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The Federal Reserve has a dual mandate: Promote maximum employment and maintain the optimum level of inflation.
But measuring inflation has been a contentious issue over the past several years. Some analysts prefer to look at commodity prices, while others use the Consumer Price Index, the core CPI, which excludes food and energy costs (the Fed’s preferred measure of inflation), or another gauge.
But I have developed my own inflation indicator, which I believe captures the true cost of goods, and can be extrapolated to give us a clearer picture of the U.S. economy. By following it, you could perhaps predict monetary policy better than other investors can, giving you an advantage on when to move into, or out of, stocks and bonds.
My indicator uses the yield on the benchmark 10-year Treasury note and the CRB Commodity Index to determine which way prices are heading.
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| The All-Weather Inflation-Deflation Indicator can be used as a good leading indicator for equities. |
These two measures don’t just tell us what’s happening in the bond and commodity markets; they also give us a snapshot of the equity markets, because bond yields typically move in tandem with stocks. Rising stock prices and higher yields generally indicate an inflationary environment, while falling stock prices and lower yields generally indicate a deflationary environment.
Analysts who only consider this part of the equation recently have been warning about inflation, or even hyperinflation. After all, they argue, the Dow Industrials and S&P 500 are near all-time highs, and the 10-year Treasury yield has exploded higher by more than a full percentage point in just two months.
But these analysts are ignoring the lack of inflation among commodities. In a robust economy, commodities normally move higher along with equities. But, lately, gold, silver, copper and other commodities have behaved in a disinflationary, if not downright deflationary, manner.
New Gauges Needed
The rise in equities over the past four years has been almost entirely attributable to the actions of the Federal Reserve and other central banks around the world. Chairman Ben Bernanke and company reacted to the global financial crisis, and the resulting falling asset prices, by pumping trillions of dollars of liquidity into the markets through purchases of bonds and other securities.
QE1, QE2, Operation Twist, and now QE Infinity (as many are calling it), created a “risk-on” environment. The European Central Bank, the Bank of England, the People’s Bank of China and, most recently, the Bank of Japan have also gotten in on the action.
All this money had to go somewhere, and it increasingly flowed into the United States. This pushed up U.S. equities, along with the dollar. But Treasury yields remained artificially low, due to continued intervention by the Federal Reserve. Commodity prices have been depressed as well, amid weak demand for raw materials, indicating an ongoing global slowdown.
Given this kind of schizophrenic marketplace, any accurate measure of inflation must take all asset classes into consideration.
The All-Weather Measure
The All-Weather Inflation-Deflation Indicator (AWID) is calculated by dividing the CRB Commodity Index by the price of the benchmark 10-year U.S. Treasury note. At the end of last week, the AWID stood at about 3.1 (CRB/10-Year Price = 288.5/92.5 = 3.1).
Inflation is defined as an AWID above 4. Between 3.0 and 4.0 is neutral; 2.9 to 3.0 is a disinflationary environment; and anything below 2.9 is deflationary. So by this measure, we are in a neutral period, but closer to deflation than inflation.
However, the trend line has been moving up. Just four months ago, the AWID was below 2.9, indicating deflation. Since then, it has slowly crept higher as the price of the 10-year U.S. Treasury note has fallen and yields have risen.
It has become clear to me and many other analysts that the three-decade bull market in U.S. Treasuries is over, meaning interest rates should continue to rise. This factor in itself is inflationary. But if a rise in rates, and a decline in bond prices, is coupled with a rebound in commodities, the AWID could begin to approach the threshold at which a neutral price environment becomes inflationary.
The AWID is easy to calculate on your own, and doing so will give you a leg up on other investors. Not only will you be able to determine whether prices are rising or falling; the AWID can also be used as a good leading indicator for equities.
If the AWID drops below 3 into disinflation, it’s a warning sign for stocks. If it falls further, it could suggest that a deflationary spiral is taking place. And if you have any questions about how negatively deflation can affect equity prices, just look at Japan’s stock market over the past 20 years.
Best wishes,
Douglas
