What is the Optimal Inflation Hedge?

Yesterday's FT noted the rising demand amongst investors for inflation-safe debt. The UK on Monday saw the second best tender, or mini-auction, for inflation-protected bonds since October 2008. Notably, inflation expectations have risen sharply in the U.S., particularly because of the credit-easing policies and record low nominal rates. Last week, there was strong investor demand for a $10bn 10-year US inflation-linked bond. Its bid-to-cover ratio was 2.65 (versus the average of 2.14 for the past five new sales).

Using the break-even rate, which is the difference between conventional U.S. treasury bond yields and inflation-linked bond yields, we can see that current inflation expectations are roughly in line with pre-Lehman levels. Worth note, since last Friday's disappointing employment report, 5Y and 20Y expectations tightened by nearly 10bps through today.

It is important to put this in context. Looking at a histogram of implied inflation expectation levels since Jan-08, we appear to be back near median forecast levels (histogram at right). It is also important to notice the modest correlation that these expectations have on the price level of both gold and oil (see regressions at right).


This begs a few very important questions for mitigating risk to our portfolios in the future; namely, what are the levels of inflation that we can anticipate in the future, when, and how best can we hedge ourselves for the long run?

I am a believer in Mauldin's view that we can expect to see a "statistical recovery", the statistics (i.e., GDP, etc.) are positive but it certainly doesn't "feel" like a recovery. First, year-over-year comparisons are looking better, since 2008 was horrific. Second, inventory levels are about as low as they will go. In the way GDP is figured, a reduction in inventory reduces GDP (perhaps GDI is an even better barometer...). That was a negative figure for most of this recession. Simply because inventories not falling any more, it is easier to get a positive GDP. Lastly, the onetime benefits for GDP from the fiscal stimulus are coming due (toughly 90% of the 2.2% growth in GDP in the third quarter was attributable to the stimulus), and we can already see the effects of federally-sponsored growth (auto sales fell in Dec-09 0.8% after a 1.2% Nov-09 gain, slumping in Sep-09 after the "cash-for-clunkers" plan expired).

I am always skeptical of outliers and when the momentum of the herd moves to quickly. Looking at how quickly inflation expectations have resumed to pre-crisis levels, despite a tremendously negative macro, gives me great pause in the bubble taking place in commodities like gold and oil. This has been a shift away from my more tactical-oriented momentum-based trading of options on the GLD in recent months. I am cautious with how quickly risky assets and inflation-sensitive commodities like gold have risen in recent months. Granted the past is not indicative of future performance, but if you look at past recessions, it is not all that unusual (8 out of 11 times) for there to be positive GDP quarters in the midst of an ongoing recession.