Tim Worstall writes for Capital.com on inflation trading:
In these troubled times, when we face the first concerted inflationary pressures in a generation, it's necessary to walk back to earlier wisdom and realise what inflation really is. It is, no more and no less, a change in the value of money. So, when there's inflation that's what will happen, money will change in value. The effect of this is that FX rates will change by relative inflation rates – the US Dollar / Swiss Franc rate (USD / CHF), or the Euro to Turkish Lira (EUR / TRY) one, will over time be defined by the relative inflation rates in the respective countries.
Inflation rates will affect trading in forex pairs like USD/CHF
For us, trading in a time of inflation, that's what we need to grasp. It's money itself that's changing. As to our distinction between investing and trading we should adopt that old saw from the London stock market – short term is now, long term is after lunch. Short term is trading, long term is investing. The distinction matters because the effects of inflation change over timescales.
Inflation is not prices changing – wheat up, apples down. That's relative prices changes. Inflation is the general price level changing – or, to put it the correct way around, the value of money as compared to real goods and services changing. Inflation, by definition, is a whole system effect, not something that affects the odd corner here and there. We also have that old banking saw to add to the stock exchange one – banks will repeat the same mistake only when all those who remember the last time have just retired. Which is just about where we are with inflation. As a general, global, phenomenon the last great inflation was in the 1970s. 50 years later the greybeards who recall that are shuffling off this mortal coil and we've got to try and recall what they learned back then.
The secret at the heart of this is to grasp that central point – inflation is a change in the value of money.
Inflation is higher in the Turkish Lira than in the Euro - for the moment (EUR / TRY)
The most obvious effect here is in exchange rates. Different forms of money can change value at different rates, inflation in Turkish Lira is higher – for the moment at least – than that in the Euro. Wheat hasn't changed price or value (well, OK, war, Ukraine, maybe it has but we're looking just at the inflation aspect here, we can have relative and general price changes at the same time) but one bushel will over time be worth different amounts of TRY and EUR. Therefore, so too with EUR and TRY change in their relative values - FX rates change. Over the long term it is an economic standard that it is relative inflation rates that determine FX rates. That long term can be a long time mind. CHF:USD was 4.3:1 in 1950, it's about 1:1 today. Turns out Swiss bankers take more care of the value of money than American politicians, funny that.
This certainty does not work over shorter timescales though. The last 5 years has seen that same CHF:USD wander around between 1.02 to 0.88 and back. No clear link with relative inflation rates over that period, even if we'd insist it will assert itself over 80 years. Over very short timescales, by the pip this morning, FX rates are closer to Brownian motion, even quantum. Timescale matters but inflation and the price of money will out eventually. The inflation trading trick is to be there when reality overcomes the randomness.
If money changes its value this also changes the relative values of different types of equities. Think of tech companies, spending vast sums now in order to corner a market in two or 5 years' time. The profits will be immense – well, we hope they will be. So, consider the tech stocks which are the basis of the famous ARK Innovation Exchange Traded Fund (ARKK), just as an example and no more. Think also of profitable companies that pay heavy dividends right now – 'baccy, booze, the type of firms which underpin the Vanguard High Dividend fund (VYM). Inflation isn't going to change the glory of all conquering tech. Nor is it likely to change consumption of fast moving consumer goods and the like. But if the value of money changes then the two business models change in relative value. High 8% inflation means those dividends this year are worth more, and those all concquering monopoly profits in 5 years are worth less. This is the kind of inflation trading insight that can tell us if it's time to go long, or short, on certain types of stocks.
The ARK Innovation ETF (ARKK) is based on innovative tech stocks
Inflation means – just as does the closely related issue of rising interest rates – that sooner is worth more than later. Even the same amounts of money, the same successes, are worth different amounts dependent upon the inflation rate. We face the same time scale problem as we do with FX though. While this is absolutely and inescapably true the time period over which it takes effects is variable. A straight trade based upon the insight and that alone could be undermined by other market movements. Even though that insight is inescapably true.
What is your sentiment on CHF/TRY?
There's another way of making much the same point. Inflation is a change in the value of money over time. Therefore when money becomes more important when inflation is higher – just as is true of higher interest rates. Things will change in relative value as inflation changes based upon when those things throw off cash that can be collected by investors – or traders, of course.
This doesn't mean that tech is worth less, nor that future monopolies are worth less than dividends now. It's that the money picked up from those different things is changing value because of the time that it is picked up. Inflation is a change in the value of money, that's the real and true definition of it. So, inflation changes the value of money, doesn't it?
Tim Worstall is a writer on business and economics and a senior fellow of the Adam Smith Institute. He has written for CapX, the New York Times, Forbes, the Times and the Wall Street Journal. He has worked as a trader in rare metals such as scandium. He is the author of The No Breakfast Fallacy: Why the Club of Rome was wrong about us running out of minerals and metals.