Inflation: Here Today, Gone Tomorrow?

Posted September 30, 2021

Before buying into central bank assurances that inflation is transitory, we must remain vigilant of the fact that the largest risk facing the economy remains a policy misstep by the Federal Reserve in their anticipation of inflation. While most investors and strategists are all in agreement with the Fed that inflation will be “transitory” in nature, over the past several months it is becoming clear that angst amongst global businesses regarding inflation is rising as the cost of raw materials rises, increasing pressure on them to raise consumer prices.

The 10-year U.S. Treasury yield has broken through key resistance, despite Federal Reserve assurances. Rising price pressures have accelerated inflows into inflation-protected exchange-traded funds this year. And the strong relationship between inflation and commodities indicates there’s more upside for raw material prices ahead.

Here are 6 charts from various corners of the market suggesting that
investors are ‘buckling up’ as inflation is trying to embed its longer-term:

Chart #1 Shows the number of times inflation was mentioned on earnings calls. Mentions of inflation during earnings calls have surged in the past year with the last quarter seeing a surge to the highest in more than two decades. The word popped up more than 3,600 times in the transcripts of analyst briefings for companies on the WORLD Index of 1,557 global stocks.

Chart #2 U.S. 10 Year – Bond traders have begun to position for the return of inflation, even as Fed Chair Jerome Powell said at Tuesday hearing that inflation will likely moderate after remaining elevated in the coming months.

Ichimoku analysis is a Japanese trend-following method for determining whether trading trends will continue or reverse. It consists of five lines that help traders determine a bullish, bearish, or neutral bias, with the blue shaded area representing the Ichimoku Cloud. The 10-year U.S. yield has broken through the cloud resistance in addition to the horizontal resistance at recent highs. The yellow lagging line also crossed above the cloud, confirming the positive reversal of the daily trend.

Chart #3: Investor demand for hedges against inflation is increasing. A total of 51 inflation-protected ETFs attracted $33.6 billion this year and registered a year-to-date gain of 3.8%. At $7.3 billion of net inflows, the iShares TIPS Bond ETF topped the list, followed by the Vanguard Short-Term Inflation-Protected Securities Index Fund at $6.5 billion.

Chart #4: Fund Flows. Inflows may continue should inflation pressures grow, with a strong correlation between inflation and commodity prices historically:

The Commodity Return Index has a strong positive relationship with the U.S. Consumer Prices Index, showing an r*square of 0.694 on the regression model over the last four decades. A reading of positive 1 would mean the securities move in lockstep. The red asterisk below the red line shows the commodity return index is undervalued for the current level of inflation.

Chart #5: Inflation Surprise. Most Inflation Index Surprise charts continue to measure greater than +2 Standard Deviations away from the mean consensus forecasts for the latest reads on inflation. Looking at the 20-year Citi Inflation Surprise Index chart below, you can see that both investors and economists alike have been caught off guard in 2021 when it comes to actual inflation measures running hotter than forecast.

Chart #6: Short-term vs. long-term inflationary expectations. Inflationary expectations remain one of the most powerful inflationary forces because of their ability to become self-fulfilling. When workers, consumers, and businesses believe that inflation will get worse, they will bid up prices and wages in anticipation of inflation thereby fueling the flames of inflation they were originally fearing! As of Q2, 2021, we have short-term expectations for inflation on the rise according to the latest University of Michigan survey. According to the survey, 1-year consumer inflation expectations are 4.7% in July, this is another record-setting highest read since the China commodity boom of 2011 post-Great Recession and up from a read of 4.6% in May. Looking out long-term to the 10-year breakeven inflation rate in the chart below we have the 10-year treasury to 10-year TIPS spread indicating elevated inflation expectations on average over the next decade of 2.37% per year.

Joe Maas, CIO | CFA, CFP®, ChFC, CLU®, MSFS, CVA, ABAR, CM&AA, CCIM
David Stryzewski, CEO | CSA, NSSA