30-day Fed fund futures prices, the market is pricing in a 23% probability of a Fed rate hike in June. Said another way, the market currently believes there is a 77% probability Janet Yellen and company will continue with the “do nothing” script at their June 14-15 gathering.

Action vs. No Action Could Determine Market’s Fate

The ratio of Treasury inflation-protected securities (TIP) vs. intermediate-term treasuries (IEF) can be used to monitor inflation expectations. All things being equal, in the current environment with lingering fears of global deflation, rising inflation expectations tend to be favorable for “risk on” assets. Conversely, when inflation expectations start to fall, it can adversely impact the equity market (see S&P 500 in the bottom portion of the graph below).

Navigating In Indecisive Stock Market Waters

The S&P 500 hit 2093 in 2014. On Tuesday, May 31, 2016, the S&P 500 traded at 2093.

This week’s stock market video examines the current state of the long-term standoff between the bulls and the bears, including some potential targets above and below the market. After you click play, use the button in the lower-right corner of the video player to view in  full-screen mode. Hit Esc to exit full-screen mode.

Yellen Leaves Both Doors Open

Janet Yellen was at Harvard last Friday to receive an award. During her visit she made some remarks regarding the future path of interest rates. From the Harvard Gazette:

Yellen said she expects the economy and the labor market to continue to improve and that, as it does, interest rates will “probably” rise. “It’s appropriate — and I’ve said this in the past — I think, for the Fed to gradually and cautiously increase our overnight interest rate over time. And probably in the coming months, such a move would be appropriate.” Still, she urged caution. “If we were to raise interest rates too steeply and we were to trigger a downturn or contribute to a downturn, we have limited scope for responding, and it is an important reason for caution.”

Deflation, Deflation, Deflation.

Central bankers around the world can’t seem to get enough of the D word. Deflation is rampant and needs to be purged, they say, justifying rate cuts and even negative interest rates.

The U.S. Federal Reserve bucked the trend last December in raising rates to a paltry 25 bps (its first hike since 2006), and remains the only developed central bank in the world whose last move was a hike.

Since the December move, the Fed has refrained from hiking again, due in part to increasing fears of deflation during the market correction to start the year. During every correction, as long yields fall, the perma bear deflationistas come out in full force screaming of deflation and another Great Depression.

How accurate are these fears of deflation in the U.S? Let’s take a look at the data.

1) Looking at the US CPI data, inflation is running about 2.2% (core, excluding food/energy) and 0.9% (overall, including food/energy) over the past year.

2) Looking at US Personal Consumption Expenditures (PCE) data, inflation is running at about 1.7% (core) and 1.0% (overall) over the past year.

3) Looking at Owners Equivalent Rent, the largest component of CPI, it is running at 3.1% over the past year.

4) Average hourly earnings in the U.S. are up 2.3% over the past year.

5) Market based inflation expectations (breakevens calculated from TIPS minus nominal) are currently running at 1.45% to 1.65% over the next two to ten years.

Inflation and expectations for future inflation are certainly lower than the historical average, but this is not deflation. Prices are still rising overall, as anyone who pays the bills for food, housing, healthcare and education will tell you.

In fact, if we look at the historical inflation data going back to 1960, we have never seen outright deflation in the United States. Yes, it has been trending lower over this time, but it is still positive.

This is interesting as it pertains to the markets today because there seems to be an increasingly vocal view that the U.S. will eventually go the way of Europe and Japan, pursuing negative interest rate policy and currency debasement.

While anything is possible, I don’t believe this is not probable in the near term as I wrote back in February (“The Easy Money Game Has Changed”). Why? Because the easy money game changed back in December with the first rate hike in seven years. The Fed wants to normalize interest rates as they recognize that there are serious untended consequences to keeping rates at artificially low levels for an extended period of time. They also likely recognize, if they are honest about the data, that there is no actual deflation in the U.S. to justify the extreme measures of the ECB and the BOJ. To shift from the path to normalization, then, would require a severe stock market downturn and another recession at a minimum.

As far as I’m concerned, Europe and Japan can have their negative interest rates. I’d much prefer higher interest rates accompanied by higher growth; yes, the two are related as you can see in the chart below (click here for our research on Treasuries).

As for the U.S. economy, Jobless Claims hit their lowest level since 1973 this week. Given this backdrop, the notion that a 25 bps Fed Funds Rate is holding back growth seems a bit absurd. This is still extraordinarily easy monetary policy.

As for the equity markets, the S&P 500 (total return) hit new highs this week, not a backdrop suggesting a need for additional monetary stimulus. The one thing missing from my silver linings playbook piece penned at the February lows? Higher long duration yields, and a steeping yield curve.

The question for investors today: are long yields being held down by the extreme policies of Europe/Japan or a real concern about growth in the U.S.? Given the rise in inflation expectations in recent months, it would seem to be more of the former. If that’s indeed the case, long bond yields should start to rise from here and the Fed will be inclined to continue normalization in the coming months.

As for the pundits screaming about deflation and depression without any data to support that view? Ignore them at all costs.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors previously held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

Fed Does Not Have A Singular Mandate

Given the big miss on the job creation side of Friday’s monthly employment report, it may appear to be easy for the Fed to continue to put off a hike in interest rates. However, the Fed has two primary mandates; full employment and keeping inflation in check. From the Federal Reserve Bank of Chicago’s website:

“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”

Inflation: Glass Half Full

The ratio of Treasury inflation-protected securities (TIP) vs. intermediate-term treasuries (IEF) can be used to monitor inflation expectations. If we use a weekly chart that plots closing prices, you can make an argument that a bullish breakout recently occurred in inflation expectations (see green arrow).

Inflation, Stocks, Bonds, and Commodities

This week’s stock market video examines current inflation expectations in the context of market history/performance of stocks (SPY), bonds (IEF), and commodities (DBC). From The Wall Street Journal:

With the global economy so sluggish, can bond investors rest easy about inflation? Not necessarily. Excluding energy prices, inflation might not be as tame as many think it is.

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.

Inflation: Glass Half Empty

If we use high-low-close bars on the same weekly TIP vs. IEF chart, an argument can be made that we have seen a normal countertrend rally in inflation expectations within the context of an ongoing downtrend. Notice the recent relationship between inflation expectations and the S&P 500 (bottom of chart). We should learn something about the relative attractiveness of stocks, bonds, and commodities based on how inflation expectations evolve over the coming weeks.

Yellen Focused On Wages

If a worker gets a raise, they have more money coming in each month. Therefore, they have more money to spend in the real economy. Therefore, inflation expectations, closely watched by the Fed, tend to rise when wages start to rise. From Bloomberg:

Three of the world’s most influential bond investors (Gross, El-Erian, and Kiesel) say the Federal Reserve is still on course to raise interest rates this year…Gross and his peers are warning investors not to count out the Fed after the Labor Department reported U.S. employers added 160,000 workers last month, short of the 200,000 positions projected in a Bloomberg survey of economists. Fed Chair Janet Yellen is also examining earnings, which rose 2.5 percent from a year earlier, more than forecast. Two-year note yields, according to Gross, are too low. “I’m not so sure that June is out,” said Gross, formerly of Pimco and who now runs the Janus Global Unconstrained Bond Fund, speaking on Bloomberg Television May 6. “Yellen, more than jobs, is focused on wages. At 2.5 percent, they’re moving up.”

Economic Data Will Play A Role