Antia: Currency Hedged Plays & TIPS Attractive

November 23, 2015

Shehriyar Antia is founder and lead strategist of Macro Insight Group, an investment strategy firm based in New York. Previously, he spent 10 years as a senior market analyst at the Federal Reserve Bank of New York, where he was closely involved in quantitative easing programs, capital markets and monetary policy. Antia is a regular contributor to prominent publications, including Institutional Investor and Barron's. Will the monetary divergence between the U.S. dollar and other currencies continue?
Shehriyar Antia: Yes. We've been talking about divergence for over a year now. We're on a precipice poised to have the Fed zig while the European Central Bank is zagging. It's looking very, very imminent. Yesterday's [Fed] minutes [Nov. 19, 2015] were more confirmation than revelation of that, so it appears the Fed is about to hold up its end of that divergence trade soon.

Certainly [ECB President Mario] Draghi has been very supportive, and has been talking up the possibility of more quantitative easing. However, some headlines from the ECB minutes yesterday showed there was some pushback that this quantitative easing may be having less of an impact than expected. That might begin to start to push back on the mode of more quantitative easing.

Quantitative easing is about lowering rates. Typically, lower rates spur economic growth. We're obviously in a mode here where lower rates—our rates are zero, or in some cases, negative—are not spurring growth. The argument then is that rates—even further negatives—are not going to have that much impact.

But to get back to divergence, we've never had stronger signs of divergence in the immediate future than we have now. Is the way to play that trade to use currency-hedged ETF that have been some of the most popular funds in the industry?
Antia: As far as the trade aspect, we know that markets tend to price in things before they happen, and currency markets especially. To pile on to that trade now might be a little too late for this current round of divergence.

The market already seems to have ascribed a very high probability to the Fed moving upward and the ECB doing some more quantitative easing within the next 30 to 60 days. The near-term events that we're anticipating are already, for the most part, priced in.

If you want to get into that trade, you have to look further out than the next two or three months. And you have to look forward to 2016. There's room for the dollar to grow even stronger because of the market being complacent about inflation. Has the trade become too crowded?
Antia: For the near term, that trade is crowded, and you're probably not going to get too much bang for your buck in the next couple of months. But if you take a longer view, that still may be a promising trade. What are your thoughts on how many times might the Fed raise rates in 2016?
Antia: The pace of Fed rate increases matters much more for asset prices and markets. It won't be growth that'll determine the pace of Fed rate increases, it will be inflation. I don't see too much room for growth either spurting forward or falling back much. But there is some potential for inflation to alter its course.

Now, the Fed has a fairly benign outlook for inflation. It sees inflation rising gradually to about 2% by the end of 2018. I refer to this as the slow-and-low path. Market-based measures of inflation are even more anemic, and they make the Fed view of inflation seem hawkish in comparison.

Markets are too complacent about the risks of higher inflation. But let's be clear: I'm not talking about 7% inflation, I'm not talking about 5% inflation; I'm talking about inflation that has a one-handle, maybe even a two-handle. There are some compelling reasons to expect that inflation will bottom out in the fourth quarter of this year and start to drift upward next year. I expect both core and headline measures of inflation to hit 2% sometime in the first half of 2016. With that view, are Treasury inflation-protected securities an attractive part of the fixed-income market right now?
Antia: I totally agree with that, because of the market's very-implausible, ultra-low expectations of ongoing inflation. It goes back to markets not really pricing in appropriately risks of higher inflation. Markets are a bit complacent about higher inflation. And there are at least a couple of reasons to think that inflation is going to turn and drift upward rather than continue its downward path.

First, base effects from last year's plunge in energy prices will be abating. Basically, the steepest falls in price inflation last year were last November, December and January. And since inflation typically tends to be measured on a year-over-year basis, once we get past November, December and January, those really bad months will drop out from the annual measure.

U.S. core inflation has actually increased pretty steadily through 2015. For example, the core CPI started off the year at 1.6%. Even with the head winds, with the plunge in commodity prices as a head wind, core inflation is at 1.9% CPI, and it started the year at 1.6%.

That shows you there are some fundamental forces for inflation that are really firmly embedded and entrenched in the economy. If real energy prices stabilize, we'll see a slowly rising rate of inflation going forward.

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