The Good Oil on Inflation (Part 3)
Insight - Interpretation - Implications
[PART 3: IMPLICATIONS - taking our Insight & Interpretation and putting it to use]
Continuing on from Part 2 …
And now for the IMPLICATIONS that build upon our Insight within the context of our Interpretation.
Oil is Inflation by another name
The Breakeven Inflation rate tracks the price of oil (see chart below). This confirms to me that people are most bullish at the top and most bearish at the bottom. No doubt, the reason for the extremes in the breakeven inflation rate (and therefore the implied price of oil) is due to positioning & flows - bond market price makers are attempting to avoid capital losses on their book, so in a strongly trending market they continue to mark the price (or yield) away from those seeking to exit their position, whether long or short). This creates a misalignment over the longer-term and provides opportunity for a value-based investment that will play out over time.
ATTN: Morgan Stanley; Goldman Sachs et.al. Here is a product to sell to your oil producer clients - a structured hedging contract. [Be sure to send me my commission].
The relationship between the price of oil and the breakeven inflation rate also provides a liquid 10-Year hedging mechanism for oil producers. For example, if oil producers want to capitalize on the current high price of oil, they can buy the U.S. 10-Year Treasury and sell the U.S. 10-Year TIPS. When the spot oil price falls, they will profit from the fall in the breakeven inflation rate to offset the fall in oil revenues.
Airlines or other fuel dependent businesses can do the opposite when the price of oil and breakeven inflation rate is at its low. They will profit as the price of oil rises to offset the fall in their business revenues.What else is Inflation telling us?
It is interesting to note that when the annual rate of inflation is higher than the U.S. 10-year Treasury yield for any significant length of time, we are normally in (or very near to) a recession. 2011 was the exception, but there was a sovereign debt crisis going on at that time (i.e. flight to safety out of European and into U.S. sovereign bonds), plus the yield curve hadn’t recently inverted.
Inflation has now been significantly above the 10-Year Treasury yield for some time and we’ve recently had the yield curve invert a couple of times.
[you know what season to insert here] is Coming!
Fortunately, bonds have backed up enough over the last 2 years to provide somewhere to park your money and provide a decent return over the next year or two. But after that, you might need an alternative means by which you can achieve diversification in your investment portfolio away from risk assets. Do you have a plan? I do1.
Remember, the correlation of risk assets during a market crash goes to 1, so position (or protect) yourself accordingly. I suspect we may soon see that crypto “assets” are just as susceptible to human behavior as stocks.
Anyhow, the implications of all this inflation talk is: it is providing us with an opportunity to buy bonds at attractive levels (specifically, high quality sovereign bonds). And that is the easiest actionable takeaway!
We live at a transitional point in history. We can say we lived during the dawn of the digital economy2 and also participated in the bond market’s last hurrah.
PS. Insight; Interpretation; Implications - it takes all 3, and I like to think that is what I offer.
Designed in anticipation of the death of bond markets and seeing the need for new methods by which diversification away from market risk can be achieved within investment portfolios: my proprietary risk-centric alternative investment strategies that blend Total Return with Absolute Return across the full market cycle, and not a bond in sight!:
Your kids (or grandkids) will say, “So what?”, because the digital economy will be all they have known. And, “WTF is a bond?”