Inflation Breakevens: A Core Holding

I have an outlier view of inflation. Contrary to the debt-will-overwhelm-us crowd, I believe the next great financial crisis will not be a deflationary shock, but a return of inflation no one is positioned for. Don’t assume I am a hyper-inflationary doomsayer though. At first, inflation will feel great. It’s not until much later will it actually cause any real problems for the economy.

Don’t bother sending me chuffed emails about how inflation will never return in our current environment of the three D’s - debt, demographics, and deflation due to technological innovation. I have heard them all. Your insistence they will overwhelm the financial system will only reinforce my belief that these worries are fully priced in.

And please don’t send me your philosophical arguments about how inflation is immoral and will hurt group blah-blah-blah the worst. You could be correct, but I am not here to decide what should be, rather what will be.

One of these days, society will wake up to the understanding that monetary policy is ineffective at kick-starting the economy and fiscal stimulus will begin in earnest. It will be effective. Too effective. For a variety of reasons, it will seem like a free lunch…. at least for a while.

Now don’t get me wrong. It will be abused. Just like monetary policy has been abused (negative rates throughout much of the world is an abomination we should be ashamed of), fiscal stimulus will be taken too far.

Right or wrong, that’s my call. You might debate different points, but I believe a return of inflation is the best long-term macro risk-reward trade out there. Hands down. No other trade even comes close to offering this payoff asymmetry.

Yet how do you play it? What’s the trade that will benefit if I am correct?

Although there are a variety of different positions that will perform well in an environment where inflation is increasing, my favorite is long inflation breakevens.

Last month when the deflation-means-all-interest-rates-throughout-the-world-will-go-to-negative-levels bond bulls were pushing fixed-income into rocket-ship-formation-that-looks-more-like-a-penny-stock-promote, I must admit, the pain for bond bears like me was immense. The bond bulls took to twitter to rub salt in the wound and explain why higher fixed-income was a “sure thing”.

However, through the moments of doubt and sleepless nights, in fact, even when it seemed like every single macro-guru and bond strategist was on TV explaining why I was wrong, there was one trade I never considered lifting. I had so much conviction that even amid the darkest day, that period around month-end when the bond bulls took fixed-income to the point of maximum pain, I had the wherewithal to add to the trade. That’s how much I believe in it.

What is an inflation breakeven anyway?

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Comments

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Susan Miller 4 weeks ago Member's comment

Very nicely done Kevin, I enjoyed this piece. Really makes one think...

Dave Schneider 4 weeks ago Member's comment

Agreed.