article originally appeared
in the May issue of REP. Magazine and online at
"Business opportunities are like buses," says Richard Branson,
entrepreneur and founder of Virgin Atlantic Airlines and the Virgin
Galactic spaceflight company. "There's always another one
But if Sir Richard peers closely at the destination sign on the
next bus, though, he might notice the way points include a swing
through "Inflation." A number of fundamental and technical
indicators are now signaling a buildup of inflationary pressures in
the domestic economy.
On the fundamental side are upward revisions in gross domestic
)) as well as goose-ups in personal income and consumption
expenditures. Then there's better-than-expected numbers for durable
goods orders, construction spending and auto sales. All told, these
are signs of a healthier economy. And of the effects of the Federal
Reserve's attempt to reflate the financial system.
The exchange-traded funds ((
)) market, too, reflects investors' sense of incipient inflation.
Just take a look at the iShares Treasury Inflation Protected
Securities Fund (
), a $12.3 billion portfolio representing the market for Treasury
Inflation Protected Securities ((
)). Average daily volume for TIP ballooned in March to levels not
seen since October 2008 as the fund racked up its first net capital
inflow in 16 months.
Like conventional Treasury obligations, TIPS pay a fixed rate of
interest but TIPS' par value rise with inflation, as measured by
the Consumer Price Index ((
You can readily measure the relative worth of the TIP fund by
comparing its value to theiShares 7-10 Year Treasury Bond ETF (IEF)
which tracks conventional government paper of comparable
maturities. The deflationary momentum in the price spread between
the two ETFs has waned, leading to a bullish cross of the 50-day
moving average over the 200-day mean (See Figure 1).
Figure 1 - Inflation-Protected Bonds Build A Base
Other ETFs offer even better clues to the likelihood, degree and
timing of an inflationary surge. A key precursor of inflation at
the consumer level is an elevation in producer prices, which are
driven by trends in the commodity sector. The GreenHaven Continuous
Commodity Index ETF (GCC), an equally weighted portfolio of 17
non-financial futures, is a bellwether of commodity price momentum.
GCC rose 9.6 percent in the first quarter of 2014.
Traditionally, the Fed uses rate increases to curb the effect of
exuberant commodity prices, but current policy precludes such
moves. We've seen, in fact, more slack in rates since the top of
the year. The iShares 20+ Year Treasury Bond ETF (TLT) gained 6.5
percent in the first quarter as rates on the benchmark long bond
dipped 50 basis points. Long-dated paper, being more sensitive than
shorter maturities, is a telltale of investor sentiment as well as
Fed action to throttle inflation.
Tracking the ratio of GCC and TLT prices yields a day-to-day
measure of domestic inflation. Indexing the ratio to pre-crisis
(i.e., 2008) levels paints a vivid picture of the recent interplay
between raw goods prices and central bank policy (see Figure
Figure 2 - Inflation Metered By ETFs
Most notable in Figure 2 is the recent wedge showing upward
(inflationary) bias in the index. Technically minded traders see
wedge formations as set-ups for breakouts in the direction of the
prevailing trend. Most often, breakouts occur halfway to
three-quarters of the way to the wedge apex. That would imply a
window between February 2014 and January 2015.
Nothing in technical analysis, of course, is absolutely certain
so it's good to know the real odds of a break towards inflation.
For that, a little probability theory can be employed. Given the
current index volatility, the chances of a move above the recent
high (82.70 on March 7) over the next year are better than 2-in-3,
ten times more likely than a break below recent index low. The
wedge itself provides a clue to the breakout target. Projecting a
line parallel to the wedge bottom through the window makes the 100
level a likely objective - a level last seen in 2011.
All this implies a strong likelihood that annual CPI can be
lifted from its quagmire to reach or surpass the Fed's 2 percent
target. So what can investors do to gird themselves?
Well, since we've already talked about TIPS, let's start there.
Presently, there are 17 exchange-traded funds in the TIPS business
- 13 focused on the domestic market and four with global
portfolios. All of the international ETFs are in the top ten based
on year-to-date performance. That's telling. Apparently, there's
more concern about inflation in foreign markets than there is in
the 'States. Not surprising, really, given the Fed's accommodative
stance. Still, there is one domestic TIPS product that has handily
outdone the global portfolios.
Table 1- Top Ten TIPS ETFs
Just like conventional bonds, longer-dated TIPS are more
volatile than shorter maturities. That's why the category's top
performer this year has been the PIMCO 15+ Year U.S. TIPS ETF
(LTPZ). With an average maturity of 22 years, two-thirds of the
fund's holdings are in the 20-to-30 year range. While the fund's
duration is also a chart-topper, indicating LTPZ's potential
effectiveness as an inflation hedge, it's also a beacon of the
product's inherent interest rate risk. LPTZ investors have to be
sanguine about rates at the long end of the yield.
The next four funds in the table - the PIMCO Global Advantage
Inflation-Linked Bond ETF (ILB), the iShares Global
Inflation-Linked Bond Fund (GTIP), the iShares International
Inflation-Linked Bond Fund (ITIP) and the SPDR DB International
Government Inflation-Protected Bond Fund (WIP) - offer varying
degrees of exposure to offshore paper. More than three-quarters of
ILB's portfolio is comprised of foreign obligations compared to
slightly less than 60 percent of GTIP's holdings. Constituents of
both the ITIP and WIP portfolios are exclusively foreign.
Further down the table are four domestic TIPS funds fairly
similar in duration (roughly seven years). Most notable among these
is the category's behemoth - the iShares TIP product - which owns a
61 percent share of the TIPS ETF market. Economy-minded investors
will be attracted to the Schwab U.S. TIPS ETF (SCHP) with an annual
expense ratio a third of the category's average.
Rounding out the top ten is the SPDR Barclays 1-10 Year TIPS
(TIPX), an ETF focused on the short end of the maturity spectrum.
The fund's short duration, less than a third of category leader
LTPZ, accounts for a rather paltry gain on the year but will likely
insulate investors against a precipitous rate uptick.
Since we're dealing with rates, let's imagine the impact of
tapering on the Treasury curve. Real and anticipated decreases in
Fed demand for long-dated paper put upward pressure on rates as
investors seek refuge from the inherent volatility on the right
side of the curve. Additional impetus comes from growing
apprehensions of embryonic inflation. All this is a recipe for
steepening in the curve - an already well-established trend. Over
the past 12 months, the spread between 2- and 30-year Treasury
yields has widened by more than 30 basis points (bp) while there's
been an even more dramatic 70 bp steepening in the 2-10
There are a few ways investors can capitalize on further flight
from long-dated paper. The simplest approach is to join the trend
by swapping longer for shorter maturities. Alternatively, the trade
can be proxied with exchange-traded products.
There are six exchange-traded products that simulate sales of
10-year government paper.
Table 2- Five ETPs With Short 10-Year Treasury Exposure
Despite the price hits taken by these ETPs in the wake of
safe-haven Treasury purchases, asset flow has actually been
positive, most notably into the ProShares UltraShort 7-10 Year
Treasury (PST) which gained $17 million in the first quarter. The
fund, a favorite bet against intermediate-term government debt,
offers two-fold leverage through its mix of swaps and futures.
PST's duration is a likely engine for outsized returns when, and
if, rates rise.
Even greater leverage can obtained through Direxion Daily 7-10
Year Treasury Bear 3X Shares (TYO), a fund comprised of swaps on
the iShares IEF fund. With its -300 percent exposure, TYO acts like
a derivative making it a useful short-term hedge. It's not as
liquid as PST, though. As with any fund of this type - PST included
- TYO's stated leverage can't be expected to persist for more than
one day. Rebalancing may be necessary if any "daily" fund is used
Both the ProShares Short 7-10 Year Treasury (TBX) and Direxion
Daily 7-10 Year Treasury Bear 1X Shares (TYNS) provide unlevered
inverse exposure to the middle of the Treasury yield curve. TBX,
like its PST sibling, uses swaps and futures in its portfolio while
TYO uses iShares IEF swaps.
Despite its name, the iPath U.S. Treasury 10-Year Bear ETN
(DTYS) doesn't limit itself to 10-year notes. Rather, the
exchange-traded note's underlying index tracks 10-year Treasury
futures which call for delivery of notes with remaining maturities
between 6.5 and 10 years. That, and a unique pricing methodology,
account for the note's low effective duration and disparate return.
Rather than employing a daily leverage factor (-100 percent,-200
percent or -300 percent), DTYS provides constant dollar exposure to
its underlying asset. Every basis point change in yield results in
a one point move in the index which, in turn, results in a 10-cent
change in the ETN's value.
The iPath US Treasury Steepener ETN (STPP) permits investors to
play one end of the yield curve against the other. The note tracks
an index that simulates a spread trade in Treasury futures: long
2-year notes and short 10-year notes. The index's spread is levered
to compensate for duration risk. The 2-year exposure constitutes 75
percent of the index weight; 10-year paper accounts for 25 percent,
resulting in the least negative duration in the category. STPP's
benchmark maintains constant yield curve exposure by notionally
rolling its investments forward, effectively swapping
soon-to-expire contracts for those with later delivery dates. The
net expense of rolling two contracts annualizes to 24bp and is
built into the index methodology. That cost, on top of the 75 bp
annual investor fee, makes the ETN a relatively expensive hold.
Given the recent track records of the products we've examined,
it may seem a little premature to be concerned about inflation and
yield curve steepening. But the odds of inflation and a hike in
interest rates are higher now than at any time in the past five
years. Once inflation is front and center on investors' radar
screens, hedging will likely be more costly. As American author H.
Jackson Brown once said, "Nothing is more expensive than a missed
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