Trade the

News Series
An asset manager’s
guide to Inflation
Theory
 Index
Introduction

Part 1
What is Inflation?

Demand-Pull Inflation
What are the main causes of Demand-Pull Inflation?

Cost-Push Inflation
What are the main causes of Cost-Push Inflation?

Asset Inflation
What are the main causes of Asset Inflation?

Implicit Inflation
What are the main causes of Implicit Inflation?

Part 2: Inflation Indicators

Survey-based Measures
Consumer Price Index (CPI)
Producer Price Index (PPI)
Personal Consumption Expenditure (PCE) Price Index
Average Hourly Earnings (AHE)
Employment Cost Index (ECI)
Import and Export Prices
Unit Labor Costs (ULC)

Gross Domestic Product (GDP) Deflator

Market-based Measures of Inflation

Oil Prices
International Gold Prices
Gold/Oil Ratio
Commodity/Bond Ratio
Trade Weighted Exchange Rates
International Asset Prices
Phillips Curve
Forward Breakeven Inflation Rate
Bond Yield Spreads

The Business Cycle

Interesting Reads

FXStreet 2017 Trade the News Series

 Introduction
“The Dollar is our currency, but your problem.”
John Connally, Treasury Secretary under Nixon

Crash Course to Become an Inflation Expert

Have you ever read news updates mentioning rising headline inflation or producer prices
yet you don’t have a clue what these mean for the Forex market?
Well, today is your lucky day as the FXStreet team has been working on a research mate-
rial to make you an expert in trading inflation data and business cycles.

Want to trade inflation and business/economic cycles like a fund manager? To accomplish
that, you should start with a solid understanding of inflation
dynamics. The more knowledge you have, the more confident you will feel trading the
inflation data. Making your own predictions, you don’t need to accept the
market estimates as written in stone anymore.

Ready to make a leap and become an inflation expert?

Awareness of the impact that inflation has on financial markets, the economy, and mo-
netary policy is growing. Indeed, it will be interesting to keep an eye on inflation expecta-
tions over the coming years, not only because inflation has the potential to greatly affect
our investment outcomes, but also because as we mentioned they are an important input
for central banks decision making processes. At the same time, they are a good measure
of the confidence of the markets in the policy makers’ ability to do their job.

In these pages, we describe a framework for analyzing inflation in its multifaceted form.
Our framework includes official economic indicators as well as market-based studies to
better understand not only which factors are potential drivers of inflationary forces, but
also over which sectors of the economy (financial assets, interest rates, currency, etc.) can
these factors exert an impact.

The content is organized as follows: Part 1 distinguishes between four different types of
inflation and describes their main causes while Part 2 looks at 18 survey- and market-ba-
sed measures of inflation. Although the study is mainly focused on the U.S. economy, at
the end you should be well geared to keep an eye on inflation levels across the globe, and
include this knowledge in your trading and investment decisions.

FXStreet 2017 Trade the News Series

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 Part 1

What is Inflation?
Inflation is a sustained rise in the general price level. Although it’s common knowledge
that prices go up over time, the general public doesn’t quite understand the forces behind
inflation. Inflation can manifest in many different ways and finds its roots in different
aspects of the economy. Moreover, different people have different understandings of what
inflation is, and accordingly, there are many ways to measure and estimate inflation.

What causes inflation? How does inflation manifest? What does inflation mean for a na-
tion’s currency? How does it affect my standard of living? In the end, is it bad or good for
the economy?

Let’s start answering these questions by taking a closer look to the different types of in-
flation and their main causes.

Demand-Pull Inflation
Inflation can start rising as a result of unchecked growth in an economy. This happens
when aggregate demand is growing at an unsustainable rate leading to increased pres-
sure on scarce resources. Extra money is then necessary because consumers are taking
money out of their bank accounts and purchasing products. It can be expected that wor-
kers’ wages will increase as well as businesses are bringing in larger revenues and profits.
As wages increase, consumers go out and buy even more goods making producers raise
their prices again aiming for bigger profit margins.

This usually occurs in growing economies when there is full employment of

resources and short-run aggregate supply is inelastic, meaning there are not
enough goods to cover the existent demand. If this spiral is not contained, then the
actual economic growth can be in danger because people have more money, but at some
point the money buys less goods due to rising prices.

What are the main causes of Demand-Pull Inflation?

Direct or indirect taxes: if taxes are reduced, consumers have more disposable
income which causes a rising demand. Tax breaks for mortgage interest rates, for
example, increase demand for housing.

Discretionary fiscal policy: higher government spending and increased borrowing

can also create extra demand in the economy, for example, military spending raises
prices for military equipment, and this in turn raises the costs of materials and
associated products.

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 Monetary stimulus: low interest
rates may stimulate the demand
for loans and lead to housing price
inflation.

Changes in the exchange rate: a

fall in the exchange rate of the
domestic currency makes impor-
ted goods more expensive (foreign
currencies rise), and at the same
time increases the competitive-
ness of exports (domestic goods
are cheaper internationally) which
iStockphoto
can affect the level of demand and
output.

Brands: marketing campaigns can create high demand for certain products, like Apple
products, which are higher priced than comparable products.

Technological innovation: a company developing a new technology will have the entire
market to grow until other companies cope with the innovations.
For example, Tesla’s electric sports car was a recent technological breakthrough.

Cost-Push Inflation
Another commonplace view of inflation, cost-push inflation, happens when firms respond
to rising costs by increasing prices in order to protect their profit
margins. Increased costs can include things such as wages, taxes, or increased costs of
imports.

The 1960s was a time when the American standard of living rose to record levels. It was
also a period during which a legitimate scarcity in skilled labor in the U.S. resulted in es-
calating wages. The rise in the cost of labor resulted in a self-perpetuating escalation in a
cost-push style of inflation with wages being the source.

What are the main causes of Cost-Push Inflation?

Raw material costs: inflation can be set off by an increase in the price of just one crucial
item, such as energy. If the price of oil goes up, for example, many other items that use
oil in their production process will increase in price, eroding the purchasing power of the
currency. The same with copper used in manufacturing or agricultural products used in
food processing.

Labor costs: wage costs, for instance, likely rise when unemployment is low
because skilled workers become scarce and this can drive pay levels higher. This is a rea-
son why the Average Hourly Earnings is such a closely monitored piece of data within the
Employment Situation Report in the U.S.

Indirect taxes: a rise in Value Added Tax, for example, may lead suppliers to choose to
pass on the burden of the tax onto consumers.
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 Monopolies: when dominant firms use their market power to increase prices well above
costs, independently of the level of demand.
Changes in the exchange rate: a fall in the exchange rate can increase the prices of impor-
ted products such as essential raw materials, components and finished products, making
the domestically manufactured products more expensive.

Cost-Push Inflation

Asset Inflation
Both prior definitions assume that the cause of inflation is deeply rooted somewhere within
the market structure – from both the demand- and the supply-side of an economy – rather
than in the perceived value of money itself. The fact is that money has several functions: it
can serve as a medium of exchange, as a unit of account, but it can also serve as a store of
value. And within this overlooked aspect of money lies the basis for a flip-side definition of
inflation: what happens when the value of money declines in relation to the value of goods
and services? Notice the word “value” as a precedent to “price”. The appearance is that
assets rise in price whereby the fundamental drive is a lack of trust in the money as a store
of value.
Rising asset prices are potentially misleading signs of a growing economy. Hard assets
can become more valuable, with no changes to the productivity levels, i.e. no real econo-
mic goods are directly produced. This creates the illusion of growth through asset bub-
bles.

What are the main causes of Asset Inflation?

Foreign investment: the perception that one currency is a better store of value than other
currencies attracts foreign investment causing asset inflation domestically. Since 1971, when
the economies of the main industrialized nations adhered to the floating exchange rate
mechanism, two-digit percentage swings every few years in the foreign exchange markets
became the norm, causing dramatic changes in the domestic rates of inflation within any
nation depending upon imports. A fall in the value of US Dollar against the Japanese yen,
for instance, makes US real estate “appear” to rise, but in fact it only does so in terms of
yen, in relative terms thus.

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 Taxes: a sustained rise in taxation can have a deflationary effect on the economy by lowe-
ring the living standards of the population. This can cause the perception that purchasing
power is being erased by taxation, and people choose to exchange their money for what
they consider “tangible” assets, i.e. assets which could be used to preserve wealth, as a
store of value. These can be high-end real estate, collectibles, art, but also stocks and more
recently, digital currencies.

Political and economical risk: the lack of trust in government or in the banking system can
also force capital to run into tangible assets, reducing the velocity of money, collapsing the
liquidity in the system, and setting the stage for an economic implosion.
Changes in the exchange rate: since everything has a relative international value, when a
currency declines, assets will generally rise in proportion to the decline. On the day Brexit
was voted, the Pound collapsed but the UK stock market rose. It did not collapse as it would
be the case if money had moved out of the stocks into other asset classes. The nominal
price of the FTSE went up in absolute terms, but there were no actual performance gains in
relative terms. Although a strong move in the exchange rate is immediately seen in financial
assets like stocks or bonds, the repricing of products and services throughout the economy
is reflected on most sectors.

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Implicit Inflation
Broader definitions of inflation are not only necessary to better understand our economies,
but also to get a sense of what the future will bring from a market and investment perspec-
tive. If we get back to the idea that a loss of the “quality” of money (as a store of value) can
manifest through inflation, we can also think of other causes of inflation which could have
the same end result, that is, a collapse in purchasing power and a lower standard of living.
By doing that, we do not necessarily search for explicit phenomena such as the rise in asset
prices or in goods and services, but rather those implicit causes which could have similar
effects as the other forms of inflation already described. Which causes can we think of
that sooner or later could manifest through apparent economic deterioration for everyone?
Notice that implicit causes could come unnoticed for most economic indicators tracking
inflation.

What are the main causes of Implicit Inflation?

Privatization of profits & socialization of losses: even at the tepid levels of (explicit) infla-
tion we’ve seen in the past few years, the population (not always fully aware of it) has to
cope with losses felt in many fields: loss of physical and mental health, of political freedom,
of environmental quality, loss of privacy (24/7 availability), of financial independence

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 (special among young gene-
rations), and loss of diversity
(in a monopolized economy).
All these factors, which fall
beyond the object of this
study, have the potential to
drive future inflation to exor-
bitant levels.

Money as debt: an economic

system which is primarily

financed through the

creation of “bad” money, i.e.
debt, will be permanently unstable and suffer from boom-and-bust cycles of greater magni-
tude than a system where implicit deflationary (or at least implicit disinflationary) forces are
allowed. With each crisis, money (or wealth) evaporates for a big part of the population resul-
ting in a similar effect as one perceived in an explicit inflationary environment.

Wealth destruction: financial crashes, bail-ins and bail-outs, arbitrary expropriations, manda-
tory debt restructuring, controls on capital movement, monetary reforms, cash elimination…
All these factors, some recently experienced in different parts of the world, have the potential
to change the way people perceive value, and therefore how they decide what can serve as
an hedge to preserve their wealth, and how to compensate for the perceived losses in many
areas of their life.

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 Part 2: Inflation Indicators

Inflation has a substantial effect on various economical factors, going from the cost of
money (interest rates), impacting on labor and growth prospects, to the behavior of all
financial assets, including currencies.

In this section you will get to know 18 inflation-oriented measures which are an integral
part of fundamental and technical analysis. The aim of this suite of indicators is to offer
you the tools necessary to expand your view on inflation and inflation expectations. Having
all these indicators at one place gives you a broad view of how strong or weak inflationary
forces come into play at any given moment.

Survey-based Measures
Measuring inflation is a difficult task for everyone, including government officials. To do this,
statisticians conduct large surveys by contacting thousands of retail stores, service establi-
shments, rental units and professional offices to acquire price information on a variety of
items. These items are put together into what is commonly referred to as a “market basket”,
and represent a scientifically selected sample of the prices paid by consumers for pur-
chased goods and services. The results are computed into indices which in the end are used
to track and measure inflationary pressures surrounding the economy.

Consumer Price Index (CPI)

The Consumer Price Index (CPI) is the most frequently cited measure of inflation out of the
various economic indicators. Also known as “headline inflation”, its release is generally the
second or third week of each month. It is used by retailers in predicting future price increa-
ses, by employers in calculating salaries, and by the government in determining cost-of-li-
ving increases for social security. Central banks also monitor this release to help guide them
in their rate and policy settings.

Calculating CPI involves considering the weighted average pricing of goods and services as
experienced by consumers in their day-to-day living expenses, analyzing more than 200
categories, which are organized in eight groups: housing (41%), transportation (17%), food
and beverages (15%), medical care (7%), education and communication (7%), recreation (6%),
apparel (4%), and “other goods and services” (3%). As you can see, the biggest single com-
ponent in the CPI is housing with a 41% weight.
To reduce some of the statistical noise in the inflation data and to give a more accurate
measure of inflation, the government publishes the Core CPI, which is the CPI without the
volatile components of food, which can suffer from seasonal price variations, and energy,

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 The Consumer Price Index (CPI) is the most frequently cited measure of inflation out of the
various economic indicators. Also known as “headline inflation”, its release is generally the
second or third week of each month. It is used by retailers in predicting future price increa-
ses, by employers in calculating salaries, and by the government in determining cost-of-li-
ving increases for social security. Central banks also monitor this release to help guide them
in their rate and policy settings.

Calculating CPI involves considering the weighted average pricing of goods and services as
experienced by consumers in their day-to-day living expenses, analyzing more than 200
categories, which are organized in eight groups: housing (41%), transportation (17%), food
and beverages (15%), medical care (7%), education and communication (7%), recreation (6%),
apparel (4%), and “other goods and services” (3%). As you can see, the biggest single com-
ponent in the CPI is housing with a 41% weight.
To reduce some of the statistical noise in the inflation data and to give a more accurate
measure of inflation, the government publishes the Core CPI, which is the CPI without the
volatile components of food, which can suffer from seasonal price variations, and energy,
which can fluctuate wildly as a result of geopolitical shocks.
The Core CPI is typically more important to traders and the Federal Reserve as a measure
of actual inflation since it tends to provide a more representative view of the inflationary
forces in presence in the domestic economy.
Comparing the CPI with the Core CPI can give you a good idea of how much consumers, who
account for two-thirds of the economic activity, are spending on commodities such as ener-
gy and on agricultural products.

Once you understand there are different types of inflation, it is fairly easy to see that the
CPI can perpetuate a kind of cost-push inflation, in which the cause of rising prices is pre-
cisely rising prices. This is not the only criticism the CPI is fraught with. Many analysts claim
that the basket of goods is too static, that it changes infrequently, and it may not always
reflect items that provide an accurate accounting of the consumer experience. For instance,

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 new products are not counted for a while after they appear on the market, or variations in
price can cause consumers to substitute the product on the spot, so that the basic measure
holds their consumption of various goods constant. And not few analysts say the CPI can be
misleading when making financial decisions, because it no longer measure the true increa-
se in inflation, required to maintain a constant standard of living.
Notice, for instance, that while certain taxes are included in the CPI, namely, taxes that are
directly associated with the purchase of specific goods and services (such as sales and ex-
cise taxes), taxes not directly associated with specific purchases, such as income and social
security taxes, are excluded, as are the government services paid for through those taxes.
It is important to know that net disposable income can be drastically reduced by higher
levels of taxation, leaving the population with a need for inflation measures which are more
relevant and appropriate to explain the perception of reduced standards of living.

Consumer prices related releases for several countries can be followed on

FXStreet’s Economic Calendar.

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 Producer Price Index (PPI)
Another standard gauge of inflationary pressures in an economy is the Producer Price Index
(PPI). The Bureau of Labor Statistics (BLS), the government body that collects PPI data, re-
leases it on a monthly basis, two or three weeks after the reporting month ends.

The PPI is somewhat similar to the CPI with the exception that it looks at the rate of chan-
ge in prices from the perspective of the producer rather than the consumer. Every month,
around the week that includes the 13th, the Labor Department receives answers to ques-
tionnaires requesting prices on about 100,000 different items. It then gauges the average
changes in those prices received by domestic producers for their output at all stages of
processing. Certain categories are intentionally left out of the PPI basket such as imported
goods and most services. Excise taxes are also excluded.

In total there are three measures of PPI which are based on the different stages of proces-
sing: the PPI Crude Goods, the PPI Intermediate Goods, and the PPI Finished Goods. One
way to forecast the future movement of the PPI Finished Goods consists of monitoring the
Intermediate index, and in turn, the direction of this index can be determined by analyzing
the PPI Crude Goods.

In the end, the PPI Finished Goods provides a sense of the expected CPI movement, ser-
ving as a leading indicator because when companies experience higher input costs, those
costs are ultimately passed on to the subsequent buyers in the distribution network.
Although firms throughout the supply chain will typically hedge their input costs, higher
prices will eventually be realized once the hedging contracts expire.
Tracking PPI also allows one to determine the cause of the changes in CPI. If, for example,
CPI increases at a much faster rate than PPI, such a situation could indicate that factors
other than inflation may be causing retailers to increase their prices. However, if CPI and PPI
increase in tandem, retailers may be simply attempting to maintain their operating margins.
Discrepancies between the PPI and CPI can be based on factors such as sales taxes and
markups as products move through the various stages of the supply chain.

But don’t look at the PPI as a short-term leading indicator. A correlation does exist, but only
over larger time horizons. The reason is the volatile behavior in food and energy prices. For-
tunately, the U.S. government also publishes the so-called “Core Rate” where energy and

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 food prices are excluded from the calculation. Despite the weak correlation in the short-
term, since this is the first key inflation gauge published every month, the markets tend to
view it with greater sensitivity.

The monthly data is subject to revisions that are published four months later, which can
also lead to a significant market impact. In addition, deviations of the most recent PPI
number from expectations can be seen in FXStreet’s Market Impact Tool (to be found in all
economic data of our Economic Calendar):

Personal Consumption Expenditure (PCE) Price Index

An alternative to the CPI is the Personal Consumption Expenditure (PCE). This measure is
the component statistic for consumption in the Personal Income and Outlays report and
also the largest part of the Gross Domestic Product (the PCE accounts for 70% of total GDP),
both collected by the U.S. Bureau of Economic Analysis (BEA).

The PCE consists of the actual and imputed expenditures of households, and includes data
pertaining to durable goods, non-durable goods and services. Thereby, it measures the
changes in prices of consumer goods and services which are affected by inflation, and its
swings can lead to major shifts in the business cycle (see “The Business Cycle”).

According to many analysts, the PCE is the preferred consumer inflation gauge for the
Federal Reserve because it switches the specific goods and services that make up its sam-
pling more often than the CPI in order to account for shifts in shopping habits.

What policy makers study most carefully though is the percentage changes in the core PCE
(that is, excluding food and energy). The reason for excluding these essential and routine
expenses for households has been explained in the previous indicators.

The PCE is presented in both current dollars (which are not adjusted for inflation) and
constant or real dollars (which removes the effects of inflation). Similarly, the GDP is also
initially calculated based on the current dollar (nominal) value of all goods and services.
However, this measure does not help to discern whether an increase in GDP came from
greater output of goods and services or simply because of higher prices.
The BEA publishes several so-called “chain-type” inflation measures that help convert cu-
rrent GDP to real GDP. This way, with complex methodologies, the statisticians aim to remove
price inflation.
On the FXStreet Economic Calendar you can find the PCE presented in percentage change in
chain-type price indices in monthly (MoM), in quarterly (QoQ), and yearly (YoY) totals. These
longer periods are calculated to avoid the short-term volatility in the monthly numbers.

So, while the quarterly GDP report lags behind many other monthly indicators, the inflation
statistics contained in the GDP -like the PCE- can make it a market mover, specially if the
numbers deviate from the Fed’s comfort zone which is a rise between 1,75% and 2,0% per
year. A Core PCE number below that range gives the doves within the FOMC members the
upper hand. Conversely, any release above the 2% target would improve rate hike expecta-
tions significantly.
The below picture shows the PCE’s market impact on the EUR/USD pair in terms of number
of pips that moved 15 minute and 4 hours after the data is published.
Notice how the short-term impact has been increasing in recent releases.
FXStreet 2017 Trade the News Series
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 Another good measure of true consumer purchasing power is the Real Disposable Per-
sonal Income expressed as chained-dollars. The reason why this is important is the the
following: if general price levels rise, and therefore inflation rises, but disposable personal
income also rises, people gain nothing from the rise in income since prices jumped by an
identical rate. However, if income climbs more than inflation, real purchasing power grows.
Data on Real Disposable Personal Income cannot be found in FXStreet’s Calendar, but a link
to the BEA’s website is provided. Once on the home page, click on “Personal Income and

Outlays”, and finally on “News Release: Personal Income and Outlays” to access the report.
Finally, search for “Disposable Personal Income” to get the latest releases of the numbers.

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 Average Hourly Earnings (AHE)
This indicator, released by the U.S. Department of Labor, measures the change in worker’s
wages. If worker income rises, it bodes well for future spending, since wages and salaries
from employment make up the main source of household income. The Federal Reserve pays
close attention to this data when setting interest rates, because of its strong correlation to
inflation. Poor wages are a drag for inflation, while strong wages are a sign that inflation
may start to growth.

Several analysts have pointed to possible caveats with this indicator. One of them is the fact
that when firms want to reduce wage costs, they can allow inflation to erode an unchanged
or slowly increasing nominal wage, instead of cutting wages in nominal terms. Some eco-
nomists argue that in the recent low-inflation environment, this erosion has been so slow
that real wage cuts effectively restrain wage growth, despite a recovering labor market. This
might conceivably also affect wages’ forecasting power for price inflation.

With wages accounting for a significant share of costs in most industries, it makes intuiti-
ve sense that rising labor costs would soon develop into higher inflation. But according to
some analysts, however, wage growth tells us little about future inflation. If anything, they
say, the relationship runs the other way, with inflation leading wage growth.

Another caveat is the changing structure of the U.S. economy, with technology making it ea-
sier than ever for consumers to compare prices. This intensifies price competition and limits
the influence of wage growth on inflation. At the same time, globalization has diminished
the role of the domestic labor market with a larger share of consumption goods imported
from abroad. And finally, the inability of many firms to adjust prices frequently generates
the need to set prices in anticipation of future costs, making inflation expectations a more
significant inflation driver than wages (more on inflation expectations when we come to
market-based indicators).

The data can be seen on FXStreet’s Economic Calendar. Past months’ data, consensus and
actual releases, are shown as a separate report from the NFP.

Employment Cost Index (ECI)

This is another indicator to add to your early-warning system of rising inflation pressures.
The ECI tracks changes in the cost of labor which accounts for the biggest part of the cost
of manufacturing a product.

Rising labor costs can ignite inflation and unleash a vicious cycle that is hard to stop.
There can be several reasons for employees to demand increases in wages and salaries, for
instance, scarcity in skilled labor, or to keep up with expected inflation. Should employers
comply and pay workers more money, this can lead to a jump in retail prices, which in turn
can be a reason for workers to demand another increase in wages. Economists call this a
“wage-price spiral”, one of the causes of cost-push inflation. This is one of the reasons to
watch the Employment Situation Report for any hints of pushing-lower unemployment.

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 While the AHE is published on a monthly basis, the ECI comes out quarterly, a reason why
the first is often preferred by analysts and traders. But on the other hand, the ECI covers
both hourly and salaried workers, whereas the AHE considers only workers who get hourly
pay. Moreover, the ECI incorporates all major expenses, including benefits that businesses
pay to their workforce (vacations, sick leaves, holidays, insurance benefits, just to name a
few), while the AHE does not.

Its source is the U.S. Bureau of Labor Statistics who conducts surveys of both private and
public sectors, then organizes the data in a fixed basket of job types, and finally converts it
into an index expressed in percentage change.

To even better gauge inflation pressures, compare the annual percentage change in com-
pensation costs for private industry with the annual change in non-farm productivity (this is
published as a standalone input in the FXStreet’s Calendar). If costs rise no faster than the
pace of annual productivity, there is no sign of price inflation. But costs rising faster than
productivity growth can fire up price pressures and eventually force the Fed to raise rates.

Once on the FXStreet’s Calendar, expand the event row, and then click on “Read the official
report” to get the suggested numbers.

Import and Export Prices

Every month, the Bureau of Labor Statistics in the U.S. collects information on export and
import prices on more than 20,000 products, weighs them against a fixed basket of goods,
and builds an index.

As in the case of other inflation indicators, the reason for establishing this index in the first
place was to convert the monthly U.S. trade figures from current dollars into real dollars.
Only by converting the trade figures into real dollars...”, you’ll know if an increase in im-
ports was the result of more products being purchased or because foreign exporters raised
prices. The same applies for exports which can increase because of domestic firms actually
selling more products, but the rise can also result from companies hiking prices.

It’s also well established that changes in import and export levels tend to be inversely
related to currency value. You don’t need to be an experienced currency trader to unders-
tand the logic: domestic goods and services are less expensive in foreign markets when the
home currency’s value falls. But this is a two-way street: a weaker currency also translates
into higher prices for imports. With imports now pricier, domestic companies will be em-
boldened to lift their own prices as well because they have less to worry about in terms of
foreign competition.

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 The same relationship implies that a stronger dollar drives up the price of domestic pro-
ducts being sold overseas. The domestic companies might prefer to keep the prices lower
just to stay competitive, reducing revenues and earnings at the end. At some point though,
it might trim exports and, perhaps, also jobs. Domestic importers and consumers, on the
other hand, are happy to see a strong dollar because foreign products are then cheaper.

To summarize: a strong currency is deflationary for the domestic economy, while a weak
currency is inflationary, a reason why this piece of information should be always analyzed
together with currency charts. The impact of the dollar can be best seen in the report’s sec-
tion for “non-petroleum imports”. Under the section for “petroleum imports”, on the other
hand, patterns can emerge in tandem with the developments in the price of oil. That’s also
a key issue for the U.S., which is dependent on crude oil imports in rather large quantities.
But when both the cost of petroleum and non-petroleum goods fall, then we can interpret
that given inflation could remain tame for a while. In such case, PPI expectations would
also decrease, as import prices and oil serve as leading indicators.

If import prices are rising, analysts expect higher reading in the CPI release, whereas a sus-
tained fall in import prices is a forerunner for disinflationary forces (or outright deflation in
case the CPI is already depressed). This makes import prices a leading indicator for the CPI.
Some analysts though, say the U.S. does not import enough for a weak dollar to push goods
inflation upward, only about 15.5% of GDP.

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 Unit Labor Costs (ULC)
This indicator is part of the U.S. Productivity and Costs report, which informs about the
output in goods and services employees produce for each hour of labor worked. It shows
also how efficient companies are when using their physical capital, which is land, material
resources and equipment, but foremost their employees. The wealth of a nation is not so
much its natural resources or “tangible” wealth, but the total productivity of the nation be it
hard labor or intellectual (ideas can be worth more than brute force labor for they are the
fuel of advancement and innovation). Note that it was thanks to the total productivity of Ja-
pan, not its resources, that Japan became the second largest economy in the world without
any natural resources to speak of.

An increase in productivity increases the supply of goods and services, then companies
generate greater revenues and these lead to greater pay for workers, higher dividends for
shareholders, all in all diminishing the inflationary pressures. On the other hand, poor
productivity is a recipe for economic stagnation and invites inflation, unemployment, and
little or no gains in real income.

The ULC indicator contains three major components: “output” (labor productivity), “hourly
compensation” and “unit labor costs”. It is published quarterly by the U.S. Bureau of Labor
Statistics, about five weeks following the end of the quarter.

Revisions can be substantial and frequent because many of the statistical sources that
underlie this report come from other indicators. Data on hours worked comes from the
monthly payroll employment report, for instance, and for output the BLS uses the total GDP.
Because of the data being already published in these other reports, traders will rarely get
excited at the ULC release. But to keep inflation in check, which is the aim of this study, you
should know how to read it.

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 Unit labor costs are driven down as long as the “output” rises faster that “hourly compensa-
tion”. It is when “hourly compensation” (labor costs) start to climb more than the “output”
(productivity), that you have an early signal of inflationary forces emerging.

Unit Labor Costs is the indicator published on the FXStreet’s calendar. In order to analyze
the data, click on the indicator row to expand it, and click on “Read the official report”. This
will take you to the source where you have access to the above table.

Gross Domestic Product (GDP) Deflator

We have already seen that one of the problems with trying to understand the performance
of an equity index is that currency movements skew results. For example, if over the past
year the Dow Jones increased by 5%, and at the same time the U.S. dollar devalues against
the Euro by 15%, in real terms, a European investor actually lost 10% buying the U.S. index.

There is the same problem with trying to understand an economy’s performance: price
inflation skews results. For example, if over the past year your wages increased by 5%, but
now as a result of price inflation it costs 15% percent more to buy goods, you’ve actually lost
buying power. Your own personal economy isn’t 5% greater: in real terms you lost about 10%
of purchasing power.

Looking at the source document for the GDP report, under “Updates to GDP”, we see a small
table with several rows of data. Of our interest, in terms of inflation concerns, are the upper
two rows. The first shows the “Real GDP” which, expressed in percentage terms, reflects the
change of the constant-dollar output, which means how much the economy really produced
in volume or quantity. The second row shows the current-dollar GDP which is the nominal
GDP or the value of aggregate output including price increases. In economies where in-
flation is positive and not negative, real GDP should be lower than nominal GDP. The real
dollar percentage change is the one you can get on FXStreet’s calendar and is the one more
closely followed to get an accurate picture of the economy’s health.

But to get a specific measure for price inflation, economists have developed the concept
of the GDP Deflator (also called “Implicit Price Deflator”). This is a way to measure the
relationship between nominal and real GDP, and is simply nominal GDP divided by real GDP
and then multiplied by 100. It is important because an economy’s nominal GDP differs from

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 its real GDP in that nominal GDP includes inflation, while real GDP does not.

The advantage this econometric has over the CPI, for instance, is that the fixed basket used
in CPI calculations is static and sometimes misses changes in prices outside of that basket
of goods, while GDP as such isn’t based on a fixed basket of goods and services. Conse-
quently, the GDP Deflator has an advantage over the CPI in that changes in consumption
patterns or the introduction of new goods and services are automatically reflected in the
Deflator. Therefore, it can be used as a measure for price inflation. A rising GDP Deflator
means inflation is mounting, whereas a GDP Deflator in its lower levels reflects the increa-
sing deflation pressures that the economy is facing.

FXStreet 2017 Trade the News Series Source: Tradingeconomics.com

18
 Market-based Measures of Inflation:

To some people it may sound enigmatic that we experienced close to zero inflation during
a period of almost a decade in many areas of the developed world, whereas markets have
behaved in many sectors like in an inflationary environment. Well, this is enigmatic insofar
inflation is not considered in its multi-dimensions. Survey-based indicators, like the ones
discussed in Part 1, do not accurately capture certain forms of inflation. Therefore, other
measures are needed to make inflation visible when it is not detected by official economic
indicators of inflation.

When trying to interpret financial market developments, and especially when trying to give
an economic meaning to those developments, we usually only have proxies for what we
really want to know. In this regard, there is no such thing as “the” real inflation rate. Rather,
there are observed patterns on specific market prices, which can be used to detect infla-
tionary forces derived from all sorts of causes.

In this section we will use asset prices as the building blocks to detect not only inflation,
but also future expectations of inflation. Most of the time, acting in anticipation is what
leads investors and policymakers in their decision making. In this sense, the selection of
market-based measures contained in Part 2 is build on the premise that financial mar-
kets act as leading indicators for economic trends. Furthermore, many of these measures
elevate the usefulness of technical analysis to the realm of economic forecasting. Markets
anticipate future economic conditions in a way that even if there is no official inflation, they
will anticipate inflationary conditions and reflect it on the charts.

Oil Prices
Are commodities, in general, reliable as a barometer of inflationary expectations? A number
of studies conclude that commodity prices can be used as a leading indicator of inflation
although some of the characteristics of an “optimal” leading indicator are not met.

Above all it’s the flexible nature of commodity prices that make them ideal candidates to
be labeled as inflation-leading indicators. Commodity prices are set in competitive auction
markets and are faster than overall prices in reacting to economy-wide demand shocks. As
an example, a change in monetary policy or a change in the supply of important commodi-
ties would tend to raise commodity prices before other prices begin to rise.

But financial markets also move on expectations, that is before facts become reality. In this
context, the relationship between the price of oil and inflation is often perceived when the
oil price is expected to rise. This is called “backwardation”, when futures prices are higher
than spot prices. Backwardation can suggest a pent-up demand for oil, which may put
upward pressure on CPI readings, lifting inflation expectations down the line.

In practice though, the opposite may also happen if people continue to use the same
amount of oil as before, they will simply allocate more money to oil and less money for

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 other goods and services, which is not more than altering the composition of spending. This
of course implies that the average price of other goods or money per unit of goods (and
services) remains unchanged or must come down, and so the CPI. For this reason central
banks stress the need to look through transitory factors like an oil-led spike in inflation,
and wait for more substantial evidence of sustained wage price inflation before pulling the
trigger based on expectations.

There are other scenarios which can be misleading: oil prices can also rise to compensate
a falling U.S. dollar. A weak dollar, in the eyes of oil producers, carries the consequence of
falling purchasing power as the weak currency erodes the value of their dollar-denominated
oil receipts. This rise in the commodity, in turn, is expected to result in inflationary pressures.

International Gold Prices

It is also well-known that members of central banks monitor the price of gold carefully and
consider it a good estimate of inflationary expectations. Not few financial observers are
convinced that central banks may intervene from time to time in the gold price.

Analogous to the cause-effect relationship between oil and inflation, a rising gold price
increases inflationary expectations, and a falling gold price may imply deflation and reces-
sion. But gold is not really an inflation hedge per se. If it was true, the price of gold would
have not felt from $850 in 1980 to $250 in 2000 with inflation every step of the way. Rather,
gold seems to perform well in specific instances, the primary ones being a loss of faith in
central banks and their monetary policies, or when political and economic instability is
sensed.

Although many real case studies reject the hypothesis that there is a reliable long-run
relationship between the level of gold prices and the level of inflation, there is a way to
measure changes in the price of gold that anticipate other inflationary signs. This con-
sists of denominating gold prices in a broad index of major-country currencies. Generally,
when commodity prices are rising, the U.S. dollar is falling, a reason why foreign currencies
usually rise along with commodity markets. But when a commodity rises in all currencies,
it means that a real inflow of capital is pushing that commodity higher. As a result, higher
asset-inflation can be expected.

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 Summarizing: gold has to rise in all currencies, and not only against the U.S. dollar in which
it is quoted, to imply it is acting as an hedge against inflation or loss of trust in monetary
or political authorities.

The below chart shows how the recent high in the gold price in USD (grey mountain) is not
confirmed by all currencies. Despite warning of a possible false breakout in the price of
gold, the chart does not contain an inflationary narrative.

Gold/Oil Ratio
On the theory that rising oil prices push up inflation, increasing demand for gold as an
hedge, conventional wisdom tells us that inflation can be eliminated from the chart if we
express the two prices as a ratio. Because both commodities react to different situations,
it’s the lack of a tight correlation between these commodities that makes the gold/oil ratio
meaningful. Expressed mathematically as the per-ounce price of gold divided by the cost of
a barrel of crude oil, the ratio tells you how many ounces of gold it takes to buy a barrel of
oil. Essentially, what this means is that if the ratio rises, oil is down (or at least underperfor-
ming), and gold is rising (or at least outperforming).

The long-term average multiple over the past 40 years sits above 15:1, and above 20:1 if we
account the first half of the 20th century based on annual closings (on monthly closings,
as in the picture below, the peaks are higher). Should the price of gold rise because of an
asset-inflation scenario - due to a collapse in confidence in the monetary system, for ins-
tance-, then this ratio could hit historical highs above the Great Depression levels (above
30:1 on annual closings).

While the gold/oil ratio may be a somehow arbitrary indicator, when it rises to extreme
levels it’s a clear signal that investors are nervous, preferring safety to growth, that is, the
safety hedge gold is believed to offer over the confidence in economic growth expressed via
oil prices.

Gold prices rise most steeply when investors hoard the metal in anticipation of some sys-
temic troubles or when reacting to any other cause of implicit - or asset-inflation. Oil prices,

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 on the other hand, soften when a slowdown in the economic activity is foreseen, namely
recession. These seemingly disparate messages imply that both inflation and recession can
happen at the same time. The famous stagflation back in the 1970s and early 1980s was a
proof that inflation and recession are not mutually exclusive.

Commodity/Bond Ratio
Continuing with the idea that commodities have special characteristics that make them
ideal candidates to receive at least a small allocation in every investor’s portfolio as an
inflation protection, another commonly used study is the ratio between commodities and
bonds.

The rationale for using this ratio is rather simple: when commodity prices are rising faster
than bond prices, we see this as an indication of inflation. Conversely, when commodities
are declining in relationship to bond prices, it is viewed as a deflationary sign.
A rising commodity/bond ratio means commodity prices are outperforming bond prices,
which can derive from either higher commodity prices (hence inflationary) and/or lower
bond prices (which means higher yields, hence inflationary as well). In either case, the
interpretation is of upward inflationary forces if the ratio rises, and deflationary forces if
it falls.

When constructing this ratio with a single commodity though, if that commodity’s price
starts to rise faster than bond prices, it can be partially a result of a falling dollar. Fortuna-
tely, there are several commodity indices which can be used as a numerator for this ratio in
order to offset the currency effect: the S&P GSCI is widely recognized as a leading measure
of general price movements and inflation in the world economy; the JOC-ECRI Industrial
Price Index developed by the Economic Cycle Research Institute is considered a leading
indicator of inflation based on a broad assortment of raw materials used in industrial
production; the Thomson Reuters/Core Commodity CRB Index, made up of 19 commodities,
also provides accurate representation of broad commodity price trends; or the S&P World
Commodity Index which is based on investable commodity index futures contracts traded
on exchanges outside the U.S. It is broad-based, world-production-weighted, and designed
to measure international commodity market performance over time. Although a ratio can’t
be calculated on our charts, you can follow the S&P WCI here at FXStreet’s Rates & Charts
section.

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 Trade Weighted Exchange Rates
In order to account for countries whose currencies experience differing rates of inflation
from each other, there are several ways to more accurately reflect the strength of a currency
relative to other world currencies. Although these measures are not meant specifically to
measure inflation, but rather economic competitiveness, if competitiveness worsens, trada-
ble goods produced abroad are cheaper than those produced domestically, which is consi-
dered deflationary. Deflation comes associated with economic downswing, unemployment,
a stunted tradable goods sector, and reduced long-run growth, besides of a non-viable
external position. On the other side, excessive competitiveness can lead to economic over-
heating and inflation, an underdeveloped non-tradable goods sector, large current account
surpluses and reserve accumulation.

As we have mentioned before, an appreciating exchange rate is usually thought to be

contractionary and deflationary, while a depreciating exchange rate is usually thought
to be expansionary and inflationary. Hence, having different ways to measure the level of
an exchange rate is important to assess the economic efficiency in terms of output gap. A
so-called “positive output gap” commonly spurs inflation in an economy as both labor costs
and the prices of goods rise in response to the increased demand, and thereby also infla-
tionary pressures.

As a Forex trader, you are probably familiarized with bilateral nominal exchange rates which
is basically the price of one currency expressed in terms of another currency. For example,
EUR/USD at 1.30 means one Euro is worth 1.30 U.S. Dollars. But there are other ways to re-
flect a currency rate.
One of them is an aggregate measure, called the nominal effective exchange rate (NEER),
which provides a clearer picture of currency value developments. The NEER is a way of eva-
luating the strength of a country’s currency which consists of weighting its value according
to the relative amount of trade carried out with each of its trading partners. If the majority
of a country’s trade is with Japan, for instance, then the movement of its currency against
the yen will be given greater weight in the overall measurement of that exchange rate’s
value. Being a nominal variable, the NEER only describes relative value: the price of the
national currency in terms of trading-partner currencies. But at the same time, NEERs are
relatively straight-forward to calculate and widely available for almost any country. As with
all exchange rates, the NEER can help identify which currencies are becoming attractive as a
store of value and thus attracting lots of flows.

There are two well-known trade-weighted currency indices. The first is the U.S. Dollar Index
(USDX), calculated using six major world currencies where the euro has more than 50% of
the weight, reason why a USDX chart is almost the mirror image of a EUR/USD chart. The
second is the Trade Weighted U.S. Dollar Index, sometimes called the Broad Index. The
Federal Reserve realized the bias of the USDX and created a trade weighted index that accu-
rately reflects the Dollar’s strength against the currencies from 26 selected countries which
the U.S. trades more frequently with. Unlike the USDX, this one is updated annually to reflect
current trading exposures.

For our purposes of detecting inflationary signals, neither the nominal nor the nominal
effective rates indicate the relative (real) price of goods. For instance, how do we answer the
question: is the value of one UK-produced car the same as an identical U.S.-produced car
of the same brand and model? In order to answer this question, we need to measure the
currency’s strength in real terms. To do that, we need to take into account price and wage
developments and construct what is known as the real effective exchange rate (REER).

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 The REER is also a nominal effective exchange rate index but it is adjusted for relative mo-
vements in national prices or cost indicators of the home country and those of the selec-
ted other countries. A rising REER means the domestic product (or consumption basket,
for that matter) is becoming more expensive than the foreign product, indicating higher
domestic inflation levels. This also means reduced cost of imports but undermined com-
petitiveness of exports, the reason why the G5 was formed in 1985, when the extremely high
U.S. dollar dropped U.S. exports.

Suppose the UK-produced car from our example costs £50,000 in the UK and $50,000 in
the U.S. The REER is thereby 1:1. If the nominal exchange rate was also £1 = $1, then we have
perfect purchasing power parity (PPP) and none of these two countries is showing stron-
ger inflation. Now suppose that the cost of the British car increases to £75,000 in the UK,
and in the U.S. it still costs $50,000. This means that the car in terms of Pound is 50% more
expensive than the one in U.S. dollar. The real exchange rate, the REER, is £1.5 = $1. But if the
nominal exchange rate is still £1 = $1, what will arbitrageurs do? They could buy the car for
$50,000 in the U.S. and sell in the UK for £75,000. They would make a profit of £25,000, which
they could convert into $25,000 at a rate of GBP/USD= 1,000 (other things being equal).
Normally, we would expect the nominal exchange rate to adjust to reflect the real chan-
ges, and if there is inflation in the UK, we would expect the Sterling to fall in relation to the
dollar. Indeed, in theory, the nominal exchange rate should reflect the real exchange rate.
But sometimes we can see divergences between the two, which induce global investors to
speculate on a devaluation.

Forex markets are very liquid and efficient so the nominal exchange rates are thought to be
always in equilibrium with the REER. Internally, the equilibrium can be kept if there is no
output gap and no inflationary pressures, and externally, if the current account is financed
with a sustainable level of capital flows. Failure to understand capital flows can make many
inflation indicators mislead you. So let’s learn something about capital flows.

You can find NEERs and REERs on sites like the Bank of International Settlements and The
World Bank.

Image source: Thomson Reuters Eikon.

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 International Asset Prices
Inflation is generally understood and perceived as the rise in price of ordinary goods and
services. This is the main reason why official and central bank policies in most of today’s
world have been expressly directed at minimizing price inflation as measured through indi-
cators like CPI and similar. A so-called asset-inflation, as we explained in Part 1 of this study,
has not been the object of much attention or concern.

As we also explained in Part 1, hard assets can rise a lot in price, with no accompanying
changes in the productivity levels, creating thereby the illusion of economic growth. The
same asset bubbles can also create the illusion that a certain asset is a very good invest-
ment because of its persistent advance in price. Remember that hard assets are non-debt
related, fixed assets in general. This includes some commodities, equities, and real estate,
but it can expand to collectibles, antiques, wines, art, etc.

Unfortunately, most people -and not few financial market pundits- do not understand the
fact that a currency (money) is most of the time playing the opposite role of hard assets
in terms of store of value. Usually, when hard assets rise, this means that the currency in
which these assets are priced, declines in purchasing power. Now, how do we find out that
a rising trend is reflecting real-asset inflation? How can we detect that a certain asset is
attracting money from all corners of the world?

To qualify as a bull market, whatever asset you are looking at must rise in terms of all cu-
rrencies.
Most of the time, bull markets never unfold simultaneously. Let’s assume that gold has dou-
bled in U.S. dollar terms, but the U.S. dollar depreciated 50% against the Australian dollar.
Down under, the gold price is unchanged, there is no ascending trend. Or imagine new highs
in the FTSE making headlines, when it is only because the Sterling is declining. Only looking
at FTSE in international terms (in USD, JPY, EUR) exposes the real trend, and in that case it
might expose a sideways meandering price as well.

This means that a sharp correction on a stock index can be mitigated by the rise in the do-
mestic currency because in the eyes of foreign investors, their weaker currencies make the
index look better priced even if it lost value in domestic (nominal) terms.
Revealing the real trend would also help understand many situations which go against text-
book theories. One of these claims that stock markets fall if interest rates are rising. From
a foreign perspective, the local stock market may rally despite rising rates, because of the
rise in the domestic currency.
The same disparities happen in the commodity world. Let’s assume commodities are de-
clining in dollar terms but this time with the dollar rising at the same time. Domestic (do-
llar-based) producers reduce production because it is now more difficult to export that
commodity with the more “expensive” dollar. The problem is that we assume all producers
(inclusive foreign ones) will do the same, when they may actually accelerate their output.
How can this be? Because in local currencies, outside the U.S., the cost of production decli-
nes. A more expensive commodity in dollars, may lead local commodity producers to pro-
duce even more, because they are selling the commodity cheaper once “translated” to their
local currencies which are weaker than the USD.

You see, money is in many ways a metaphor for language. We look at the world of financial
and hard assets without making the effort to translate the different languages or trying to

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 see the world from a different perspective. Nominal quotes in any asset are like a message
expressed in a native language. If you are looking at the Nikkei’s quote, and your financial
“language” is not Japanese, by not translating that nominal quote into your home currency,
you will not be able to discover the real value the Nikkei may have for you.

In order to monitor capital flows capable of igniting a so-called asset-inflation, we look for
situations when we see domestic assets and the currency value both rising in an aggres-
sive manner. A currency with a bullish trajectory because of a strong capital inflow, one
based upon foreign investment, will make assets quoted in that currency also look attracti-
ve for global investors. So, one trend feeds the other: a true bull market in stocks will bid up
the currency in which those shares are negotiated. Ratio analysis, made of asset/currency
studies, provides a useful technical tool for spotting true trend changes in these complex
global relationships.

The above chart illustrates the Dow Jones Industrials Average in USD (in black). Concurrently
the the same DJIA expressed in EUR (in blue) is staging a different sort of performance, an
inconsistency that argues against a true bull market.

Phillips Curve
The Phillips curve is a graph describing the relationship between wage changes and price
level changes on the one hand, and the unemployment rate on the other. This relations-
hip is often attached to monetary policy decision-making by several central banks. Its
framework purports that greater demand drives unemployment lower, and as the labor
market tightens, higher aggregate spending pulls prices up and create thereby inflation. It
posits that inflation and unemployment have a stable and inverse relationship.

But modern economy, with its global and technological features, has challenged our un-
derstanding of labor market equilibrium. This was the case during the oil shock and resul-
ting stagflation - rising inflation and unemployment - experienced in the 1970s. This see-
mingly paradoxical outcome ignored cost-push inflation, or inflation-driven by changes on
the supply side (see Part 1.). It was also the case in the early 1980s when the Fed responded

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 to runaway inflation by raising rates so high that the U.S. economy fell into recession.
More recently, Fed officials have been surprised by a deceleration in U.S. inflation despite
a continued decline in unemployment, the opposite of what the Phillips curve relationship
would predict. It looks like rising unemployment was sometimes able to help predict lower
inflation, but falling unemployment didn’t help predict higher inflation. What’s missing in
this model?

In case you haven’t noticed, many of the dedicated contributors at FXStreet.com are critical
with the Fed’s reliance in the Phillips curve, in that the tighter labor market will eventually
push wage growth implying higher inflation. Several causes of the rupture of this broken
relationship have been noted, so that we can still form a conjecture on the evolution of
inflation.

Some analysts mention the increased focus on the deflationary effects of technology,
demographics, and the debt burden as main reasons why the model doesn’t actually help
predict inflation. Others mention the problem is that the tightness of the labor market
is not the only factor determining wage growth: after many years with low interest rates,
employees expect inflation to remain low. In fact, they can live with low wage growth, as real
wage growth may look solid. Inflation is then less likely to reach the target, at least from a
cost-push perspective.

Still others consider the flaws in the model coming from the time when the curve was
created for the first time, in 1958. It has been modified several times since, like in the 1960s
when the Phillips curve was expanded, but the monetary system was still under Bretton
Woods and its fixed exchange rate system. The point is that in fixed exchange rate regime
there is no issue of inflation derived from currency movements, making its basic assump-
tions irrelevant in today’s globalized economy.

Once again, we recognize how difficult it is to de facto measure inflation. There is no yards-
tick by which the purchasing power of money can be effectively measured. We are also
forced to recognize that both money and goods are subject to changes in supply and
demand, hence averaging the prices of goods and services simply makes no logical sen-
se when the issue at hand is money itself which sees its lure changed. As the supply and
demand of goods and services goes down and down, the supply and demand of money also
goes up and down.

Although the original concept has been challenged empirically, we should pay attention to
the Phillips Curve since the Fed has been using this model for decades as a guideline to
set interest rates.

Forward Breakeven Inflation Rate

As you have seen so far, there are many methods of varying complexity that investors and
central banks alike use to estimate inflation levels. One of these refers to the expected or
implied inflation.
While inflation is what affects the purchasing power of the money in the people’s wallet,
expected inflation is what people think their purchasing power is likely to be in the future.
For modern policymakers measuring inflation expectations is a major objective, because
controlling inflation expectations is the first step to control inflation.

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 The logic of this measurement starts with the following assumption: if you could enter into
an agreement today to buy a 5-year bond 5 years from now, that term structure would tell
you something about the expected inflation. Likewise, the interest rate on that future bond
is something you could calculate today from the current 5-year and 10-year yields to matu-
rity. This is known as the “5-year, 5-year forward rate”. Effectively, there is a way to do that:
you would sell a 5-year zero-coupon bond (without periodic interest payments), let’s say,
currently worth $1,000, and simultaneously buy a 10-year zero-coupon bond also worth
$1,000. You wouldn’t have any net cash flows in or out for 5 years, at which point you’d have
to pay back the redemption value on your 5-year bond. After five years, you’d collect the
redemption value on your 10-year bond.

One relatively straightforward method to calculate such a forward rate is to examine the
difference between the yield on a nominal fixed-rate bond, and the real yield on an infla-
tion-linked bond of similar maturity and credit quality, such as a Treasury Inflation Protec-
ted Security, or TIPS. This difference is sometimes described as the forward “inflation com-
pensation” or “break-even inflation” rate, and might be interpreted as the inflation rate
that market participants anticipate to hold in the future. This method has the advantage of
being determined by market prices, so it reflects the views of investors who have money on
the line.

Let’s break it down a little bit for clarification purposes: TIPS are so-called “inflation-in-
dexed government bonds”. A plain-vanilla bond, like a Treasury note in the U.S., is a stream
of payments that is fixed in nominal terms: for example, $1,000 in 10 years, and 6% interest
paid semi-annually ($30 every 6 months). In case inflation goes up, the purchasing power
of that $1,000 goes down, and the bondholder may suffer real losses when collecting the
redemption value of the vanilla bond because of the effects of inflation.
By contrast, an inflation-indexed bond also provides investors with a fixed-rate yield with
interest paid semi-annually but with a key difference: the principal is then adjusted to some
measure of inflation like CPI.

A TIPS bond may have a $1,000 face value and pay a 2% interest rate. However, every 6 mon-
ths, the interest payment is adjusted for inflation. Then, after 10 years, the bondholder gets
back $1,000 multiplied by the ratio between the CPI at the end of the period and the CPI at
the beginning of the period. This way, the bondholder is guaranteed a 2% real return no ma-
tter what the rate of inflation is in the interim. Because the amount of principal an investor
receives on the original investment is adjusted, the coupon rate represents the investor’s
“real return,” or return above inflation.

The difference between the yield on a regular plain-vanilla bond and the yield on an
inflation-indexed bond with the same maturity is the implied inflation expectation. If the
5-year Treasury has a yield of 4% and the TIPS with a same maturity of 5-year has a yield of
2%, then inflation expectations for the next five years are (roughly) 2% per year. Similarly,
using two- or ten-year issues would tell us the expectation for those periods.

The reasoning is: since plain-vanilla bonds carry no inflation protection, leaving investors
fully exposed to the impact of inflation, they demand a premium- a higher interest rate-
, which can be thought of as the amount of “protection” investors require to buy regular
bonds rather than TIPS. This, in turn, tells us what inflation expectations may be. And effec-
tively, an investor has to be paid a higher yield to compensate him for the level of inflation
that he expects.

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 If you didn’t follow that, don’t worry, just remember how to read a forward break-even rate
chart: if investors expect future inflation to be greater than this difference (the break-
even rate), then this would make TIPS outperform regular bonds, and the break-even rate
would increase as investors sold bonds (pushing down the price and the yield up) to buy
TIPS (pushing the price up and the yield down). The opposite effect would occur if inflation
expectations were lower than the breakeven rate, then bonds would be more attractive than
TIPS.

Therefore, in equilibrium, the difference should reflect the market’s consensus for future
inflation, but only roughly. This distortion happens because actually, in addition to expected
inflation, the bond investor bears the risk that inflation may be very different from the level
expected by the market. All things being equal, it is better not to have inflation risk than to
have it. But investors in TIPS, which are adjusted for whatever inflation occurs, do not bear
this risk. So the implied inflation expectation is actually slightly less than the breakeven rate
because the bond yield may include an extra risk premium to compensate for this additio-
nal risk.
Another reason why the breakeven inflation rate is not a perfect estimate of inflation ex-
pectations is that the bond market is more heavily traded and liquid than the TIPS market.
In this case, the yields on TIPS may have an additional premium to compensate for lower
liquidity. This can push its price down (yield up) in an eventual rush to liquidity, which can
be misinterpreted as a signal of expected deflation.
Also some investors believe that official measures of inflation, like the CPI, are not accurate
measures of the true level of inflation (see Part 1), which can make the forward breakeven
inflation rate less reliable.

Nevertheless, it’s worth keeping an eye on this measurement of far-forward inflation espe-
cially in those economies where people believe that monetary mavens are not capable to
keep inflation under control. In contrast, in countries with credible inflation targeting, the
breakeven rate does not react as much to economic developments.

You can use the Treasury and TIPS yield curve rates which are published daily on the U.S.
Treasury Department website.

Bond Yield Spreads

The term “yield spread” refers to the spread between yields on long- and short-term debt
securities, and is a market-based measure that you may see quite frequently mentioned.
Usually, it’s a way to measure bond investors’ feelings about risk. You will also see analysts
looking to the yield spread as a potential source of information about future growth and
inflation at moderate horizons of a few years. The yield spread is also used as a gauge for
near-term monetary policy expectations, which is yet another reason why it’s widely moni-
tored.

In order to understand why the information in the yield curve is considered to be

forward-looking, and therefore containing predictive power for real growth and inflation, it’s
important to know why different maturities (or “time-until-maturity”) have different yields
attached (remember, the yield on a government bond is the annual rate of return, or inte-
rest rate, that would be earned by an investor who holds the bond until it matures).
Consider how investors would behave if they expected one-year interest rates to be higher

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 next year than this year: investors would demand a higher annual return for holding a two-
year bond than for a one-year bond, causing the two-year yield to be higher than the one-
year yield. Wouldn’t you prefer to have funds at your disposal, rather than at the disposal of
a third party? The interest rate is therefore the “price” paid to convince you to lend. As the
maturity term (the time horizon) of the loan increases, lenders demand an increase in the
interest received. In addition, lenders may be concerned about future circumstances, for
instance, higher inflation (or even a potential default), so they demand higher interest rates
on long-term loans than they demand on shorter-term loans to compensate for the increa-
sed time they are bearing the risk.

The yield spread precisely describes this relationship between yields at different maturity
lengths, reflecting the direction of future inflation changes. Thereby, the yield spread also
provides information on the slope of the so-called “yield curve”. The slope of the yield curve
is equally used by financial and policy analysts as an indicator of future real activity and
inflation.

The larger the spread, the steeper the slope of the yield curve will be. A positive slope
reflects investor expectations for the economy to grow in the future and, importantly, for
this growth to be associated with a higher inflation. Remember, higher expected inflation
erodes the value of an investor’s existing bond holdings and creates a need for a risk pre-
mium associated with the uncertainty about the future rate of inflation. For this reason, the
front-end of the curve is normally fairly well “anchored”, while yields at the long-end of the
curve are pushed higher when inflation is expected to make the spread larger and the curve
steeper.
A large spread also predicts that in response to relatively accommodative monetary policy,
real growth will pick up and inflation will increase. The same expectations of higher inflation
can also lead to expectations that the central bank will raise short-term interest rates in the
future.

If widening spreads lead to a positive yield curve, contracting spreads, however, are indicati-
ve of worsening economic conditions in the future, thus resulting in a flattening of the yield
curve, another sign that market expectations for inflation have eased. Long-term maturity
securities are the ones usually affected by inflation expectations. Yields on short-term ma-
turity securities, in turn, are more affected by changes in monetary policy.

Improved credibility of monetary policy, or a response to the relatively tight stance of mo-
netary policy (aimed to slow economic activity and to decrease inflation), may also trans-
late in a suppressed spread, that is, when current short-term yields are high relative to
long-term yields. Long-term yields may react to policy as well, but they rarely rise mirroring
short-term interest rate increases. Generally speaking, in a rising interest rate environment,
professional money managers shift to shorter maturity bonds.

Narrower spreads can even lead to a negatively sloped yield curve indicating not only
lower growth and inflation but also a possible recession. A so-called “inverted yield curve”
means the yield difference between a long-term bond and a shorter-term one is negative.
This is in contrast to what is considered a normal market, where longer-term instruments
should yield higher returns to compensate for time. Inverted yield curves thereby imply that
the market believes inflation will remain low because, even if there is a recession, a low
bond yield will still be offset by low inflation.

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 In the U.S., Treasuries are traditionally seen as a safe haven asset. Under this view, when
long-term yields are rising, that’s usually because investors are selling long-term bonds in
hopes of finding better short-term investment opportunities elsewhere. But when long-term
yields are falling, that means an increase in demand for bonds on the long end of the yield
curve, and that’s an indication of a so-called “flight to quality”. When investors clamor for
safe haven assets in the event of global economic troubles or currency related situations,
long-term rates start to fall, narrowing the spread substantially, so much that the curve
can invert.

The Business Cycle

The idealized business cycle (or hypothetical economic cycle) revolves around a point of
balance known as equilibrium. This equilibrium can be thought of as a period in which the
economy is neither expanding nor contracting. Such periods do not produce volatile price
swings in financial assets, a reason why investors are not concerned with periods of exten-
ded stability. Instead, they capitalize on prices which have been overextended and are due
for a return back to equilibrium.
Knowing that financial markets have a so-called “discounting mechanism” which means that
future expectations are reflected in today’s prices, it follows that the greater profits can
be made when prevailing expectations can be anticipated, and investment decisions are
made just before the point of maximum economic distortion or disequilibrium.

The chronological sequence of peaks and troughs in the various asset classes (bonds, stoc-
ks and commodities) can be used as a framework for identifying in which phase of the cycle
the market is in, so that gyrations in the different assets can be anticipated.
These gyrations of the different asset classes in the business cycle reflect distinct changes
in the rate of growth in economic activity, as well as changes in the employment backdrop
and monetary policy. Unforeseen macroeconomic events or shocks can sometimes disrupt
the business cycle, but nevertheless its framework provides a relatively reliable guide to
recognizing the different phases of an economic cycle and with its inflationary and defla-
tionary forces in play. During the early stages of the business cycle, for instance, deflatio-
nary forces predominate, whereas inflationary pressures come to the fore as the recovery
matures in later stages.

The idealized picture usually starts with bond prices bottoming in an early recessionary
phase (below the equilibrium line). Midway during a recession, commodity and stocks are
still falling together, but at some point, falling bond yields are positive for equity prices.

Once the economic recovery has been underway, commodity prices bottom and also start to
rally, and all asset classes are rallying together. Gradually, the economic and financial slack,
which developed as a result of the recession, is substantially absorbed, and the demand for
credit puts upward pressure on interest rates. As a consequence, the bond market peaks
out and begins its bear phase. When bonds peak, usually in the late upswing phase (above
equilibrium), it’s a signal that a period of healthy non-inflationary growth has turned into
an unhealthy period of inflationary growth.

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 Later during the economic expansion, other signs of inflation begin to crop in, usually in
the form of high commodity prices, and the rally in the three markets leads policymakers to
raise interest rates in the front-end of the curve to combat inflation. Initially, the resulting
inverted yield hurts equities which top out. At the same time, a tight economy (rising yields)
is favorable for industrial commodity prices which are sensitive to business conditions. Sin-
ce the stock market discounts trends in corporate profits, investors sense that the economy
is overheated, and that the potential for an improvement in profits is very low, so people
start to switch the money to fixed income and take profits in the stock market, and equities
enter into a bear market.
Inflation pressures are the strongest near the end of the expansion. Because inflation is a
lagger, it will persist until the rise in interest rates takes its toll on the economy. The stock
market discounts the development and tops out. Now that inflation has been brought under
control, commodity prices also begin to slip.

In the latest phase, when the economy starts to slow, the demand for commodities reduces
and the cycle slips into a recession. At this point, all asset classes are declining together
until the credit markets bottom out first and the cycle starts once again.

Now let’s take equities in isolation, analyze the different sectors of the stock market in their
own rotation cycle, and categorize them according to their sensitivity to deflationary or
inflationary forces. The stock market peaks and bottoms in stages, which means that not all
issues change their trends simultaneously. This also implies that different stocks will dis-
play leading or lagging characteristics, which can be used as a gauge of inflationary and
deflationary forces.

Cyclical stocks, also named consumer discretionary (automobile, steel, real estate, hou-
sehold durable goods) tend to follow the business cycle and are thereby considered infla-
tion-sensitive. These are consumer-linked industries that typically benefit from increased
borrowing, including diversified financials. Financials, albeit being liquidity-driven, sees
money flowing to them because interest rates are starting to rise. Also speculative informa-
tion technology and transportation stocks bottom first in the early stage of the cycle becau-
se they depend on capital spending and consumer demand. These groups, although they
typically benefit most from a backdrop of still low interest rates, are considered leading
indicators of early inflationary pressures because they are boosted by shifts from reces-
sion to recovery.
While it is important to note outperformance, it is also helpful to recognize sectors with
consistent underperformance. In this sense, basic materials and energy stocks are conside-
red to be laggards at this stage of the cycle because interest rates are still low and so are
commodities. Yield spreads are now widening and the yield curve steep, but inflationary
pressures tend to be still low during a recovery from recession.
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 In the late expansion, industrial stocks which are considered economically sensitive sec-
tors (aerospace and defense, industrial machinery, tools, lumber production, construction,
cement and metal fabrication) take the lead. They are closely tied to economic trends and
higher demand for products leading companies to expand their production capacity. So-
mehow higher inflation also favors other so-called “inflation stocks” like basic material
stocks (aluminum, copper, and mining shares), and energy. Near the end of an economic
expansion, energy stocks usually take over market leadership primarily due to rising energy
prices (oil) and the resulting build up of inflation pressures preluding a peak in the cycle.
The energy sector has seen the most convincing patterns of outperformance and are the
ones which peak last. This usually signals the end of an economic expansion and the begin-
ning of a contraction.
At this stage consumer staples and services are underperforming because the economy is
still growing and there is no perceived need for defensive stocks yet. Investors drop these
groups because they still expect more future inflation. Utilities and financials are also not in
vogue because interest rates are probably still rising.

One way to tell when the economy has crossed the threshold from late expansion to early
contraction is when leadership switches from energy stocks to more defensive stock groups
like healthcare and consumer staples. Drug stocks are also defensive in nature and show
better relative strength when investors begin to glimpse signs of an economic slowdown.
Their leadership is a sign of lack of confidence in the stock market and anticipates defla-
tionary forces in the economy. This is also the stage when the yield spreads can get nega-
tive and the curve inverted.
On the opposite side, industrials, basic materials, information technology, and cyclical stoc-
ks (which are inflation-sensitive) tend to suffer the most during this phase, as inflationary
pressures crimp profit margins.

In the late contraction or recession phase in the business cycle, those stock sectors that are
defensively oriented move to the front of the performance line. Telecommunication services
and healthcare which consumers are less likely to cut back on during a recession (auto-re-
lated, entertainment, home-builders, home appliances, restaurants, and retailers, i.e. pro-
ducts with inelastic demand) are now leading. Note that inelastic items constitute aprox.
80% of the CPI, the remaining 20% being commodities other than food and energy.
Service companies in general, which don’t rely on large amounts of debt to finance their
business are also preferred. Interest rate-sensitive stocks like utilities usually bottom first
owing to topping interest rates. Utilities are big borrowers and their profits are enhanced by
lower interest costs. The business model of telecommunication firms is reminiscent of utili-
ties firms, which have stable, predictable cash flows and typically carry high debt levels
While deflation favors these interest rate-sensitive stock groups, energy and basic industry
groups, which are related to interest rate-sensitive commodities, are now in disadvantage.

The business cycle approach is best deployed with the use of relative strength studies
(ratios) which are an ideal technical tool to visualize shifts in phases allowing investors to
adjust their exposure accordingly. For Forex traders, it can be used to complement the other
approaches we have been studying, and so anticipate changes in monetary policies.

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 Interesting Reads

 Predict Inflation With The Producer Price Index by Arthur Pinkasovitch

 Making sense of international interest rate movements by Elisabeth Andreew
 Fed Study Shows Phillips Curve Is Useless: Admitting the Obvious, by Mike “Mish” Shedlock’s
 Do We Need to Wait for a Yield Curve Inversion to Predict a Recession? No. by Wells Fargo Research Team
 USD/JPY, Fed Funds, Yields: Levels, Ranges, Targets, by bian Twomey
 Forecasting, Causality, the Black Swan, and your Edge, by Jack Crooks
 UK economic focus: What inflation, wage data and retail sales mean for stocks, by Kathleen Brooks
 The Breakdown of an Economic Indicator: CPI, by Power Trading Radio
 Inflation vs. Deflation, by Power Trading Radio
 Predict Inflation With The Producer Price Index, by Arthur Pinkasovitch
 411 on Commodities, Inflation, and Monetary Policy, by FXStreet Expert Contributor
 What the Heck is CPI and Why Should I Care?, FXStreet Expert Contributor
 What You Need to Know about Commodities and Inflation, BabyPips.com FX-Men Team
 5 Forex News Events You Need To Know, by Littlefish FX Analysts
 Journalists vs central bankers: Who’s got it right?, by Barbara Rockefeller
 FOMC Grapples with Inflation Drivers, by Wells Fargo Research Team
 Real Output and Unit Labor Costs as Predictors of Inflation, by Ya.sh P. Meha

FXStreet 2017 Trade the News Series

34
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FXStreet 2017 Trade the News Series