Dirty Little Secret

By: Michael Ashton | Thu, Jun 10, 2010
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Who needs data to lighten the mood when the mood seems to lighten spontaneously every night? Stocks rallied early and today actually held onto their gains, finishing +3% on the day (the third best rally of the year) albeit on much lighter volume than on recent sessions.

It is highly unlikely that the market rallied so sharply because of good growth reports from China, Japan, and Australia, as Bloomberg suggested. It also seems unlikely to me that the failure of the ECB to cut interest rates today (Nouriel Roubini says that they ought to move rates to zero immediately to offset the austerity plans being implemented) is salutatory for dollar markets.

Initial Claims were a little weak, at 456k versus 450k expectations and with an upward revision to the prior week. No good rally reason there. Maybe some oscillators were oversold...

Whatever the reason, there is no doubting the result (although we may fairly doubt whether it will continue tomorrow, especially given the tepid volume). Bonds, too, were under pressure: the Street has a bunch of paper to distribute after the auctions this week, and they were distributing it into a falling market as the 10y Note futures fell 32.5/32nds and the 10y yield rose to 3.32%. Inflation swaps rose 2-4bps, which is actually pretty weak considering the 13bp rise in yields.

I continue to be negative on stocks. I am unimpressed by rallies on declining volume. And I am not nuts about bonds at a 3.32% yield, and TIPS are not cheap either. Commodities don't pay dividends, and while I think everyone should have some money in a commodity index because the long-run sources of return are robust and have little to do with commodities (or other assets), you can't put all your money in that basket. We're all worried about what will happen to cash when inflation arrives, as I am confident it eventually will since it is the only way to escape this vortex. So what's an investor to do?

Here's a dirty little secret that inflation people do not like to mention very much. Treasury bills, or other short-term paper, are not horrible investments in inflationary times.

The reason for this counterintuitive result is that central banks' reaction function is tied at least informally to inflation (if a central bank follows the Taylor Rule religiously, it is almost formally tied to inflation). When inflation goes up, so do short-term interest rates, albeit with a lag; when inflation goes down, short-term interest rates often follow. In the chart below, covering the period of the modern Federal Reserve (basically from Chairman William McChesney Martin onward), I've plotted the 3-month Treasury Bill rate and the year-on-year change in headline CPI. There is a very high correlation, and it is plainly not spurious: high inflation tends to cause interest rates to rise since investors insist on at least some real return; moreover, of course the Federal Reserve tends to reinforce that effect by raising the overnight rate and restricting liquidity to choke off inflation.

3-Month T-Bill Yield versus Y/Y CPI
Historically...Tbills aren't so bad!

As an aside, for the 3-month Bill I used the monthly auction average (provided by a great little site called EconoMagic that I subscribe to) from 1951 until 2000, when the series was discontinued; thereafter I used the H.15 average TBill rate for the last business day of the month (Source: Federal Reserve).

So the message is that by sitting in cash you won't do spectacularly well, but you probably won't get killed, either. And you don't have as much to worry about from inflation as you may think. Note of course that I distinguish cash-type investments from currency, which naturally is eroding away with every tick of the price level.

Now, it is fair to ask whether the current situation may make cash slightly less attractive, since there is a plausible argument for the FOMC to keep rates very low in an attempt (admitted or not) to push inflation just a bit higher. After all, the current 0.1% rate for TBills is below both the core and headline inflation rates. But even though I think this is likely to be the case, it isn't a horrible opportunity cost. In most cases you may lose 1-2% in real value per year until the Fed normalizes interest rates; in the case where you would lose more, because inflation accelerates suddenly, you will still be better off than in other asset classes such as stocks (which get killed in rising inflation environments) or bonds. Losing 3-4% beats losing 40% any day.

If inflation explodes,you lose a lot of real value in Bills, stocks, and bonds...but if you're worried about that case then just buy TIPS even though they are a little bit rich and be done with it. (By the way, at the moment a decent alternative to buying TBills, if you can get a decent price from your broker, is to buy the Jan 11s or Apr 11 TIPS).

So, although I am largely in cash right now, I'm not as worried as you would think I should be, since I have one eye on the inflation situation.


I will not publish a comment tomorrow (and thanks in advance to all of you who will write lovely notes or even poetry telling me how much you miss it!), but there is some economic data. Retail Sales (Consensus: +0.2%, +0.1% ex-auto) and the Michigan Sentiment number (Consensus: 74.5 from 73.6) will preoccupy us, a little, although as today's action showed there is more going on behind the scenes than economic wiggles can explain. Next week we get inflation data! In the meantime, probably the most significant thing happening tomorrow is the kickoff of the World Cup. Expect liquidity off the Continent to begin to slacken around 10:00 ET, when South Africa plays Mexico. At 2pm France "battles" Uruguay, but by that time of the day the Europeans aren't providing as much liquidity in our markets anyway.

U.S. battles England on Saturday. It would be a huge win (or even draw) for the Yanks, but I'm not holding my breath. We just want to get out of group.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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