Dust off Your Inflation Trading Strategy Now: Portfolio Manager

 | May 04, 2016 | 8:00 AM EDT
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Investors have yet to price in the possibility that inflation will increase rather quickly, and it is worth getting ahead of the pack on this one. Bond yields are still abnormally low for what is ahead, so let's take a look at what to expect and how investors can position for it.

According to the calculations of Rainer Singer, strategist at Austrian bank Erste, inflation will certainly rise later this year when the effect of lower oil prices wears off.

"If yields were to remain unchanged, the foreseeable acceleration in inflation would push real yields on 10-year notes back to extreme crisis levels, which would make no sense whatsoever," Singer wrote in recent research. "Unless oil prices slump again in the course of this year, inflation rates will rise, and bond yields should follow."

Bryce Doty, senior fixed-income manager at Sit Investment Associates and the portfolio manager of the Sit Rising Rate ETF (RISE), said in an interview with Real Money that the market has started to some degree to position for upcoming rises in inflation, but the move is still not enough.

Since the Federal Reserve left interest rates on hold in early April, two- and five-year U.S. Treasury yields increased by around 20 basis points from their lows. The breakeven yield on Treasury Inflation Protected Securities (TIPS) has also risen, while the yield gap between traditional Treasuries and inflation-protected ones widened.

All of this indicates that inflation expectations are going up, but Doty said that "it takes a while to dust off your inflation-protection strategies." With core inflation -- stripping out the effects of volatile food and energy prices -- at more than 2% for months, when will the day of reckoning come?

"I think you won't be able to ignore it in July and August," Doty said. "The headline CPI as well as the core CPI and the employment cost index will probably be over 2%. The core PCE deflator, which is what the Fed watches, might be the only one left that hasn't pierced the 2%, but will be very close.

"At that point, how can you argue that the Fed isn't at full employment?" he added. "At that point, the debate will heat up very quickly. I think Janet Yellen wants to be pushed to raise interest rates. It would be better if central bankers would have the courage to lead. But we all saw the pushback after December, and I think the courage has left her."

The portfolio manager is one of the minority of observers who believe the Fed is actually behind the curve on inflation and should do more to tighten policy. "At the bare minimum, they should at least reduce their balance sheet by selling some securities," Doty.said. Of course, as the manager of an ETF that is positioned for interest-rate rises, he would be well positioned if the Fed does indeed hike.

In the meantime, talk about the U.S. economy slowing down is increasing as well. Doty does not exclude the dreaded possibility that the world's biggest economy could go through a period of stagflation -- low or no growth and rising inflation. "We could actually have slow growth and inflation rising over 2%," he said. "It's not the nightmare scenario of 8% inflation, but it's a real shift. ... Am I nervous about it? Sure."

The European Central Bank is not making things easier by joining the asset purchasing game. In Doty's words: "You know, you don't have to repeat every mistake that we make."

Despite many investors' enthusiasm for negative interest rates -- the markets go up whenever a policymaker hints at them or, in Europe, says they could go even more negative -- the expert warns that these have "really muddied the water" by making it very difficult for investors to allocate capital.

"The negative interest rates policy is very corrosive," Doty said. "It sucks money out of the system. You end up with more failed trades [and] it sets you up for liquidity crises. It doesn't encourage spending, either. People who are saving for a life event like a trip, wedding, college, buying a car [are] not going to not save for that event, they just won't do it by keeping the money in the bank. They'll keep it somewhere else."

He added that negative interest rates could even scare people into saving more, as they will need more money to reach the same goal. After all, there will be little or no return on their savings.

RISE, the ETF that Doty manages, is short on two- and five-year Treasury notes in the expectation of higher inflation. One strategy that he also suggests is going long on the iShares TIPS Bond ETF (TIP), which invests in TIPS. But investors risk losing money if interest rates go up without corresponding inflation, so he recommends they pair it with RISE, which benefits from rising interest rates.

Investors could also look at floating-rate notes to protect against inflation -- the iShares Floating Rate Bond (FLOT) is an ETF to do that -- but should stay out of bank-loan funds, in Doty's view. This is because these trades take a long time to close (sometimes two to four weeks) and the underlying loans are more or less those of high yield, junk-rated companies.

"We saw in January when high yield spreads widened that these bank loans were trading more like high-yield loans," the expert said. "There are certain flaws that you're not compensated for. People are using them as if it's a short-term fund that they can get in and out of, [but] it's not."

As for high-yield debt itself, index funds have been contaminated by the problems in the energy sector, so Doty said investors would be better off in a managed high-yield portfolio than in an index fund. "Outside of energy, I am positive on high yield," he said.

If you want to take a deeper look at distressed debt companies, check out our special coverage.  Meanwhile, here are more stories from Real Money to help you on your investment journey:

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