We're on the cusp of some major changes for the economy and the stock market -- changes that I've covered in my recent posts and columns.
The recovery looks ready to reaccelerate. Inflation is on the rise. The Federal Reserve, which started its two-day policy meeting today, is set to end its $600 billion "QE2" money printing stimulus but keep interest rates pegged near zero. And risk appetites have returned as the situation in Europe moves towards a new solution.
All of this is a perfect recipe for big losses on the one asset class considered to be "risk free": U.S. Treasury bonds. Here's why.
The end of the Fed's QE2 bond buying program was discussed in my June 9 blog post "It's time to bet against the government" which looked at how much buying power that's about to disappear from the T-bond market and how professional traders are positioning themselves to profit from the weakness that's sure to result. So I won't repeat those points here.
Instead, let's talk about the potential for higher inflation -- one of the key reasons I've recommended a heavy short position against U.S. Treasury bonds to my newsletter subscribers. On a purely theoretical level, higher inflation is pretty much inevitable at this point with the economy stabilizing and the Fed committed to its zero-interest rate policy. This is the "stealth stimulus" I discussed in my last column.
In the real world of data and consumers, theory is quickly becoming reality. Last week, the latest consumer inflation data showed that prices rose at a 3.6% annual rate in May -- which was mainly the result of blossoming food and energy prices. Furthermore, other areas, such as vehicle and apparel prices have also perked up.
But here's the thing: What started as high food prices on droughts and natural disasters and high gas prices on Middle Eastern unrest has spread like a cancer. Now other, unrelated categories are showing meaningful price gains. This suggests that the inflationary pressure won't be as "transitory" as the Fed would like to believe.
Housing, believe it or not, is also playing a significant role due to its heavy weighting in the CPI. Analysts at Barclays Capital point to the reversal of disinflation in housing prices as a structural driver of higher inflation numbers in the months and years to come.
As you can see from the graph above, shelter costs have been the main source of disinflation in core CPI calculations. The recent reversal of shelter costs will have a significant effect on CPI data, as 41.4% of the total score is attributed to investments in housing. What’s significant about this finding is that although some FOMC members attributed earlier disinflation to a plethora of reasons, the main driving force behind changes in inflation have been a result of increasing shelter costs; a fact that seems at odds with the ongoing double-dip in home prices.
Without getting technical, the disparity is due to the fact that shelter costs are gleaned from rental prices -- which have been on the rise as people are either unable or unwilling to become homeowners. The competition for desirable rental properties is driving up lease rates.
The big picture here is that inflation expectations have not been fully discounted for. As a response, Barclays Capital has bumped up their Q4 forecasts for core CPI to rise 2% year over year, up from their previous forecast of 1.8%.
Not only does inflation have effects on prices of goods, it also influences the Fed’s stance on monetary policy. According to the Barclays Capital report, “with core inflation moving up, it would take a significant growth disappointment for the Fed to introduce more stimulus.” This confirms what I've been covering over the past several weeks: QE2 will end, inflation will rise, and the stealth stimulus will go on as the Fed finds it political unpalatable to raise interest rates with the unemployment rate still north of 9%.
Given the low possibility of a policy shift from the Fed, these three factors will continue to linger and suppress Treasury prices -- both through a lack of buying power (no "QE3" direct purchases from the Fed) and through higher inflation (which will push down T-bond prices). As T-bonds fall away from overhead resistance, short Treasury ETFs are poised for big gains.
I've recommended my newsletter subscribers take advantage of the situation with the leveraged Proshares UltraShort 20+ Year Treasury (TBT), which returns twice the inverse daily return of long-term Treasury bonds and was selected with the help of technical screens developed with Fidelity's Wealth Lab Pro back testing toolset which you can find here. (Editor's note: Fidelity sponsors the Investor Pro section on MSN Money.)
Disclosure: Anthony has recommended TBT to his newsletter subscribers.
Check out his new investment advisory service, The Edge. A two-week free trial has been extended to MSN Money readers. Click here to sign up.
The author can be contacted at anthony@edgeletter.com and followed on Twitter at @EdgeLetter. Feel free to comment below.
Anthony, when are you going to talk about US competitiveness, the big elephant in the room? The US’s workforce is not competitive in the areas that matter the most: science and technology. That's the reason *real* unemployment is and will remain close to 20% for the foreseeable future.
How can the US possibly grow when it has to feed 20% of the population who ought to be in the workforce making the economy more competitive?
When are you going to address the single most important problem in our economy?
It confirms that equities will be under severe pressure.
I don't see how you can mention the Fed reacting to inflation (which inevitably means raising the interest rate) and contend that equities will be a good place to be.
The amount of money the Fed loans to banks isn't going to go up just because inflation is higher. That is the only reason stocks would march forward. We're in an earnings area where year-over-year gains are going to be hard to beat, inflation will not grow wages, but rather prices, and therefor global consumption will be tepid at best.
I just don't see how a 600 billion buying program that largely inflated markets (by your own reasoning back last august, and we had stealth lending back then before August 2010, inflation was high last year as well. The market was stuck. The Fed unleashed.
So how is that program ending and nothing else starting because of the inflation fear going to be positive for stocks in general?
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