Wednesday, August 2, 2017

Where Did the Inflation Trade Go?

Over the past month, Crude Oil, Gold, and the US 10-year Treasury have all been advancing higher. On the surface the feedback from the price action is conflicting. I'll start with higher oil prices, as I believe it is leading the group, indicating higher producer and consumer prices down the pipeline.

According to the December 2015 Dallas Fed Economic Letter titled, 'Cheaper Crude Oil Affects Consumer Prices Unevenly', the pass-through time for the non-energy components of the Personal Consumption Expenditures (PCE) Index can be severely delayed. The Economic Letter highlights that though non-energy categories make up 95-percent of the PCE weight, it can take up to six months for 50-percent of the long-run pass-through of price changes in oil to materialize. And more than two years for consumers to realize the complete price adjustment.

For purely technical reasons, I see the price of a barrel of crude oil advancing and remaining above $50. The fundamental rationale will become apparent in time. With this assumption as my anchor, I can turn my attention to Gold, and the US 10-year Treasury. With Crude Oil trending higher over the interim, I would expect the price of Gold to also reflect the sentiment, driven primarily by demand from inflation hedging. The US 10-year Treasury then seems to be the odd-man, as its value is eroded by both realized and expected increases in consumer prices.

The last month's higher prices for the US 10-year Treasury also contradicts the rationale of a fixed-income market that is facing dual headwinds of explicit monetary tightening through FOMC rate increases, and implicit monetary tightening through balance sheet reductions via asset roll-offs. I interpret this to mean the trend of buying that has become apparent in the US 10-year Treasury market in the past month will be relatively short-lived, as there are macro-economic fundamentals that are working to push that market in the opposite direction.

My context for the Inflation Trade is Crude Oil leading Gold higher, and the eventual return to a sell-off in the 10-year Treasury market, especially as the Fed stops re-investing proceeds from maturing instruments.