Reverse repo, Fed Treasury buying, and a cash glut problem

The channels of monetary policy represent a complex system. The Fed is buying bonds and creating reserves, but if the velocity of money is low or declining, the impact on economic activity is limited. Reserves can build but if there is no lending, there may not be corresponding investment growth. Similarly, large excess cash balance may mean that consumer will buy more goods and service which will generate economic growth and inflation to bring the market back into equilibrium, but an alternative response could be an increase in the purchase of financial assets, financial inflation. Consumers can also hold greater money balances as precaution against uncertainty. Money growth may not lead to the intended economic benefits.

Now we have another plumbing problem. Banks are awash in reserves and don't want the money. Money funds are seeing cash balances build and the Fed does not want to see negative interest rates. Hence, there is an extraordinary demand for reverse repo (RRP)  which temporarily reduces money in exchange for Treasury collateral. The size of reverse repo has been at the greatest recorded and we are not in a crisis. These RRPs reverse the $120 billion in Fed purchases of Treasuries per month. 

Monetary policy is not like a car on an icy road - sliding to one side only to overcompensate to get back in your line with the unintended consequence of further action. The Fed has to do RRPs to keep rates from going negative. Money funds have to do RRPs with Fed to earn some positive return. The Treasury is reducing their balances at the Fed which places more money in bank deposits which banks don't want. The system is not effectively working yet the Fed says it is not ready for any policy change. 

This money market behavior cannot continue so there is a greater likelihood for a tail event that creates a divergence from the status quo. 

Inflation effects are complex - so investors need to dig deeper into the numbers

Looking in more detail about inflation will help with asset allocation decisions. There is a difference between core and headline inflation.  Headline inflation will be impacted by energy costs. Put in the context of today, if inflation is coming through increases in wages the effect  on asset prices will be different than an increase in oil, food, and or metals. A commodity shock to inflation should be viewed differently from a wage cost shock. An inflation shock associated with higher energy prices should not be viewed as the same as other inflation shocks. (See "Getting to the Core: Inflation Risks Within and Across Asset  Classes".)

The impact of core inflation on stocks is different than headline inflation. Stocks are not sensitive to  headline inflation, but there is a strong negative effect from core inflation and a positive beta from energy price increases. The sensitivities to inflation vary highly against different asset classes.  The conventional hedges for inflation such as commodities and currencies are less effective against core  inflation. The relationship between inflation and asset prices is time varying. Hence, it is difficult to make broad generalization concerning past inflation shocks  and current market conditions.

Clearly there has been a pandemic inflation shock and energy costs have risen from the extreme lows of last spring, but the current inflation shock is also driven by an increase in income. The demand for products has  increased which has supported firm profit margins. Similarly, this inflation shock based on percentage change is huge, but the level of inflation is still low versus other shocks. Notice that stocks do well even in rising inflation when the level of inflation is still low. 

Investors need to be specific about inflation risks in order to make good investment decisions. 

Commodities - Hard to go wrong during inflation decades

Looking over the long history of commodity investing suggests that using any number of strategies would have done well during periods of higher inflation. Holding commodities are not without risks based on the size of drawdowns during each decade; however, whether momentum, basis, value, long/short or long-only, commodities can be a good addition during periods of higher inflation.  (See Two Centuries of Commodity Futures Premia.) 

While the purpose of the paper was to measure commodity futures risk premia, it also provides some indirect evidence on commodities and inflation. There is gain from momentum - prices trend  and show momentum. There are gains from value - prices that have extremely low move to longer-term averages. There are gains from basis - the cash/futures curve which shows backwardation and contango displays the congestion and value from holding cash inventory.

Of course, the level of inflation during the 1980's and 1990's was still significantly higher than what we are currently seeing, so the potential returns may be muted. Nevertheless, the quick pandemic recession coupled with excess money has already created a huge boom for commodities. Whether this will continue is less clear, but the last year has generated explosive commodity upside but may still allow for further price gains. 

Protection against inflation - Work with trend-following

Inflation is coming. Inflation is here. Investors, if they have not already, need to review and implement portfolio strategies for a different inflation regime. It is possible that the recent prints of high inflation will be transitory, but policy-makers desire to have a higher inflation environment, so investors should only disregard inflation at their own peril.  

Investors have to look at the impact of inflation on both the asset classes and strategy styles. From this analysis, it is clear that trend-following across many asset classes will do well for investors. The process of trend-following going long or short in any asset class can protect from the downside impact from inflation and allow for upside capture. See The Best Strategies for Inflationary Time. 

Making good inflation choices is critical for investors given the large dispersion in returns across asset classes and styles. The return dispersion within equity asset class styles is tighter than what is seen across asset classes, but the data suggest holding momentum during inflation shocks. Within the trend style, holding bond and commodity exposure will do better than currencies or equities. There is less inflation ambiguity - short bonds and long commodity during unexpected increases in inflation is an effective strategy combination. Adjusting for inflation is more than just changing asset classes, it also is an adjustment of strategy thinking with a focus on trend-following. 

Sam Zell's success in business in seven rules

Reread the classic business book by Sam Zell, Am I Being Too Subtle? Straight Talk From a Business Rebel. He is not a subtle guy. He is not conventional, but you have to respect him for his honesty, straightforward approach to business, and his willingness to have fun. The last chapter of the book outlines his key points for success. 

I am getting older, but I will always benefit from focusing on his advice. I am planning to give this book to a newly minted college graduate in our family He will benefit from following these rules which are not often learned in classrooms. There are no business secrets here rather many of his points focus on the under-appreciated idea of character.  

1. Be ready to pivot.

2. Keep it simple. 

3. Be the lead dog 

4. Do the right thing.

5. Shem Tov - Maintain your good name

6. Prize loyalty. 

7. Obey the eleventh commandment - Don't take yourself seriously 

The three D's of inflation uncertainty - Distortion, Delay, and Destruction

 

Haunting the Fed in 2021: The Mistake of 1937

History provides great lessons from the past. Unfortunately, many don't want to follow the past and maintain the "this time is different" view. Alternatively, history can also haunt us. We may be constrained by our inability to leave history behind.

I am worried about Fed complacency about inflation. Inflation is only transitory ex post. At zero nominal short rates, negative real rates, and $120 billion in Treasury buying a month, there is significant excessive monetary stimulus. Talk is growing about the Fed having to do something in the face of inflation, yet early action has its own downsides. There are no good choices; however, the bias is to have everyone take the pain from inflation instead of a stalled recovery.

So what can we pull from past Fed history that may can give us some insight on current Fed thinking? A relevant piece of history is the "Mistake of 1937". (See "Commodity Prices and the Mistake of 1937: Would Modern Economists Make the Same Mistake?" from the NY Fed Liberty Economics blog for any interesting review.) The policy mistake was a premature tightening by the Fed based on rising commodity prices and the belief that the US economy was in recovery. It wasn't, and Fed action pushed the Great Depression economy back into an economic downfall that was only reversed by World War II.

We have similar signs today; improvement in the economy and strong increases in commodities. The Fed does not want to fall into a 1937 trap, so they may be more conservative toward any change. I can appreciate this view. I am not making a normative judgment that this is the correct or wrong view. I do believe the haunting of 1937 may cause a policy delay, so investor should be ready for the consequences. 

 

Dollar index as a relative inflation money indicator - Standard model but still useful as a starting point

 

Forecasting is not easy, but an effective method is to start with a simple construct or explanation and then add complexity or counter-examples for why the simple may not work. Of course, a good forecast is not the same as a narrative. The narrative will use data to provide an explanation to the past or current environment. Even a detailed narrative is not the same as making a prediction about the future. 

A quick look at the dollar (DXY) index and some current macro information sets the stage for what is important for a continued dollar trend or a reversal. One, inflation spiking in US relative to other major G7 countries is placing significant downward pressure on the dollar. Two, the relative money growth in the US over the last year relative to the other top central banks (C5) also places more downward pressure. The dollar  slide will stay in place given a continued guidance that Fed policy to keep rates lower for longer and allow inflation to run hot. Even with transitory inflation, using macro numbers in the US with a monetary model does not look dollar attractive. The trend will only change if there is a switch to hawkish sentiment from the Fed coupled with some taper action.

The forward dollar prediction is a judgement on relative inflation, relative money, and relate rates differences. While for many this may be viewed as obvious, it is always good to go back to basics for framing predictions.

Currency investing, mean-reversion of real effective exchange rates (REER), and portfolio flows

There can be value investing in currency markets through using information on the Real Equilibrium Exchange Rate (REER) which is the trade-weighted average exchange rate adjusted for inflation differences. REER provides a better measure of currency equilibrium over the standard purchasing power parity model  against a numeraire like the dollar.

A shock to REER will show a strong tendency to mean-revert albeit with different speed of adjustments based on the size of the shock and potential portfolio flows. The adjustment of REER can actually occur in a matter of months based on the type of shock. A deviation or shock in the REER will usually lead to changes in interest rates that will generate portfolio flows that will lead to currency adjustments. Greater flows will speed the closing of any REER deviations. Hence, if there is a large deviation in REER, that make for attractive capital flows, there is an opportunity for return gains. It is an easy enhancement to a standard currency carry model. See "What Flows Around Comes Around: Mean Reversion and Portfolio Flows"

We have found that sorting by size of the deviation from a longer-term REER can allow for unique currency trade opportunities. Buy or sell those currencies that have the greatest deviations from some measure of fair value in this case REER. Wait for a trend in portfolio flows to place trade opportunities. 

There is growing information from some custody banks on portfolio flows that can be used reinforce any REER signals. This type of trading can be conducted in conjunction with trend and carry strategies. Measure the  REER dislocation, follow the portfolio flows, follow the trend, and trade the carry. 

G7 versus C5 - Fiscal versus monetary policy coordination a key focus for investors

Perry Merhling, the monetary economist, coined the phrase "Forget the G7, watch the C5" during the early post-GFC period. He was focusing on policy coordination among the Fed, BOE, ECB, SNB, and BOJ. His view of focusing on central bank behavior was critical a decade ago and is still relevant, but there is a new emphasis on fiscal policy, back to a focus on the G7. G7 coordination on tax and spend policies is having more relevance for investors during the reflation. "Don't forget the G7 when looking at the C5."

Since the last financial crisis, we have moved from a strong emphasis on monetary policy and less discussion of  active fiscal policy to an emphasis on fiscal policy with monetary policy accommodating the needs of finance ministers. The coordination, or lack of coordination, between the G7 and C7 is now the focus of investors. It will be critical for the inflation path as well as growth.

Call it war-time fiscal and debt policy with monetary coordination to reduce the cost of financing. This policy coordination is not a bank liquidity problem (the GFC), but a government funding problem. At one extreme is the US with large deficits and monetary coordination to support fiscal spending versus a mix with the ECB and eurozone where coordination is less defined. US money supply has grown over 24% YOY versus 9.5% for the ECB and just over 9% for the BOJ. Many other countries have spent less but increased equity, loans, and guarantees. There is large difference between developed economies and emerging economies which will impact relative country  growth rates. Investors have to look at the combination of fiscal and monetary policy to answer growth and financial asset return potential.

 

Inflation and logistics - Potentially transitory but significant

 

Inflation is higher because of the surge in logistics costs. It is  not the only reason, but it is a key rationale for the transitory inflation story. The choices made last March are haunting a global economy that is now in recovery. The price of shipping as measured by different freight indices have exploded to the upside although there may be some evidence that the positive acceleration has slowed. 

The Fed is optimistic that these increases are temporary like the logistical price behavior after the GFC; however, a flattening of rate of change is not the same as a price reversal. Additionally, warehousing and inventory costs are increasing. Solving just-in-time shipping issues leads to other business costs. 

If you are tracking transitory inflation, these logistical indices should be front and center with any discussion.

Semiconductor inflation hysteria or something else? Follow prices, not the news

No chips! No chips! There have been recurring stories and a meme that the US and global economy is having a semiconductor shortfall. Shortages and supply problems exist. Farm equipment cannot be sold to dealers and framers because there is a chip shortage. Auto plants are closing because of chip shortages. Chip shortages are becoming described as a national security issue. 

If there is a chip shortage one would expect that semiconductor prices will increase significantly. The data show something else. Year over year price changes are still negative. A look at the semiconductor SOX index ETF (SOXX) shows a price decline from April highs and is at the same level as mid-January.

Follow the news or follow the price action. There may be logistical issues and bottlenecks, but it is generally better to follow prices.

 

Why value and momentum risk premia are a good combination - Different sensitivity to macro risk factors

A number of researchers have found that blending value and momentum is a good diversification strategy. Some have found that trend and value also work well together. The benefit from blending value and momentum premia returns comes from their negative correlation. Additionally, these two risk premia strategies have been proven to be the most consistent of all tested over long periods. These risk premia are time varying but have proven to be successful over long periods, across all asset classes, and across different countries. 

So, what makes this combination of value and momentum so special? We can find the rational of the value and momentum combination through looking a number of traditional global macro risk factors that have been long identified as useful. 

A useful set of global macro factors (variation of Chen Roll, and Ross 1986 factors) include: the term premium (identifies monetary policy and business cycle), the growth in industrial production (business cycle), unexpected inflation, change in expected inflation, and the default spread. The sensitivity of value and momentum risk premia to these macro factors are found to be the opposite signs. However, the sensitivities or strengths are different, so the macro factor effects do not cancel out return potential. These common macro risk factors will impact all asset classes and are associated with asset pricing anomalies.

 

A diversified portfolio that may include value and momentum risk exposures also has exposure to a set of global macroeconomic factors. An investor can change the tilt or mix between value and momentum based on their view to these macro factors. An investor that wants to hold different risk premia strategies should realize that he is holding different global macro factor exposures.

New inflation and the old descriptions

 

"Cost push inflation"

"Demand pull inflation"

When was the last time you heard those phrases? You may have to get into the way-back machine from decades ago. These inflation phrases are still taught in introductory macroeconomic costs, but little time was spent dwelling on the specifics especially given the sub 2% period post-GFC. Inflation was often discussed as a necessary evil to allow for policy flexibility.

We are certainly in a different inflation world than the 70's. Oil price shocks and union wage demands do not have the same potential impact for creating cost-push pressures. Globalization and output slack also does not allow for the demand pull reaction seen in the past. Yet, it may be time to brush up on inflation dynamics and their potential impact on the economy. 

Investors have to focus on two issues. 

1. What is the threat of pass-through from increases in input prices? If commodity prices increase, will there be an increase in end user prices? If there are increases in wages, will this translate into higher check-out prices? If supply chains are stressed, will prices increase? Given earnings have been high, profits can be squeezed without the failure of firms. Firms can choose to hold prices steady. Will they follow this strategy now?

2. What is the threat of price increases from excess demand? If incomes are higher, there can be stresses from higher demand that was not anticipated. We have already seen this  in the lumber market. Many lumber yards cut inventory in the spring of 2020 under the anticipation of falling demand. They were wrong and the cost has been demand-driven shortages. Again, firms have to determine whether to increases prices in the face of higher demand. Or, consumers have to determine whether they will pay higher prices to ensure delivery and reduce waiting times. 

The pricing game is simple - can firms adjust prices and get away with consumers accepting less at the same or higher price? If firms perceive that consumers will accept price increases, they will do it. We are seeing this with airfares. Prices are moving higher, and planes are being filled although load factor data are still not available for the current month. The increases are sticking, so demand pull price changes are happening. If this occurs across many industries, we have inflation.

"All inflation is transitory until after the fact."

Simple monetary arithmetic - P-star suggests higher inflation

Few money managers are monetarists. Many lost money and in some cases their jobs for believing that the expansive QE of the post-GFC period would lead to higher inflation. Follow money at your own risk, but some analysts say this time is different given the magnitude of money growth and the large decline in money velocity. See, for example, Lars Christensen "The Market Monetarist" blog and his simple use of the P-star model. 

P-star is a simple toy model. Take the classic quantity theory of money equation, MV=PT and include money growth, long-term trend in velocity, and long-term NGDP growth to solve for inflation potential. P-star = M(V*)/NGDP*. 

P-star is the price inflation that would exist given current money growth and if velocity and GDP were at their long-term trend. It is then easy to compute the gap between P-star and P. This gap would be the expected inflation given trend velocity and GDP versus actual inflation. This inflation gap can be closed a number of ways; however, if money growth stays high and velocity and growth normalize to trend, the only solution is an increase in actual inflation.  

There will be a delay effect between a money shock and economic trend, but the logic is straightforward. If excess money balances are drawn down, velocity which has been excessive low will increase and move back to long-term trend velocity. GDP may rise above trend, but if it reaches potential GDP, prices will have to rise. If GDP growth is constrained by its potential, then higher money will need to be held as higher balances which will lower velocity or prices will have to rise to equilibrate our classic equation. 

There are a number of simplifying assumptions with this toy model, but it provides a point of departure for discussion using a simple monetary framework. If growth is below potential, there is less likelihood that prices will rise. If money balances are high (velocity is low), there is less inflation, but if balances are reduced and spent, prices will rise especially if GDP is constrained. Output gaps which are closed will also close inflation gaps. 

Of course, this does not account for leakages into the financial system which have been high and have served as an alternative to purchases of goods and services. Money balances may decline not to buy good but to purchase financial assets. The financial leakages have driven financial prices not real assets. It is assumed that as the economy normalizes, financial leakages will switch to real purchases.   

Working with this simple equation leads to the uncomfortable conclusion that inflation may rise significantly in the next year as economic growth returns to potential and velocity normalizes. This inflation will only be transitory to the extent that money growth slows going forward. This is not a prediction but a point of departure with the classic monetary identity. 

Investors forming bets around transitory inflation arguments

There is heightened discussions on inflation especially with the higher than expected April CPI print, but the real focus is on the issue of transitory inflation. The Fed has fostered this discussion with their argument that there is no need for any preemptive early action even if there is an inflation spike because it will not last. Any inflation fears today should be tempered. This is consistent with market consensus inflation forecasts and inflation breakeven term structures. Overall inflation expectations are higher, but the inflation term structure is inverted. In a year to eighteen months inflation should decline albeit be slightly above 2 percent. 

We have listed a set of arguments for transitory inflation in the table below. Many of the transitory inflation arguments make sense and have good foundations. For example, supply chain bottlenecks can lead to higher prices now which should be offset over time. Some labor shortages will be eliminated as pandemic rules are further relaxed. Base effects and inflation dispersion will be moderated over time as we return to pre-pandemic economic behavior. 

However, a focus on short-term transitory inflation is a smokescreen versus the core issue of whether current monetary and fiscal policy provides a foundation for a higher inflationary environment. Recent history suggests that any link between money and inflation is weak, and any Phillips curve trade-offs is illusionary, yet these are the questions which have to be addressed for higher long-term inflation. A bet on higher inflation and a monetary policy mistake is against the consensus yet betting on or hedging against extremes is a time honored approach to higher performance. The cost of following the consensus may be very high in this case. 

 

SPACs and changing optimism - A possible sign of changing sentiment

IPO and SPAC issuance provides a measure of market optimism and potential speculative excess. An increase in issuance tells us something about demand, but price performance against benchmarks provides a measure of market optimism in the face of uncertainty. IPOs provide a measure of optimism on potential growth of small new firms that are driven by new ideas and technology. Investors look at the filings and recent past performance and extrapolate this growth into future to form a valuation. 

SPACs have the process backwards. Rather than bet on the known past, investors buy into a management team that will find a future opportunity within a fixed time period. The SPAC investor forgoes known behavior for an unknown future. You are buying pure optimism on unknown opportunities. 

There are ways to track the SPAC market, the CNBC SPAC 50 index and the SPAK ETF. Both show strong optimism in early 2021 only to see a quick reversal. The SPAC ETF can be compared with an IPO ETF (IPO). Both show the same behavior with a slight upward bias toward the IPO portfolio. These moves may represent an early change in overall market sentiment.