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Yellen's Potentially Massive Problem: Inflation Correction?


Inflation expectations are rising, and that might be a big problem for the Fed chair.

Intellectuals solve problems, geniuses prevent them.
-- Albert Einstein
Janet Yellen's testimony was no surprise in terms of her continued dovish tone. While the economy has been improving, the Fed chairwoman views low rates as justified for a "considerable" amount of time beyond the end of quantitative easing.  Inflation trends are "transitory," and as long as inflation expectations remain well-anchored, the Fed does not need to worry about accelerating rate hikes or a situation where inflation gets away from it.
The problem is that inflation expectations actually have been rising.  Many focus on breakeven spreads as a way of seeing if the crowd believes inflation will rise.  Perhaps a better way to track inflation expectations is through the demand for inflation-sensitive assets.  Take a look below at the price ratio of the iShares Barclays TIPS Bond Fund ETF (NYSEARCA:TIP) relative to the iShares Barclays 7-10 Year Treasury Bond Fund (NYSEARCA:IEF).  As a reminder, a rising price ratio means the numerator/TIP is outperforming (up more/down less) the denominator/IEF.  A rising ratio means the price of TIP is accelerating at a faster clip than IEF, which implies money is actively bidding up inflation protection.

Note that the price ratio is nearing resistance and that we seem to be at an important juncture from the standpoint of market expectations.  A breakout higher would mean inflation expectations are indeed rising, and investors are preparing for that.  This could dramatically alter intermarket dynamics and result in the Fed legitimately being behind the curve on when rate hikes happen, should those expectations be right.  This should, in turn, result in long-duration Treasuries selling off, which might be on the verge of happening relative to the IEF.  The ratio has gone sideways, and may be consolidating.

For my firm, in our absolute return and equity sector rotation mutual funds and separate accounts, we remain ready to rotate defensively based on our weekly quantitative inputs.  In our Beta Rotation vehicle, this means a full move back into utilities, health care, and consumer staples.  In our Absolute Return inflation rotation vehicle, this means back into Treasuries, potentially short-duration should long-duration Treasuries continue to sell off.
This remains one of the most deceptively difficult tactical environments in history, and Yellen's problem may end up being a market reassessment of inflation, which in turn shakes interest rate-hike expectations and ultimately various asset class performance.

Twitter: @pensionpartners
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No positions in stocks mentioned.

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