Why is the market pricing the stag but not the flation?

July 27, 2021

12:30 am

  • ‘Antinomy’ is the posh word for contradiction. In his ‘Critique of Pure Reason’ (1781), Immanuel Kant presented a number of examples of situations where rational thought about the world came up with contradictory possible answers. With respect to causality, one such antinomy was the idea of explaining the world through causal relationships but where spontaneity (free will) played a part. The antinomy of this was that spontaneity didn’t exist, and all events and objects in the world were causally determined by the fixed laws of nature alone. Exciting stuff.

  • Financial markets appear to be displaying a number of contradictions of their own at present. On the 22nd July, Unilever (ULVR.LN) stock fell 5.8% following their Q2 earnings report which revealed sharply higher input costs caused by commodity price inflation, with the expectation that these costs would persist. On the same day, the gold mining stock Newmont (NEM.US) in its Q2 earnings report suggested that they were expecting 3-5% input cost inflation over the next few years due to higher commodity prices. Enduring inflation of this sort, reported by ‘real’ companies doing ‘real’ things, severely undermines the thesis, proposed by the US Federal reserve among others, that the current inflation is temporary as it is transitory.

  • If one looks at the bond market in 2021 though, there is no hint that inflation is anything but transitory. Indeed, the bond market is reflecting nothing more than a slight blip above the long-term inflation target of 2% for which most central banks aim. 10-year nominal US treasuries are at 1.24% at the time of writing. 10-year US real rates are at -1.10%, so inflation, as priced by the bond market, is 2.34%. US CPI inflation for June came in at 5.4% YoY, and 3.6% year to date. One could call that an antinomy.

  • An objective way to examine such contradictions in markets is to quantify the current situation through regression analysis against the past. The assumption here is that the ‘rules’ of the market are fixed, and that there is total continuity with respect to events in the past and those in the present. This is in itself a huge assumption, but there it is. The graph below shows a regression of 10-year US Treasury yields and US CPI inflation. The red star of the June 2021 CPI print is circled, along with those of May and April. 

Source:  Bloomberg, as at 23 July 2021

Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.


  • This regression analysis goes back to July 1980, so represents 41 years of data, a reasonable sample size by any measure. What it shows is that in the last 3 months, never have US 10-year Treasury yields been so low while CPI inflation has been so high. Given the large data sample, this suggests that something very peculiar is going on at the moment. If the bond market is right, then inflation is about to give way to deflation in a rapid and serious way. If the inflation print is to be believed, and also reckoned to be stickier (as ‘real world’ company data such as the Unilever and Newmont Q2 results suggest), then either nominal yields ought to be much higher, or real yields ought to be considerably lower.


  • Another such contradiction is the poor performance of gold in 2021. Gold generally does well when real rates are low, inflation high, but more generally when the market is concerned about the sustainability of the monetary system. Running huge fiscal deficits, monetised by central banks (thereby debasing the currency) has in the past been a trigger for gold to flourish, yet in 2021 gold has been the leper of asset classes as investors have shunned it in favour of meme stocks and coins and other good-time trades.


  • Again, to quantify the underperformance of gold, one can run a regression of gold versus real rates of interest. Negative real rates generally reflect economic stagnation, one of the causes of which is monetary debasement. Over a similarly long-time horizon (1980 until today), the correlation of gold to US 10-year real rates is -0.93. This is as strong a relationship as you are likely to find anywhere. Low or falling real rates should be catnip for gold, but in 2021, this particular cat has been locked in the back garden and there is no fishy in its dishy for now.


  • The extent of this aberration is illustrated in the graph below. The blue line shows 10yr US real rates, the yellow line shows the gold price inverted (1 divided by the USD spot gold price). When real rates were this low in January 2021, gold was at $1,950. In August 2020, gold was pushing $2,100. Currently it is languishing at around $1,800. Arguably it should be trading nearer $2,000 at present, all else equal.

Source: Bloomberg, as at 23 July 2021

Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.


  • But all else is not equal. Gold is a monetary metal, with only 6% of annual output used for industrial purposes. 2021 has seen outflows from gold exchange-traded funds, so the investor bid has not been there, whatever the reason. The market is also more complex than just bars of gold, with many multiples of the amount of physical gold being delivered daily being traded on the derivatives markets in the US and London. Technical issues relating to options expiries, quarterly book marking by the banks and the ongoing implementation of new Basel III accounting rules (which have come into force in the US and Europe already but which only ‘go live’ at the end of 2021 in London) have all contributed. Central banks have been buying, but in the West at least, the siren call of the stock market has so far meant gold has been overlooked, even if it is attractive on a fundamental basis. This is the spontaneity side of Kant’s argument over the laws of nature part.


  • The same analysis can be applied to the bond market. Although the Fed has raised the possibility of a taper to quantitative easing (QE), the Fed’s balance sheet has grown by $877bn in 2021 (the most recent data as of 21/07/2021), and it is currently still buying at a rate of $120bn per month. This relentless buying by the Fed and other central banks around the world has depressed bond yields. The reduction of the US Treasury’s balance at the Fed (the TGA or Treasury General Account) has increased reserves in the banking system against which there has been less Treasury bond issuance, thereby tightening up demand in the bond market. The extent of this can in part be seen by the huge reverse repo balance currently being deposited at the Fed by commercial banks – $898.2bn by 73 counterparties as of 22/07/2021. These are just a few reasons why bond yields are so low at present, notwithstanding the fact that central bank policy rates (outside China at least) are at, around, or below zero.


  • One of the unspoken laws of the market is that price means truth. The efficient market hypothesis, whether in its pure or modified form, suggests that prices reflect the aggregate of market participants knowledge about the asset, and that prices adjust immediately to new news to price in the new reality, hence prices being a true reflection of the world as it currently is or is currently anticipated to be.

  • As can be seen from the gold price or the bond market, there are in reality myriad technical and short-term reasons for prices to be distorted. In the age of central-bank dominance (which coincidentally also appears to be the age of debt), these distortions can last for decades – negative interest rates have been a feature of the Japanese bond market for some time now, and the Bank of Japan is the key mover here. If one looks at the evolution of central bank policy, especially the persistence of what was once called extraordinary monetary policy in the form of QE, one can legitimately ask whether what bonds are telling us now is the same as what they were telling us in the 1980s or 1990s. This would in part explain the oddness of low bond yields and high inflation. Whether this continues to be the case is the interesting thing.


  • Since the last Fed FOMC meeting in June, the US yield curve has started to flatten. This can be seen in the graph below, with the green line showing the current yield curve out to 30 years, and the curve as of the 15th June dotted in yellow. Given how low rates are, the fall in the 10yr and 30yr of over 20 basis points each is notable.

Source: Bloomberg, , as at 23 July 2021

Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.


  • The long end of the yield curve tends to reflect growth assumptions in the economy, and often inflation as a by-product of this. The flattening of the curve ought to be seen as the market starting to show that the US economy is going to slow. The National Bureau of Economic Research (NBER) reported on 19/07/2021 that the US was only in recession for two months in 2020 (March and April). One could argue that such a short recession was merely a blip in the longer economic cycle, and therefore the US economy remained late-cycle despite what happened early in 2020. This would certainly explain the absence of the usual elements of the credit cycle one sees during a recession, most notably corporate-balance-sheet repair in the form of deleveraging.


  • Perhaps the market is sensing that US fiscal largesse is going to wane, or at least not continue at the same extraordinary pace it has maintained since March 2020. Mid-term elections are coming up in 2022, and history suggests that the thin Democrat majority in the House of Representatives may come under pressure, and with it, the impetus for the spend-a-thon. Senate Republican leader Mitch McConnell is clearly now acting all fiscally responsible in opposition, so one would imagine that the Republicans in general would make life much harder for President Biden were they to have greater control in Congress.


  • This is where the bond-yield-versus-inflation debate starts to get more interesting. An economic slowdown, which threatens the stock and bond market, would likely demand more action not less from the Fed, just at the point at which tapering and hiking is starting to become a key issue. If they are forced into more action, possibly with emergency action on the fiscal side should things start to get ugly, then its arguable that inflationary pressures driven by deficit spending paid for by Fed monetisation would start to un-anchor the 2% inflation target which is the key pillar of Fed policy.


  • On the other hand, if the supply-side issues which are currently adding to inflation prove less than transitory, a theme which one can readily observe if one listens to what corporations are currently saying (and which incidentally both Treasury Secretary Janet Yellen and FOMC Chairman Jay Powell have both recently admitted, even if President Biden is still poo-pooing the idea), then you could get falling growth with stickier inflation.


  • A combination of lower growth and higher inflation (otherwise known as stagflation) was very much the story of the 1970s. Financial repression (keeping bond yields artificially low while inflation is high) was very much the story of the 1940s, and the 1940s was a period of high fiscal spending due to World War II and its aftermath. The interesting thing about the 1940s though was that it was a period of high real growth levels for the US economy. Perhaps it is the potential for aspects of the 1940s and the 1970s running concurrently, something that would be essentially new, that explains this odd high inflation, low real yield, low nominal yield world that we are currently pricing. Perhaps we’ll need a new word for it.

Unless otherwise stated, all opinions within this document are those of the RWC Diversified Return Investment Team, as at 28th July 2021. 

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