The Inflation Trade

Long slow-motion deflation…or Fed-goosed inflation? They appear to be the only questions worth debating when it comes to the U.S. economy. With respect to the latter, an ‘unanticipated’ return of inflation offers potential profits for investors in commodities and natural resources…

We’re as skeptical as the next guy that the Fed’s latest rate cut will be any more beneficial for the U.S. economy than the 11 prior rate cuts. But we’re not skeptical at all that the Fed’s easy-money policies, coupled with a rapidly growing money supply, will rekindle inflationary forces. The question is simply…when?

Governments do so few things well. But they have always excelled at inflating away the value of currencies. We see little reason to doubt that the Greenspan Fed’s reflationary efforts will ‘succeed.’ In the meantime, certain market factors indicate that an immediate return to inflation is unlikely.

In fact, the financial markets seem to be anticipating a period of low inflation unprecedented in the modern era. Inflation-indexed Treasuries, for example, are pricing in an average inflation rate of about 1.5% over the next 10 years.

The last time the 10-year average inflation rate dipped below 1.5% was in the early 1960s. President Lyndon Johnson’s Great Society was still in the incubation stage, and the escalation of the war in Vietnam had not yet begun. Will our next rendez-vous with ultra-low inflation occur as the war on terrorism is heating up, and the budget is falling further into deficit? Not unless Chairman Greenspan and his merry band suddenly decide that ‘printing money’ to pay for spending is a bad idea. (File that one under ‘not bloody likely.’)

As hurtful as inflation can be for the average Joe over the long term, it is very helpful for commodity prices. In fact, investing in commodities and natural resources is one of the very few ways in which an investor can profit from inflation. But a successful ‘inflation trade’ doesn’t require a dramatic inflationary spiral. Even a slight uptick in the inflation data would be sufficient to create big profits for some trades.

For example, Eurodollar futures (Eurodollars are priced off of short-term interest rates) have been rising lately, effectively “pricing in” an expectation of low inflation and low short-term interest rates. In a recent issue of Outstanding Investments, John Myers and I recommended buying long-term puts on Eurodollar futures. These options will increase in value if short-term interest rates rise. And because of widespread concerns about deflation in the marketplace, puts on Eurodollar futures can be had at bargain-basement prices. Those who hang back from buying Eurodollar puts until it dawns on everyone that inflation is alive may well pass up a chance to profit from inflation’s resurgence.

There’s also money to be made in metals. Silver and copper prices have rallied nicely in the last month. The upturn coincided with the stock market’s rally in October, as the metals tend to do well when economic optimism is on the rise. The interesting thing is that even in the face of a weak global economy this year, demand for base metals has remained surprisingly healthy. As a result, inventories of various metals like aluminum, nickel and copper haven’t built up since July, as would typically be the case. Over the past few decades, there has been a seasonal inventory build in late summer when vacations, year-end changes by manufacturers and the move to indoor construction activity punched a hole in demand. But not this year. Furthermore, this year’s change of pattern may be the beginning of a longer-term trend as a thriving China and offsetting seasonal effects around the world even out demand.

Copper consumption, in particular, is usually highly leveraged to an economic recovery. So, if demand remains stronger than normal in present conditions, the red metal would be poised to move higher when the global economy improves. Even after the past month’s rally, copper prices remain at historically low levels; as recently as 1995, the price hit a high of more than $1.30 per pound, vs. $0.72 now. However, recently announced supply cutbacks will lead to a tighter market in the next few years, thereby shrinking relatively high copper inventories and subsequently lifting the price – assuming demand increases, of course. Silver prices also remain historically low.

Recently, however, the commercial traders – what’s known as the ‘smart money’ – pulled back their short positions in both silver and copper, a move that tends to anticipate a rally.

Finally, any discussion of the inflation trade isn’t complete without a look at the prospect of a weakening U.S. dollar. The threat of inflation only tightens the noose on a currency already suffering the effects of the mammoth U.S. current account deficit. One way to play the greenback’s weakness is to go long the Canadian dollar, which also tends to move with commodity prices.

The ‘loonie’ has rallied more than 2 & 1/2% since early October, a fairly significant move, particularly if you’re using options as leverage. Our northern neighbor’s currency also does well in an improving economy, but it might benefit additionally from a period of global risk aversion. The reason, quite simply, is that Canada is running a current account surplus of about $12 billion, compared to a U.S. deficit of more than $400 billion. Unlike the United States, Canada doesn’t have to worry about attracting foreign capital to plug its financing gap. The euro’s recent rally indicates that wariness about the greenback is growing, and buying the loonie allows us to take the same side of the bet without having to invest in a struggling European economy – or even worse, a still-sinking Japanese economy.

In sum, there are many ways to make money in these markets while steering clear of stocks that still carry nosebleed valuations. Why worry, for example, that Main Street will one day catch on to the risk presented by all those underfunded pension plans? Now that we’ve entered an era in which throwing darts at the stock tables will no longer fund a retirement plan, the return to favor of some good, old-fashioned hard assets may be just beginning.

Sincerely,

Andrew Kashdan,
for The Daily Reckoning
November 12, 2002

Editor’s note: Andrew Kashdan, a top writer at Apogee Research (formerly Grant’s Investor), is a regular contributor to John Myers’ Oustanding Investments and Resource Trader Alert. Both of these excellent publications cover longs and shorts in the commodities and resource markets. Recent trades in the Resource Trader Alert, for example, have included these gains: 304% on soybean calls (in only 12 days!)…another 125% on coffee…and 145% on the Swiss franc. For more information on trading through these volatile markets, please click here:

The Resource Trader Alert