A perpetual inflation worrier, I habitually confront the fact that bond prices don’t signal inflation. I am forced to point out that they never do — interest rates did not forecast the inflations of the 1970s, nor the disinflation of the 1980s. And I say inflation is unforecastable, a risk like a California Earthquake.
But for once there does seem some inflation risk in asset prices.
These are option prices. The main forecast remains subdued inflation. But these option prices are pointing to a larger chance that inflation does break out.
1. I assume that what the option market is screaming about inflation is “I don’t know!” Some folks think that inflation will be close to zero, and some think it will be above 3 percent.
2. But if there are more worries about inflation priced into the options market than into the bond market, this might suggest an arbitrage opportunity: be a seller of options, where inflation risk is priced high, and be a buyer of inflation-indexed bonds, where inflation risk is not priced as high. Adjust your hedge dynamically as needed.
The best inflation hedge most people can access is a 30 year mortgage. I would look at housing prices and mortgage rates for a view of peoples inflation expectations.
I don’t trust TIPS because that’s the fox guarding the henhouse.
Why oh why couldn’t he have expressed this as a bet.
What you are proposing is basically a covered call, which typically don’t work well as arbitrage since they decline in value easily or fail to keep pace with the upside due to leverage.
Not quite an arbitrage, but two separate bets. A (directionally-hedged) short options position is a bet that inflation will be less volatile (less risk or uncertainty) than priced into options. A net long position in TIPS, or more precisely a net long TIPS position hedged with a short nominal treasury position, is a *directional* bet on inflation, i.e., a bet that the level of inflation will be higher than expected.
Perhaps there will be inflation, as measured by the CPI or PCE core, in the next few years.
What is interesting is that nearly the entire global central-banking corps is dismissive that inflation is coming, from the Reserve Bank of Australia, to the ECB, to the Fed, to the Bank of Japan, to the Bank of England. Not sure about the PBoC, but inflation in China is well below their 3% target.
The Reserve Bank of Australia just announced last week they will keep interest rates at historically low levels at least through through 2023 (10 basis points on three-year government bonds) and keep on with aggressive quantitative easing.
All these central banks have large staffs, are generally led by smart people, and have histories of being excessively worried about inflation. Almost universally, all central bankers are calling for more fiscal stimulus.
What to make of it?
Beats me.
Well, perhaps short bonds, way out on the timeline. You can lose your money or score big. Form a limited partnership, become a limited partner, and leverage up to the max. If you bet right, see you in Davos. If you bet wrong, you run away and let the partnership go belly up.
If John is right when he says:
inflation is unforecastable, a risk like a California Earthquake.
that means “monetary theory”, a la Friedman, is false.
The use purpose of any theory is to make forecasts, which are then tested for truth.
My theory: more money printing means more inflation pressure. When markets are allowed to work for producing food and consumer items, with excess production capacity available to increase production if more product is bought, that inflation pressure results in asset inflation.
More financial money creation means more asset inflation – financial assets and housing (in good areas) and gold and bitcoin, etc.
Even asset hyperinflation.
Which the world has never really seen before (This Time It’s Different!)
Grey’s Law: No consumer hyperinflation without shortages – more money then means higher asset prices.
Arnold assumes that what the option market is screaming about inflation is “I don’t know!” meaning they don’t know where to bet their money. Literally. Their buying and selling bets are how they, the option market human decision makers in the aggregate, communicate with others.
Where is the econ theory which caps stock prices or p/e earnings or bitcoin prices?
In the 1500s there were maps, with uncharted areas: “Here be monsters”.