Inflation Is Back and Tradable
The news confirmed what every consumer knows. Inflation is creeping back into the world. The latest data from the Bureau of Labor Statistics confirmed that prices are rising, and analysts were surprised by how much more expensive a variety of items are.
Bloomberg summarized the story, “U.S. consumer prices rose by more than projected in January as apparel costs jumped the most in nearly three decades. The report sent Treasuries and stocks tumbling, as it added to concerns about an inflation pickup that have roiled financial markets this month.”
The consumer price index, or CPI, is a measure of inflation that shows how much more the items a typical family buys are. CPI in January are up 0.5% compared to December. Economists surveyed by Bloomberg prior to the report’s release had been expecting a 0.3% increase.
Excluding the more volatile prices of food and energy, a measure that economists call core inflation, prices still rose faster than expected. Core inflation was up 0.3%, more than the consensus estimate of 0.2%.
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Compared to the same month last year, core inflation was up 1.8%, a little more than the 1.7% estimate. The chart below shows that inflation accelerated sharply in the last month.
“Some of laws of normal economic nature seem to be reasserting themselves,” Nathan Sheets, chief economist for PGIM Fixed Income and a former Fed and Treasury official, told an interviewer on Bloomberg Television.
While Sheets said he wouldn’t raise his outlook for the path of inflation, the report “gives me increased confidence that we are in a place where inflation is likely to be gradually rising more or less in line with the Federal Reserve’s forecast and consistent with an economy where we are seeing diminished slack, strengthening labor markets, solid growth.”
Several factors contributed to the gain. The 1.7% month over month increase in apparel prices, which account for about 3% of the CPI, was the largest increase in that category since 1990. Women’s apparel costs jumped a record 3.4%.
Other items contributing to the gain in CPI included rents and owners’ equivalent rent, which both rose 0.3% from December; medical care, up 0.4%; and motor vehicle insurance, which advanced 1.3 percent, the most since 2001. The increase in car insurance is being blamed in part on the increased use of medical marijuana which has led to an increase in the number of accidents.
The increase in the core CPI brought the three-month annualized gain in that measure to 2.9%, the fastest since 2011, according to data compiled by Bloomberg. Core inflation is widely followed by the Federal Reserve and analysts expect the latest report to reinforce the Fed’s plans to raise interest rates.
Trading Higher inflation
When inflation rises, interest rates should also move up. This is because interest rates are intended to reward investors for lending money. The interest rate should include a component that pays the investor for use of their money and a component to compensate the investor for inflation.
When interest rates rise, bond prices fall. This is because new bonds will be issued at higher interest rates. To entice traders to buy older bonds which carry a lower payment due to the lower interest rate, the older bond will need to fall in price. That price decline raises the rate that buyers receive.
This relationship is shown in the next chart. iShares 20+ Year Treasury Bond ETF (Nasdaq: TLT) is an ETF that holds Treasuries that mature in 20 years or more, on average. The 10-year Treasury note yield is shown for comparison. Notice the two lines move in opposite directions.
That means traders looking to benefit from higher inflation could consider bearish strategies on bond ETFs. An ETF is an exchange traded fund that owns a number of individual bonds. Bearish strategies benefit from a decline in prices.
A trading strategies to Benefit From Potential Weakness
The prospects of a short term rebound in TLT seem to be remote. Traders should consider using an best option trading strategy known as a bear put spread to benefit from the expected downward price move.
This strategy can be profitable when a trader is looking for a steady or declining stock price during the term of the options. The risks and potential rewards of this strategy are illustrated in the payoff diagram shown below.
Source: The Options Industry Council
A bear put spread consists of buying one put and selling another put at a lower exercise price to offset part of the initial cost of the trade. This trading strategy generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally.
The Trade Specifics for TLT
The bearish outlook for TLT, at least for the purposes of this trade, is a short term opinion. To benefit from this outlook, traders can buy put options.
A put option gives the trader the right, but not the obligation, to sell shares at a specified price until the option expire. While buying a put is possible, it can also be expensive. The risk of loss when buying an option is equal to 100% of the amount paid for the option.
To limit the risks, a second put can be sold. This will generate income that can offset the purchase price, potentially allowing a trader to buy a put with a higher exercise price. That increases the probability of success for the trade.
Specifically, the March 2 $118 put can be bought for about $1.25 and the March 2 $117 put can be sold for about $0.75. This trade will cost about $0.50 to enter, or $50 since each contract covers 100 shares, ignoring the cost of commissions which should be small when using a deep discount broker.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $50. This loss would be experienced if TLT is above $118 when the options expire. In that case, both options would expire worthless.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in TLT, the maximum gain is $0.50 ($118 – $117 = $1.00; $1.00 – $0.50 = $0.50). This represents $50 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $50 to open this trade.
That is a potential gain of about 100% of the amount risked in the trade. This trade delivers the maximum gain if TLT closes below $117 on March 2 when the options expire. There is a relatively low probability of that according to the options pricing models. That indicates the gain is likely to be less than the maximum possible gain.
Put spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $50 for this trade in TLT.