To begin the year I advised readers to focus on the value of the US dollar because of its influence on the market's inflation premiums, which I view to be the single most important financial metric. In The Single Most Important Market Price to Watch in 2014
, I led off with the following:
Regular readers know that I am a big proponent of observing the market's embedded inflation premium, which is the extra compensation investors command for inflation risk. All else equal, inflation premiums govern real interest rates, the slope of the yield curve, the value of the dollar, commodity prices, and risk multiples.
In their latest Quarterly Review and Outlook
, Hoisington Investment Management's Lacy Hunt and Van Hoisington reiterated the importance of the inflation premium in their analysis of the breakdown between nominal and real interest rates by citing Irving Fisher
’s The Theory of Interest
and the Fisher equation, which states the nominal bond yield is equal to the real yield plus expected inflation. It serves as the pillar of macroeconomics and as the foundational relationship of the bond market.
Hunt and Hoisington go on to break down the difference between the real rate and the inflation premium through different cycles in history. This is what they conclude (emphasis mine):
The significant point is that while average inflation and bond yields were volatile, the average real yield was far more stable. Over these longer stretches the average real yield was never far from the post 1871 average of 2.2%. Thus, over long periods of time, bond yields fluctuated in response to rising and falling inflation. However, the real bond yield steadily reverted to its mean indicating that inflation was the driving force in determining the bond yield over time.
This is an extremely important concept to understand, and as I suggest above, it can also be applied to risk premiums. Just like real interest rates are consistent through various cycles, economic growth is similarly consistent over time. It’s not economic growth that drives stock market performance, it’s the multiple paid for that growth. The multiple is not a function of the growth rate but rather the inflation risk premium. Thus it's not real interest rates or earnings growth rates that are volatile; it's the market's discount for inflation risk that drives both bond market and stock market volatility.
Last week's slew of inflation data showed continued weakness in price pressures that have persisted since the Fed ceased QE II in 2011. The year-over-year (YoY) growth rate in import prices came in at -1.3% vs. the estimate of -0.6% with last month's reading revised to -1.9% from the prior -1.5%. The YoY PPI was slightly stronger at 1.2% vs. the 1.1% estimate, and stronger than the prior month's measly 0.7%. The YoY CPI hit 1.5% vs. last month's 1.2% growth rate. The Fed's preferred inflation bogey, the personal consumption expenditures (PCE) deflator, has yet to be released, but the November 2013 reading of 0.9% remains far below the Fed's 2.0% target which hasn't been seen since April 2012.
It’s important to keep in mind, though, that there is a difference between actual inflation and the market's inflation premium. There is no doubt that currently, inflation pressures are benign, however I want to examine what factors could lead to an increase in the inflation premium that impacts market prices and price volatility. Inflation premiums in bond yields and risk multiples are a function of inflation risks, which manifest themselves in the currency and commodity markets. Thus to perform this analysis I want to focus on the relationship between the value of the dollar, which is near cyclical highs, and the prices of various commodities, which are near cyclical lows.
CRB Commodity Index Vs. USDJPY
Commodity-sensitive currencies such as the Aussie dollar (AUD) and the Brazilian real (BRL) have been under pressure since the dollar began bottoming against the Japanese yen in 2011. The AUD has been under pressure due to waning Chinese demand for the industrial metals it exports (such as copper) and in fact it tumbled to a new low last week. The BRL has been under pressure due to a number of geopolitical issues but also arguably because of a glut in agricultural supply (such as corn). Just last week the Bank of Brazil raised interest rates more than expected to curtail inflation caused by a weak BRL.
Inflation premiums are low because inflation risk is low because the dollar is strong relative to commodity-sensitive currencies. The biggest risk for US asset prices is a return of inflation risk, and I think the two markets investors need to keep an eye on are copper in relation to the AUD and corn in relation to the BRL.
The decelerating Chinese growth story is well-known. As a result, iron ore prices have been dropping amid forecasts for a reduction in Chinese steel production. According to mining.com
, Chinese iron ore stockpiles rose to "88.6 million tonnes in December, up a whopping 21% from a year ago and up 26% since January 2013." What’s interesting, however, is there has been a recent divergence between the price for iron ore and its industrial cousin, copper.
Iron Ore Vs. Copper
This weekend’s Wall Street Journal
stated the following:
Copper consumption by the world's biggest user remains resilient even as China's economy cools and Beijing attempts to tighten access to credit, analysts say. Stockpiles of the metal in London Metal Exchange warehouses have fallen 50% since late June. Much of that copper has been moving to China, industry experts say.
AUD Vs. Copper
Copper prices are up 7.1% from a three-month low reached in mid-November.
Historically the relationship between the price of copper and the AUD has been positive. If the rally in copper were to be sustained, it could be the catalyst for a reversal in the AUD and renewed dollar weakness.
Perhaps the most important commodity in terms of its influence on US consumer inflation is the price of corn. Corn is the main feed for livestock, with nearly half of all US production going into feeding our protein supply; this has enormous influence up and down the food chain. Not only do corn prices influence the price pork, chicken, and beef, they also influence the price of eggs, dairy products, and anything artificially sweetened with corn syrup.
The last major spike in the price of corn was between the middle of 2010 and 2011 when the price jumped 150% in 12 months. You will recall this was during the QE II program and the dollar was under assault by the Federal Reserve. Over the same period the USDJPY lost 20% of its value and overall inflation rates were rising rapidly with the YoY growth rate in producer prices topping 7% in June 2011.
Over the past year, corn production has been robust both here and in Brazil, which is the largest corn exporter. As a consequence, the price has been falling and the US dollar has been rallying, especially against the BRL.
Brazilian BRL Vs. Corn
This past week California's Governor Brown issued a state of emergency due to severe drought conditions. While these severe drought
conditions haven’t made it to the Corn Belt in the Midwest, there are pockets where drought exists.
The current price of corn is below what many producers deem to be the breakeven level: $4.50/bushel. If the price remains below breakeven into the spring planting season, you may see corn acreage capacity drop, or the acreage may be shifted toward other crops. If drought conditions persist or spread into the Midwest, it could set up a perfect storm for a supply disruption.
Now, I am not suggesting that the price of corn and the BRL are directly correlated, but they are positively related. Were US supplies to take a hit, corn prices would rally and we could see the dollar weaken against the BRL as demand shifted to Brazil.
The dollar is strong, inflation risk is low, and risk multiples are high. I can't see anything on the horizon that will change this trend. The Fed is in the process of removing stimulus (which is dollar bullish), inflation expectations remain well-anchored, and equity and credit risk are the place to be. The market already knows this. What the market doesn’t know is what would happen to risk multiples if inflation premiums steepened because commodity prices started to rise and the dollar started to weaken against commodity-exporting currencies.
Recently Fed officials have expressed concern with the low levels of inflation, and there has been some suggestion of raising the Fed’s 2.0% inflation target. I say they should be careful what they wish for. The last two spikes in inflation risk were in 2008 with oil and 2011 with corn. Both those episodes didn’t pan out so well and were followed by a crash in risk assets. Today it’s all quiet on the inflation front, and inflation risk premiums remain subdued. However, these risk premiums are dependent on commodity prices and the currencies of commodity producers such as the AUD and the BRL. These prices are all depressed and poised to reverse, which would put pressure on the dollar, inflation premiums, and risk premiums.