How to trade inflation
hot inflation
Inflation, the rise in the price of goods and services, is common. Inflation, as measured by the Consumer Price Index (CPI), rose to a record high of 9.1% yoy in Europe, hit double digits in the UK and is cooling much more slowly than expected in the US, where it is currently at 8, 3% YoY.
Central banks around the world are raising interest rates at the fastest pace in decades to tame rising prices, but inflation is showing few signs of slowing down quickly.
Higher interest rates are holding back growth, but central banks have made it clear that high inflation poses the greater risk. Policymakers are poised to raise interest rates aggressively, even if it means pushing the economy into recession.
The prospect of aggressive rate hikes and rising recession fears have fueled a solid risk aversion in equity markets. US indices posted their worst weekly performance last week since early June.
What can you trade in today’s highly inflationary environment?
Broadly speaking, certain assets tend to outperform during periods of high inflation, such as gold, commonly referred to as an inflation hedge, commodities, real estate and blue chip stocks.
However, the fact that gold is trading at a 2.5-year low and that oil is down 30% from its June highs suggests these are not good inflation plays this time around.
Instead, the USD stands out as a strong inflation play and somewhat explains gold’s weakness. Not only is the USD benefiting from the hawkish Federal Reserve, it is also gaining ground on safe-haven inflows. And let’s face it, while Europe and the UK are in much worse economic shape than the US, investors are likely to continue buying the dollar simply because there are a few other reasonable alternatives.
The USD could continue to perform well against the Japanese Yen as central bank divergence remains strong and potentially against other currencies where central banks are trying to slow their pace of tightening such as the AUD and CAD.
The USD could lose its luster if US inflation shows clearer signs that it is cooling and if the Fed shows signs that it is ready to take its foot off the accelerator.
This week both the Fed and BoJ meet to discuss monetary policy. The results could further highlight central bank divergence, which means USD/JPY could continue higher.
Where Next for USD/JPY?
USD/JPY has been trending firmly higher since the start of the second quarter, making a series of higher highs and higher lows. The pair is trading above its 20 and 50 moving averages and is being led up by rising trendline resistance. Recent consolidation around 143.50 has caused the RSI to come back out of overbought territory. Buyers will look for a move above 145.00 the 22 year high hit last week to extend the uptrend towards 146.55 rising trendline resistance. To the upside, support is seen at 141.20, the 20-dma and last week’s low. A break below will open the door to 140.00 round number and 139.40 July high.
Other inflation games
Highly leveraged companies also perform poorly in a high-inflation environment. This is reflected in the underperformance of the tech-heavy Nasdaq. The Nasdaq has underperformed its Wall Street peers as inflation remains persistently high. Shorting the Nasdaq could be another inflationary game if the Fed ramps up its hawkish rhetoric. Meanwhile, as inflation eases, the Nasdaq could be a strong recovery trade.
For individual stocks, look for companies that are able to pass higher costs on to the consumer. Consumer staples are often a good place to start.
Crashing into recession?
One of the biggest market risks is that high inflation and rising interest rates could trigger a recession. High interest rates make borrowing more difficult, causing existing services to become even more expansive and stifling economic growth.
In a recession, safe-havens like the USD could remain firm, in addition to defensive stocks with strong balance sheets like utilities, energy and consumer staples.