Inflation ? What's that ? Yes, it's a New Year and time for the usual inflation warnings .....

ref :- "Feeling TIPSY" , Buttonwood in the Economist, Finance and Economics

We're a bit slow getting round to this piece from the Economist ..... we were going to have a look at this last Friday but inconveniently President Trump decided to sanction the drone attack against Iranian general and political heavyweight Qassem Suleimani. In doing so of course he may have set off a chain of events that some might say the markets have not yet fully taken into account. Gold has got excited, oil too to a degree, but a less than 1% fall in stocks and a 12 basis point drop in the yield of 10yr US Treasuries  --  the archetypal safe-haven  --  is hardly evidence of panic.

Mind you, we have to confess that we are constantly underestimating the resilience of markets. They're at it again this morning, with the exception of gold shrugging off Iranian missile attacks against two US airfields in Iraq . Shrugging off ? Did you ever think you'd ever read that about Iranian missile attacks on American airbases ? Granted , something was expected and the attacks were comparatively ineffectual by all accounts, but to think that this is the end of the matter seems excessively optimistic  --  whatever the Iranian Foreign Minister may have said publicly this morning.

In more normal times (when were they, exactly ?) , bond markets were driven by rather more mundane factors  --  particularly by inflation AND the expectations of future inflation. Rising prices are bad news for bonds because they eat into investors' future returns  --  which of course are fixed. This time last year, many of the foremost bond gurus were warning us of rising inflation and therefore sharply rising bond yields and falling bond prices. We haven't actually seen any prognoses for 2020 from those guys yet. presumably, they're too busy wiping egg from their faces but it's January, and inevitably there's some chat about how stronger inflation pressures must, sooner or later, make a reappearance.

Many might question that assumption. We've often talked about how the factors that drive inflation have changed, and assumed that the old generators of rising prices have been undermined by such things as globalisation, automation and changing demographics. Even central bankers are having to admit that they have been making decisions on principles that are now outdated. Buttonwood relates how in July of last year Federal Reserve boss Jay Powell admitted to Congress that the Fed's estimate of the lowest sustainable unemployment rate had been too high, and the implication was that as a consequence they had set interest rates too high too. He said that the Phillips Curve, the economic theory that states that lower unemployment meant higher inflation and vice versa and which seemed so logical for so long was barely alive any longer.

So whilst it would be a brave pundit to forecast the return of inflation in a way that might upset markets, particularly if the Fed is prepared to tolerate a spell of above-target price growth by way of catch-up, that's really not what this article is doing. What it's saying is that IF it should happen the markets are particularly unprepared for it, and suggesting how they might best go about getting some protection.

Since low yields mean high prices, this extended period of ultra-low yields has meant a price surge (bubble ?) across a whole range of assets  --  equities, bonds, property etc. Any serious and unexpected burst of inflation and the likelihood of subsequent rate hikes would undermine the lot of them. In the past, when it was standard for equities and bonds to move in opposite directions, it was traditional to hedge your highly-priced stocks with high-quality government bonds. Right now, the whole world owns highly-priced stocks but if the prospect of higher rates would damage share prices then the spectre of inflation would have an even worse effect on bond markets. It would be a lose/lose scenario.

The answer ? Well, if asset prices are tumbling then you could always revert to cash. Rates of interest will be on the up, but in many cases will still be lower than even subdued current level of inflation. So the suggestion is .... TIPS. You remember these fellahs, right ? Treasury Inflation-Protected Securities.

To be frank, for newcomers the article's explanation of these instruments is not entirely clear and we would point you to Investopedia.com but in essence :

The Principal  --  or Face Value  --  of a TIPS are linked to an inflation index, the Consumer Price Index (CPI). As inflation rises the face value of the bond goes up. Thus, in an inflationary environment, the periodic coupon (or interest) payments increase due to the increased face value, and these higher payments act as protection against inflation risk.

Of course, without inflation, they pay less than a normal Treasury of the same maturity and perform worse in a deflationary environment. But the way to look at TIPS is as INSURANCE, and even in deflationary times, they will always be redeemed on maturity at PAR . In other words, investors can't lose money on them if they hang on to them.

Yeah, yeah ..... but is it worth it ? Problem inflation's dead, isn't it ? Perhaps, but Buttonwood makes the point that for all the theories we don't really understand what's kept inflation so low .... that's why central banks have made policy mistakes over the last decade.

And if we don't understand what's brought it down, how can we be sure it's going to stay there ?