“What is the data that I need to look at that could give the earliest non-false signal of sustained or high inflation that destroys the value of certain financial assets?” That question comes courtesy of a friend of DataTrek we’ve mentioned before – the +30-year Wall Street veteran, former WSJ writer, and current money manager. Today we’ll attempt an answer as a continuation of our recent work on inflation by looking at capital markets prices.
As a reminder, here’s the history our friend and many others are thinking about: the period from 1960 to 1982. The chart shows the annual changes in the US Consumer Price Index over that time, with the first peak of 12.2 percent in November 1974 noted. The second peak in March 1980 was at 14.4 percent annualized inflation. These are the sorts of numbers that Chair Powell referred to today in his press conference, stating “The kind of troubling inflation people like me grew up with seems unlikely in the domestic and global context we’ve been in for some time”. Fair enough, say we, but what if he’s wrong?
Let’s kick off our search with some of the usual suspects:
#1: 10-year Treasury yields: these were NOT a good signal that inflation was going to be a problem in the late 1970s. The chart below shows that, yes, Treasury yields (blue line) did go from 4.2 percent in 1965 to 8.0 percent in 1970, but they didn’t really respond any further after the 1973-1974 inflation wave hit (red line). To us, that means Treasuries did incorporate the inflation caused by the Vietnam War and Great Society social spending, but did not factor in the aggregate effects of those along with the 1973 – 1974 oil shock.
#2: Total 10-year Treasury returns also DID NOT signal impending inflation risk from the 1960s – 1980s. Care to guess how many years T-notes had a negative total return over that time? The answer is 4 and none were worth more than 5.0 percent: 1967 (-1.6 percent), 1969 (-5.0 pct on the nose), 1978 (-0.8 pct) and 1980 (-3.0 pct). Of course, inflation-adjusted returns were negative in many years, but on a nominal basis Treasuries did OK because the coupons were high enough to offset capital losses. As much as inflation was a persistent problem in the 1970s, relatively low bond durations insulated investors and perhaps lessened their worries that inflation could persist as long as it did. We’re obviously in a different position now, but we’ll save that discussion for another day.
#3: Funny enough, gold prices didn’t have much greater predictive value than Treasuries from 1968 (earliest data we could find) through the early 1980s. As you can see in the chart below from this time period, gold rallied from when President Nixon took the US off the gold standard in 1971 (at $35/troy ounce) through late 1974 ($184/oz). But the yellow metal then took a long nap and did not make new highs until 1978. As with T-notes, gold seems to have not incorporated either energy prices or lax Fed policy into where its clearing price should be. Once that second leg of inflation hit in the late 1970s, gold went parabolic.
#4: Enough of what didn’t work – here’s one thing that did: dollar exchange rates, in this case between the greenback and the Japanese yen (blue line) and German deutschmark (red line). The scale here is reversed, so declining lines mean dollar weakness, and the dataset starts in 1971 just before the end of the Bretton Woods agreement. As you can see, the mark strengthened by just over 50 percent from 1971 to 1980 (3.6/$ to 1.7/$) and in pretty much a straight line. The yen appreciated by 48 percent over the same period (357/$ to 184/$) but meandered a little more than the mark to get there. Remember that Japan was a large growth economy at the time and Germany had the world’s most inflation-averse central bank. Good places, in other words, to move capital when the US was seeing stagflation.
Conclusion: fast forward to today and the Chinese offshore yuan is to the current market what the yen and mark were to the 1970s, so that’s the one currency pair we’d be watching as a sign US inflation trends were growing worrisome. No, this isn’t a perfect comp. The PBOC is not the old Bundesbank, and CCP is not the LDP. But China does have something like Japan’s old growth and certainly has larger economic heft than the old West Germany.
We will therefore close with this chart of the offshore yuan, highlighting that at current levels of 6.50/$ we’re slightly closer to the 10-year highs of 6.03/$ in early 2014 than the lows of 7.2/$ from September 2019. If and when US inflation does pick up a head of steam, history says it won’t be Treasuries or gold that have forecast that development. It will be the currency markets – the largest, most liquid market in the world – that will have seen it coming.