Investors wager that a coming surge in inflation will alter the market’s behavior after 30 years.
Certain investors are bracing for wild swings in financial markets, fearful that inflation, and the Federal Reserve’s commitment to allowing it to rise, will result in a more volatile world.
The reason is that the economic policies currently aimed at inducing inflation are the polar opposite of those that have kept markets relatively stable for decades.
Simplify Asset Management recently launched the Interest Rate Hedge ETF, which is designed specifically to benefit from rising longer-term Treasury yields.
The ETF, which is managed by Harley Bassman, a former Merrill Lynch trader who invented the widely used MOVE index, will invest half of its cash in intermediate Treasury bonds and half in seven-year options referencing a 20-year interest rate of 4.25 percent. As long-term interest rates rise, these options should appreciate in value.
This is a high yield in comparison to the current yield on the 20-year Treasury note, which is around 2.2 percent. However, at higher rates, between 3.5 percent and 5%, stock and bond prices become more volatile and move in lockstep—and this ETF is intended to protect investors against that outcome as well, Mr. Bassman explained.
“From 2009 onward, the Fed’s goal was to force money out of safe assets and into riskier assets that would fund growth,” Mr. Bassman explained.
Mr. Bassman said investors purchased longer-dated bonds, riskier credit instruments, and complex products that directly or indirectly involve selling options to generate income. These types of investments become ineffective as inflation and volatility increase, he added.
Other investors concur that the Fed’s recent emphasis on economic support through financial market stability will be upended by its more dovish stance on inflation since the Covid-19 pandemic began. When things got tough in the past, the Fed increased liquidity, lowered the cost of credit, and ultimately boosted stock prices.
That was a virtuous circle as long as inflation remained low and the Fed could intervene whenever volatility spiked—which has been the general trend for the last three decades.
However, Christopher Cole, chief investment officer of Austin, Texas-based Artemis Capital Management, believes it will deteriorate into a vicious cycle. The Fed has stated that it will not tighten monetary policy until inflation is well and truly established and has remained elevated for an extended period.
This means that the Fed will end up restricting credit at a time when rising inflation is already causing markets to be more volatile, and this action will exacerbate the problem, according to Mr. Cole. “The issue here is that if we see inflation—real inflation—we lose the Fed’s ability to support credit,” he explained.
Mr. Cole is well-known on Wall Street as the author of a lengthy paper published in 2017. He described how massive sums of money were effectively betting on volatility easing and remaining low, whether investors realized it or not. A spike in volatility in early 2018 demonstrated that he was correct.
He sees danger in the decades spent by investors becoming accustomed to an old paradigm that kept volatility in check. When trouble loomed and stocks fell, investors relied on the Fed’s rate cuts and, since 2008, bond buying to prop up bond prices. This would generate gains to compensate for stock losses. Then easy-money policies would assist in reviving lending—both in bond markets and by banks—which would lift stocks once more.
This pattern, which has repeated itself in each downturn since the late 1990s, explains the rise in popularity of passive investing, balanced portfolios of stocks and bonds, and specialty fund strategies such as risk parity and volatility control. All of these are implicit bets on volatility declining or remaining low: they are, in the jargon, short volatility.
According to analysts, over $1 trillion is still invested in these specialized strategies and trillions more in passive funds. Over $100 billion is invested in strategies that employ options to make explicit short volatility bets, which have been rebuilt following last year’s massive volatility spike, which was averted once again by the Fed.
“The implicit assumption of continued Fed support has significantly boosted the profitability of the short volatility trade,” Mr. Cole explained.
Artemis Capital’s response is to insure against rising volatility via options markets and to speculate on commodity and currency trends in the same way that it does with traditional stocks and bonds. There is a fifth leg to this stool as well: ownership of alternative currencies, which includes gold and, to a lesser extent, cryptocurrencies.
According to other investors, the increased role of government spending during the Covid-19 pandemic will exacerbate volatility. Governments will want inflation to run high in order to assist in eroding the size of the debt they have incurred.
“We know that when the economy slows again, fiscal stimulus, rather than monetary stimulus, will be the answer,” said Matt Smith, co-manager of Ruffer LLP’s Total Return Fund in London.
Ruffer believes that the next 30 years will follow a pattern similar to the last 30: a steady decline in inflation-adjusted asset values punctuated by occasional upcrashes or sudden rallies fueled by inflationary injections of government spending or tax cuts.
Mr. Smith stated that governments such as the United States will reduce their debts over time through inflation, as happened following World War II. They will not do so by attempting to repay debt through spending cuts and increased taxes, as they have done since the 1990s.
Ruffer’s strategy is to invest in inflation-linked bonds, gold, and possibly bitcoin in order to hedge against inflation—although a recent experiment with bitcoin ended in April due to the cryptocurrency’s massive rally.
Mr. Smith also protects himself from a spike in volatility by betting on corporate debt in credit derivatives markets: He purchases default protection on the most popular companies that are the cheapest to insure and sells it on a few of the most deeply unpopular.
To hedge against the risk of inflationary bursts, he also invests in companies that benefit from rising bond yields. At the moment, that means banks, particularly inexpensive ones in the United Kingdom and Europe.
There are additional ETFs that provide direct protection against volatility and inflation, such as Nancy Davis’ Interest Rate Volatility and Inflation Hedge ETF at Quadratic Capital Management. It is designed to profit from rising interest rate volatility and long-term yields increasing faster than short-term yields, while also investing in inflation-linked Treasury securities.
Ms. Davis stated that the fund is intended to provide a better hedge against inflation than investing in esoteric commodities that become popular, such as lumber.
