If the inflation surge persists, it could cause a further reset for nominal rates, which remain well below where they should be based on their correlation to inflation expectations. But the Fed’s gigantic balance sheet plays a role in keeping rates below normal. (THREAD)
If there is an inflation scare, the Fed could be forced to overshoot the neutral rate (R*) by tightening faster/harder, and in the process forcing rates to rise beyond what the economy can withstand. That would be your classic late-cycle policy error (three steps & a stumble). /2
The alternative scenario is that the Fed understands that today’s over-indebted economy is highly levered to low rates, and that it will just have to accept higher structural inflation and keep policy on the looser side of neutral. /3
In that scenario, real rates could remain negative for a long time, in a repeat of the 1940s (which continues to be a compelling analog for today). /4
If that scenario happens (and I think it’s more likely than the first scenario), inflation expectations via the TIPS market are likely mispriced. That should be an opportunity for gold & Bitcoin. /END

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More from @TimmerFidelity

8 Nov
The Fed’s taper starts this month & should be a wrap by mid 2022. The rates market has experienced quite the whipsaw, at first pricing in more rate hikes sooner, then un-pricing some of them. As of Friday, the market expects the Fed funds rate to end 2022 at 0.53%. (THREAD) Image
A stunning disconnect: Even though the economy has roundtripped back to full capacity and inflation continues to run hot well beyond what was first considered transitory, the market does not expect the Fed to return to a neutral policy stance for years to come—if ever. /2
Consider the implications: Below, we see the neutral rate (R-star), the inflation-adjusted Fed Funds rate (blue), and the inflation-adjusted Fed Funds Shadow rate (which accounts for balance sheet shenanigans). /3 Image
Read 6 tweets
5 Nov
Bitcoin in recent weeks has beautifully fulfilled its premise as a hedge against declining purchasing power. (THREAD)
The chart above shows a hypothetical portfolio with 98% intermediate bonds and 2% Bitcoin. Even a small Bitcoin allocation could protect a conservative bond investor against a loss of purchasing power resulting from rising inflation and financial repression. /2
In 2018, the 2% allocation would have added almost 4 points of annualized volatility, while also amplifying drawdowns (i.e. the opposite of what a diversifier should do). But... /3
Read 4 tweets
5 Nov
Why should any investor own bonds at this point, given that they barely produce any nominal income, and are likely to lose value in real terms? Take a look at this chart, and we'll explore the question a bit more. (THREAD)
In recent years, the reason to go with a 60/40 portfolio was to diversify and protect. We can see this in the chart above. /2
60/40 produced about 2 percentage points less return per year than the S&P 500, but still a very respectable 9% – well above the inflation rate. It also helped investors sleep at night when the stock market was down (which it was about 40% of the time). /3
Read 8 tweets
4 Nov
Following up on the last thread regarding sector returns during periods of inflation: Here is the energy sector relative return during the four inflation regimes (1942-50, 1965-80, 1987-92, 2003-08): (THREAD)
And here is the retail industry group (GIC2). Consumer stocks can do OK at the start of an inflation wave, but apparently the lack of pricing power eventually takes over. /2
Next, the healthcare-equipment industry group. Huge winner during the 1940s, and did well during the 1960s and early '70s also—perhaps because both were war periods? Big pharma stocks were part of the Nifty Fifty, which carried the market into its peak in 1973. /3
Read 8 tweets
4 Nov
Inflation is much on the minds of investors and rightly so. So let’s take a look at sector performance during inflation waves in the past. It may surprise you. (THREAD)
In addition to the inflation regimes of the 1940s and 1970s, there were two smaller waves over the past few decades, as measured by swings in the 5-year inflation CAGR. The first was 1987-92 and the second was 2003-08. The chart above shows these four regimes. /2
The next chart shows the S&P 500 real return during those regimes. The long-term CAGR for the inflation-adjusted S&P 500 is 6.82% (since 1926). Stocks have done OK during inflation regimes (the '70s being the exception), at least compared to its long-term trend. /3
Read 9 tweets
3 Nov
Until a few years ago, investors pursuing a diversified 60/40 portfolio got decent bond yields and downside protection when stocks slumped. But if that regime comes to an end (not a prediction, but certainly a possibility), how do we diversify from here? (THREAD)
The chart above shows that during the past two inflation super-cycles (the 1940s and 1965-80), bonds offered little protection. The scatter plot shows the nominal return index for the 60/40 model on the horizontal axis, and the real return index on the vertical. /2
Indexed to this series are the real returns for long-term government bonds, cash, high yield, TIPS (using a colleague’s synthetic series), gold, silver, the CRB, and the S&P 500. /3
Read 6 tweets

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