From the desk of Steven Strazza @Sstrazza and Ian Culley @Ianculley
We could sit back and speculate on what measures the Federal Reserve is likely to take to curb inflation. But it wouldn't change the fact that inflation is already here.
We’d rather focus on what market participants are doing now to position their portfolios for these inflationary pressures.
Since last year, inflation has gripped markets, and we don’t foresee it going away anytime soon. We think the best course of action is to get used to this environment and focus on assets that tend to perform well during periods of inflation.
One of our favorite ways to measure inflation expectations is by analyzing Treasury Inflation-Protected Securities (TIPS) versus Treasuries.
Relative strength from TIPS implies that investors are positioning themselves for a general increase in the prices of goods and services. That’s exactly what we’re seeing today.
Let’s take a look and discuss what we want to do about it.
Here’s an overlay chart of the $TIP/$IEF ratio and the US five-year breakeven inflation rate:
These two charts are almost identical, following a similar path through peaks and troughs since the advent of these ETFs. And this comes as no surprise as we’re just analyzing the same credit instruments in a different way.
Breakeven inflation rates are simply the spread between the yield on Treasuries and TIPS of the same duration.
As for TIP/IEF, we’re looking at this same relationship but measuring it using the prices of these bond funds as opposed to their yields.
In recent sessions, breakevens and the TIP/IEF ratio have been rallying higher. This tells us that market participants are pricing in more inflation in the future.
This also means they’re getting more comfortable with the reality that the Fed will be raising rates to combat this inflationary economy.
So, how do we want to position ourselves? It’s simple, really…
Some stocks -- like cyclicals -- tend to perform better in an inflationary environment. At the same time, other types of stocks -- such as growth -- tend to perform worse.
A great example is the Metals and Mining ETF $XME.
Here is an overlay chart of the TIP/IEF ratio and XME:
A few months ago we highlighted the strong correlation between these two charts. We pointed out that metals and mining stocks tend to do well against a backdrop of inflation and strong global growth.
Fast-forward to today, and XME is printing fresh 10-year highs while the TIPS/Treasuries ratio is carving out a series of higher highs and higher lows.
This is exactly what we wanted to prepare for. And it's what we want to continue to prepare for in the coming months, quarters, and years.
It’s no secret that commodities are hot. We think inflation expectations are likely to follow in the path of XME and make new highs any day now.
And with the prospect of a prolonged period of inflation becoming a reality, commodity-related stocks are the place to be.
We’re seeing it this week, as industrial metals and agricultural stocks are dominating the new highs list along with energy.
We’ll continue to focus on these areas of the market and highlight our favorite long opportunities in those names showing relative strength.
Stay Tuned!
Countdown to FOMC
Following Powell's congressional testimony today, the market is pricing in a 25 basis point rate hike at the March meeting.
Here are the target rate probabilities based on fed funds futures:
