Monday, September 8, 2008

Watch smart funds on their long bond position

Further to my last post which shows that smart funds are long the commodity trade (inflation) and long the US long bond trade (dis-inflation), a further word of explanation seems to be in order. I believe that the key macro view underpinning this position is:

  • The secular trend is for more inflation and official inflation rate is understated
  • The cyclical trend is for inflation to fall, setting up for a rally in the bond market

Official inflation rate understated
The Fed focuses on core inflation and that statistic has been consistently lower than the other measures of inflation. The chart below shows the progression of headline CPI, core CPI, or CPI ex-food and energy, and PPI.

As the chart shows, core CPI is consistently lower than the other measures of inflation. PPI, or one, is more sensitive to commodity prices, which has been rising. Moreover, PPI has none of the hedonic and other adjustments that the CPI has from the recomendations of the Boskin Commission. Others have also commented that even the headline CPI has problems and doesn’t reflect true changes in the cost of living.

Even if you were to focus on one of Greenspan’s favorite indicators of inflation, PCE, the Dallas Fed’s measure of trimmed mean PCE seems to be consistently higher than core PCE.

Inflationary pressures cyclically easing
Recently, there have been abundant signs that the economy is weakening. The latest Beige Book report indicates sluggish growth. Reconstituted M3 growth is falling off a cliff. Various Fed officials have been signaling that inflationary pressures are easing and therefore the pressure to hike interest rates are lessening. In response to these signals the bond market has responded and the spread between TIPS and the 10-year Treasury are in retreat.

What does an investor do?
Mutual funds tend to have longer term time horizons than the average swing trader. Smart funds have been saying: “We are not fooled by the official inflation rate and our long term view is for inflation to stay high. In the short term, however, the weak economy is going result in a bond market rally.”

One of the keys to spotting a bottom to the US equity market will be to watch for smart funds to switch their stance on the long bond.


Unknown said...

brilliant and insightful post

Hedge Thing said...

I agree with Rocky! But what would be the best way for one to "watch for smart funds to switch their stance on the long bond"?

Cam Hui, CFA said...

Hedge thing - I see that you are at a hedge fund. One thing you could do is to assemble a list of "smart investors" and do some factor analysis to see the beta of their portfolios to the long bond.

Otherwise, I will keep an eye on this and write a post when I see changes.

Hedge Thing said...
This comment has been removed by the author.
Hedge Thing said...

Thanks, I will try that.

Ah yes, assembling a list of smart investors... almost as easy as picking stocks...

(Will re-read your February piece on An idiot's equity market neutral fund)

Cam Hui, CFA said...

Hedge thing - If you have trouble please email me and I will try to answer your questions. Note that you can use the same technique to watch the macro exposures of your competitors...

keithpiccirillo said...

See: Some limitations on this form of analysis (off to the right side).
He cites: "this technique is inappropriate for extreme high turnover funds."
CGMFX has had a 400% annual turnover rate in the past!
He also just had two great days (now 30% financials) in a row, and have made +20% @ year average investing with him for twenty years.

Cam Hui, CFA said...

When I refer to "high turnover" I meant average holding periods of 1-4 weeks.