This year has been a very tough year for most investors except for global macro investors. This is because there is a very strong macro theme this year and that is inflation. Global macro investors made money from putting on the inflation trade. What is the inflation trade? Other than the obvious beneficiary being long commodities, short stocks, short bonds, and long USD also benefitted.
The inflation theme was kept alive every time the official CPI came in hotter than forecast. This led to hawkish rhetoric and rate hike action from the Fed with four consecutive 75bp hikes. This gave the inflation trade plenty of legs to run. However, something changed this month. For the first time, CPI came in convincingly below forecast on 10th November. This allowed the Fed to contemplate slowing down future rate hikes. Indeed, the Fed is largely expected to only hike 50bp in the next meeting.
As a result, the inflation trade began to unravel. The VIX also came tumbling down and the VIX term structure is now back in the normal contango shape. The VIX looks ready to drop below 20.
Is The Inflation Trade Dead?
I think that the bout of inflation we experienced this year is a result of the world re-opening up from COVID. Of course, the Russian-Ukraine war and the China zero-COVID policy led to supply chain issues which also contributed to inflationary pressures. As the normalization continues, some of these effects will dissipate. There are some clues that we can watch out for.
Turning to the wisdom of crowds, we can monitor the market’s expectation of future inflation. As long as it remains anchored around long-run inflation levels, we should be safe. One of the indicators we can use is the 5-year breakeven rate which measures the market’s expectation of the average inflation over the next 5 years.
Commodity prices have fallen from much higher levels but remain stuck in a range. It would be good if prices can continue to fall but as long as prices do not start to go up again, inflation should continue to come down.
Before this bout of inflation came about, there were already signs of frothiness in the market. With nowhere to go and nowhere to spend their free money given during the pandemic, many people became gamblers either in the stock market or in the newfound frontier of digital assets. Technology and growth stocks received the bulk of the money. Cryptocurrencies and NFTs were also beneficiaries as well. This led to ridiculous valuations in many companies, spurred the rise of meme stocks, and digital artworks became mistaken as the next “Mona Lisa”. Once the Fed started to tighten monetary conditions, all this froth was sucked out faster than a burst balloon. If ever such froth returns to the market again, it is a sign that inflation may rear its ugly head again.
Cleveland Fed’s Nowcast
The most reliable clue would come from the seer of inflation itself, the Federal Reserve Bank of Cleveland. They maintain an inflation nowcasting tool on their website https://www.clevelandfed.org/indicators-and-data/inflation-nowcasting that provides updated nowcast of inflation which is real-time and pretty accurate.
Is The Recession Trade Next?
Part of the contributing factors to inflation coming down is a slowing down in the economy. Consensus thinking is that the Fed wants to engineer a recession to bring down inflation. This naturally leads to the question of whether the next thing to hit is a recession. Therefore, it is perhaps not surprising that many market participants are anticipating a recession.
I do not know whether we will indeed experience a recession next year. However, markets have a funny tendency to turn the other way if too many people expect a certain outcome. Let’s see if this turns out to be the case this time.