Get it while you still can
As the inflation picture begins to unfold, it is difficult to determine the best path in what could be a rocky environment.
By Joseph B. Shatz, Banc of America Securities-Merrill Lynch Research
In the current economic environment, the risks of inflation should be on everyone's mind. For those who have not yet done so, now is the time to buy insurance against the risk of inflation while the insurance is still relatively cheap. Given the extremely slow velocity of money due to the current lack of lending, inflation is unlikely to be a problem in the near term. But as we all know, it is too late to buy insurance when you see smoke coming from the house. With the massive amount of money being injected into the system through both fiscal and monetary policy, the risks of substantial inflation occurring at some point down the road continue to grow.
There are two ways that the United States can deal with the massive national debt: tax its way out or inflate its way out. As the economic recovery slowly takes place, increased growth should help decrease the size of deficits somewhat. But the United States is highly unlikely to be able to just grow its way out without raising taxes and/or creating inflation. From a political perspective, inflation seems a much more palatable solution than substantially raising taxes. Inflation is basically a back door tax, which on a relative basis hurts those who have lent money and benefits those who have borrowed money. Since the U.S. government is massively in debt, inflation allows them to pay back this money with dollars that are worth less. Although a small amount of well-contained inflation may be beneficial, allowing inflation and inflation expectations to rise is a Pandora's Box. And once it is opened it is extremely difficult to control.
The substantial fiscal and monetary policy stimulus from the U.S. government, U.S. Department of the Treasury and the Federal Reserve should eventually be inflationary over the long-term. Even with the massive amount of money being injected into the system, inflation is still likely to remain low in the near term due to the slow velocity of money resulting from a lack of lending (See chart below, left). Eventually though, when the credit markets and the economy improve further and lending increases, the velocity of money should increase. Unless the Federal Reserve quickly drains massive amounts of money out of the system at that point, which will be difficult both operationally and politically, an increase in inflation is a likely scenario.
Tightening monetary policy could be difficult
The Federal Reserve's balance sheet has expanded at an incredible pace over the last year (See chart below, right). The central bank has many options to drain reserves from the system, such as asset sales, reverse repos, supplementary financing program bills (SFP)/Federal Reserve debt and increasing reserve requirements but each method has its difficulties. The changing composition of the Federal Reserve's balance sheet has also made it more difficult to rapidly decrease the size of it. The securities bought through the Federal Reserve's purchase program - Treasuries, agencies and mortgage-backed securities (MBS) – are becoming a larger part of its balance sheet (See chart below, right). These assets, especially MBS, could be very difficult to quickly remove from the balance sheet without negatively impacting the market.
One potential inflation-fighting strategy is raising the Fed Funds rate and the interest rate paid on reserves kept at the Federal Reserve. This move would increase the relative attractiveness of keeping this money with the central bank rather than lending it out, thus slowing the velocity of money. But central bankers will be hesitant to begin this process until they are certain that the risks of a "double dip" recession have passed. It will also be extremely difficult from a political perspective to raise rates as long as unemployment remains high. Given that unemployment is typically a lagging indicator, it could remain high well into the recovery, creating pressure to keep rates low for longer than is wise from an inflation fighting standpoint.
Protecting against inflation with TIPS
Depending upon one's view of future economic growth, there are many different variations on obtaining inflation protection. One could take long positions in Treasury Inflation-Protected Securities (TIPS), short positions in nominal Treasuries and/or a combination of the two (i.e., long TIPS breakevens). The spread, or breakeven, between nominal Treasury yields and TIPS real yields is a widely watched gauge of inflation. For example, investors who expect low growth and high inflation should just be outright long TIPS, while those who expect strong growth and high inflation should prefer to just be short nominal Treasuries. Investors who are uncertain of what future growth will look like and just purely want to protect against inflation may prefer to be long TIPS versus short nominal Treasuries, (i.e., long TIPS breakevens).
Once the velocity of money eventually increases, the economy should experience the inflationary effects of the immense amount of money being injected into the system. Combined with the continued massive supply of Treasuries, particularly nominal Treasuries more than TIPS, this should eventually put considerable upward pressure on longer maturity nominal Treasury yields and on longer maturity TIPS breakevens.
At current levels, 10-year TIPS breakevens still offer good value, about 1.75 percent as of mid-July 2009, for longer horizon investors, even though they have risen considerably from their November 2008 lows. They are still relatively low in comparison to both historical year-over-year (YOY) and 10-YOY inflation (See chart, left). Over the last 90 years, YOY inflation has averaged about 3 percent. The long-term risks to inflation are considerably skewed to the upside versus current levels. Even if massive inflation is not the most likely scenario, it is certainly a significant risk. For this reason, a much higher inflationary risk premium, for the risk of a "tail" outcome of the distribution, should also be priced into TIPS breakevens.
Futures protection
CME Group's product suite offers many liquid, low transaction cost opportunities for investors to protect themselves against inflation. Treasury bond and note futures, for example, provide an easy way to put on short positions in the nominal Treasury market in order to benefit from a rise in Treasury yields in particular sectors of the curve. Accounts that would like to be long TIPS breakevens – long TIPS versus short Treasuries – as a hedge against inflation, but cannot short Treasuries because of restraints in their ability to engage in repo transactions, may be able to use short positions in Treasury bond and note futures instead of the shorts in nominal Treasuries.
There are also many other products outside of the interest rate complex available at CME Group that could be extremely useful for hedging against inflation risk, such as agricultural, energy and gold futures. Inflation is coming at some point down the road and now is the time to protect against it.
Joseph B. Shatz is senior director, interest rate and derivatives strategy, at Banc of America Securities-Merrill Lynch Research.
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