From the desk of Steven Strazza @Sstrazza and Ian Culley @IanCulley
It was only a month ago that we discussed the TIPS versus Treasuries ratio hitting its highest level since 2013 as investors prepared for rising inflation.
Fast-forward to today, and the inflationary backdrop looks very different.
Inflation breakeven and forward expectation rates have rolled over aggressively since the middle of November. This is illustrated by the TIP/IEF ratio, which recently undercut its May highs. Combine this action with the lack of follow-through on last week’s kick save from the 30-year yield, and the prospects of rates rising across the curve aren’t looking too hot.
But what does that mean for risk assets?
For starters, commodities will miss out on all the usual tailwinds that come with inflationary pressure. Let’s take a look at a chart that highlights that relationship.
Below is the TIP/IEF ratio overlaid with the CRB Index:
In a previous post, we pointed out the strong correlation between the TIP/IEF ratio and cyclical stocks, using metals and mining stocks as an example. As you can see in the above chart, when we overlay inflation expectations with the broader commodity market, there's also a very strong positive correlation.
The truth is that the TIP/IEF ratio can be overlaid with a wide variety of risk assets, and it will show a strong relationship. This is because stocks, commodities, and other risk-on trades tend to perform well when investors are anticipating a rise in the rate of inflation.
Following this same logic, it would mean these areas tend to perform poorly when the market is pricing in disinflation or a slowing in the pace of inflation.
With that in mind, TIPS sliding back within their prior range as they underperform Treasuries on a relative basis does not bode well for commodities. Investors are no longer anticipating an inflationary environment that favors these raw materials, and that could take the wind out of the sails of the recent rally.
Of course, the corrective action in inflation-protected Treasuries on a relative basis could be no more than a classic retest before resuming higher.
In that case, we'd expect commodities and cyclical stocks like materials, industrials, and energy to resume higher as well. We’ve already been seeing pockets of strength from certain cyclical subgroups like homebuilders and railroads. But there are plenty of other consolidations and sideways patterns out there that need to resolve higher.
And one of the most important on our radar is TIPS relative to treasuries. If this ratio repairs the recent damage and resumes higher, we’re expecting risk assets to follow.
With the ratio just hitting its lowest level since September, though, there's a lot of work to do if this is going to happen. For now, it looks like more range-bound action is the higher-probability outcome. And if this is the case, we should expect further consolidation and messy price behavior from commodities too.
We’ll be sure to update you on this relationship as soon as anything changes!
Countdown to FOMC
Following yesterday’s Federal Open Market Committee meeting, the market is now pricing in the first rate hike in May 2022.
Here are some of the probabilities for the May meeting based on fed funds futures:
