Market Inflation Hedging Lagging : Risks Rise

Market Inflation Hedging Lagging; Risks Rise 

Despite clear indications that the risk of price growth is increasing, there is still limited evidence of investors hedging against inflation in the markets.

This week, attention remains on inflation, especially with the upcoming release of the first quarter's US Personal Consumption Expenditures (PCE) data on Friday. Although one data point may not tell the whole story, the overall trend suggests that inflation has halted its decline, with multiple leading indicators hinting at a potential resurgence.

The inflationary trend is not confined to the US; it's a global phenomenon. While last year saw a decrease in the Citi Inflation Surprise indices across many regions, the trend has reversed in 2024, with these indices rising in around two-thirds of the countries they cover.

Despite these warning signs, market prices don't seem to reflect the looming inflation threat. Even if there's a notable increase in core PCE this week, it's unlikely to significantly impact the selling pressure on two-year Treasuries in the short term. However, market yields, including those on two-year Treasuries, have yet to fully account for the possibility of a substantial inflation shock necessitating multiple Federal Reserve rate hikes. While this scenario isn't the current base expectation, its likelihood is being underestimated.

Although bond yields, gold, and silver prices have been climbing, there's a noticeable absence of the urgency regarding inflation that was prevalent in 2021 and early 2022 when CPI reached its highest levels in a decade, and the Federal Reserve had yet to respond with interest rate hikes.

As an example of this complacency, consider two ETFs designed to hedge against inflation, INFL and IVOL. While they experienced significant inflows in 2021, investor interest has waned since the Fed began raising rates in 2022.

Similarly, there hasn't been a notable increase in flows to ETFs holding inflation-linked bonds, such as the TIP ETF. Short interest in Treasuries remains low, with JPMorgan's Client Treasury Survey indicating near-record-low outright shorts, and short interest in the TLT long-term UST ETF barely rising.

Currently, there are no significant alarm bells ringing regarding inflation. However, this lack of concern may be misguided given the clear indications of inflation resurfacing. This concern is further amplified by the structural backdrop, characterized by increasingly coordinated fiscal and monetary policies, which could fuel a sustained increase in price growth.