Conclusion: Our soon-to-be released 1Q12 macro theme of Deflating the Inflation II portends negatively for the price of Treasury Inflation-Protected Securities.
Position: Short Treasury Inflation-Protected Securities (TIP).
If there’s one thing Old Wall St. fails to understand it’s that being perma-anything in the Macro arena will get you carted out the back door over a long enough duration. Mean reversion and spread risk remain arguably the two most dominant drivers of price within, and across, asset classes.
Having authored the Inflation Accelerating call late in the summer of 2010 – a time when “deflation” and “double-dip” were the #1 and #2 topics de jour on the Street – we are in a unique position that should help our clients prepare for what’s next.
Specifically, we understood that Burning the Buck to near-record lows would fuel a reflation rally in commodities that would eventually become corporate margin pressure that was ultimately passed through to end-consumers as higher price points/less discounting on a YoY basis.
Meanwhile, the consensus storytelling of “no wage growth = no inflation” has evolved into: “transitory supply-side shocks as a result of geo-political tension (crude oil) and ‘rapid’ emerging market demand”. Emerging market demand? The MSCI Emerging Market Index crashed -20.4% in 2011 as “rapid” emerging market demand slowed dramatically. The “BRIC” markets all finished down in a range of -18% to -25% as their demand for materials, like bricks, slowed alongside their domestic economic growth.
As Keith suggested on in the live Q&A segment of our daily Morning Macro call, “In Macro, your best short ideas are usually borne out of the realization of your best long ideas – of course after ceding the appropriate amount of time to the topping process.” Looking at TIPS/inflation hedges specifically, we think that topping process is beginning to draw to a close – appropriately well after we initially authored the bearish call on commodities in 2Q11.
Now we are in beginning to enter a sweet spot where our bottom-up view (our models point to lower-highs in CPI over the intermediate term) is supported by our top-down, quantitative view (King Dollar breakout; CRB Index breakdown). Together, those signals suggest that investors are likely to start to demand a lower premium for inflation protection over the intermediate term.
Where could we be wrong on the slope of U.S. CPI? While QE3 is always a possibility, we interpret the U.S. dollar’s quantitative setup (Bullish Formation) as: whatever the Fed does (if anything during this pivotal election year amid strengthening U.S. economic data) is likely to be trumped by the ECB, the BOE, the BOJ and other foreign central banks. That spread risk is bullish for the USD, as no currency is priced in a vacuum of itself.
Additionally, the potential for geo-political risk to create another oil price shock is a factor we must consider. It is, however, rather difficult to interpret how much of that is already baked into the current prices of crude oil and TIPS. Moreover, just like with long-term TAIL growth and inflation forecasting, we have no edge on what is coming down the pike next from the unstable EMEA region. In either scenario, anyone who tells you otherwise is sacrificing analytical integrity for the sake of compensation.
For now, we are short TIP for a trade and will look manage the immediate-term risk. A breakdown through the TREND line would give us further conviction in this thesis.