Summary of My Post-CPI Tweets

December 17, 2014 Leave a comment

Below is a summary of my post-CPI tweets. You can follow me @inflation_guy :

  • 1y inflation swaps and gasoline futures imply a 1-year core inflation rate of 0.83%. Wonder how much of that we will get today.
  • Very weak CPI on first blush: headline -0.3%, near expectations, but core 0.07%, pushing y/y core down to 1.71% from 1.81%.
  • Ignore the “BIGGEST DROP SINCE DECEMBER 2008″ headlines. That’s only headline CPI, which doesn’t matter. Core still +1.7% and median ~2.3%
  • Amazing how core simply refuses to converge with median. Whopping fall in used cars and trucks and apparel – which is dollar related.
  • Core services +2.5%, unch; core goods -0.5%, lowest since 2008. But this time, we’re in a recovery.
  • Medical Care Commodities, which had been what was dragging down core, back up to 3.1% y/y. So we’re taking turns keeping core below median.
  • Core ex-housing declines to +0.800%, a new low.
  • That’s a new post-2004 low on core ex-shelter.
  • Accel major groups: Food, Med Care (22.5%) Decel: Housing, Apparel, Transp, Recreation, Educ/Comm, Other (77.5%). BUT…
  • But in housing, Primary Rents 3.482% from 3.343%, big jump. Owners’ Equiv to 2.707% from 2.723%, but will follow primaries.
  • Less-persistent stuff in housing responsible for decline: Lodging away from home, Household insurance, household energy, furnishings.
  • Real story today is probably Apparel, which is clearly a dollar story. Y/y goes to -0.4% from +0.6%. Small weight, but outlier.
  • Similarly used cars and trucks, -3.1% from -1.7% y/y (new vehicles was unch at 0.6% y/y).
  • On the other hand, every part of Medical Care increased. That drag on core is over.
  • Curious is that airfares dropped: -3.9% from -2.8%. SHOULD happen due to energy price declines, but in my own shopping I haven’t seen it.
  • I don’t see persistence in the drags on core CPI. There’s a rotation in tail-event drags, which is why median is still well above 2%.
  • We continue to focus on median as a better and more stable measure of inflation.
  • Back of the envelope calc for median CPI is +0.23% m/m, increasing y/y to 2.34%. Let’s see how close I get. Number around noon. [Ed. note: figure actually came in around 0.15%, 2.25% y/y. Not sure where I am going wrong methodologically but the general point remains: Median continues to run hotter than core, and around 2.3%.]

Quite a few tweets this morning! The number was clearly roughly in-line on a headline basis: gasoline prices have dropped sharply, in line with crude oil prices. How much? Motor Fuel dropped from -5.0% y/y to -10.5% y/y. The monthly decline was over 6%, and so a decline in headline inflation on a month/month basis was all but certain. Had core inflation been as low now as it was in 2010, we would have seen a year-on-year headline price decline (as it is, headline CPI is +1.3% y/y).

However, core inflation is not as low as it was in 2010. It continues to surprise us by failing to converge upwards to median CPI. Last year, the reason core CPI was inordinately low compared to the better measure of central tendency (median) was that Medical Care inflation was weak thanks to the effects of the sequester. But that effect is now gone. Medical Care inflation is back to 2.5% on a year-on-year basis; this month’s print was the highest in over a year. The chart below (Source: Bloomberg) shows the y/y change in Medical Care Commodities (e.g. pharmaceuticals) – back to normal.

medcarecommod

The 2013 dip is very clear there, and the return to form is what we expected, and the reason we expected core inflation to return to median CPI. But it hasn’t yet; indeed, core is below median by around 0.6%, the biggest spread since 2009. Now, it may be that core is simply going to stay below median for an extended period of time as one category after another takes turns dragging core lower. From 1994-2009, core was almost always lower than median. That was a period of disinflationary tendencies, and the fact that different categories kept trading off to drag core CPI lower was one sign of these tendencies.

I do not think we are in the same circumstances today. Although private debt levels remain very high (weren’t we supposed to have had deleveraging over the past six years? Hasn’t happened!), public debt levels have risen dramatically and the latter tends to be associated with inflation, not deflation. Money supply, especially here in the US, has also been growing at a pace that is unsustainable in the long run and it seems unlikely that the Fed can really restrain it until they drain all of the excess reserves from the system. These are inflationary tendencies. The risk, though, is that the feeble money growth in Europe could suck much of this liquidity away and move global inflation lower. This is an especially acute risk if Japan’s monetary authorities lose their nerve or if other central banks rein in money growth. In such a case, global inflation would decline so that, while US inflation rises relatively, it falls absolutely. I don’t consider this a major risk, but it is a risk which is growing in significance.

Of course, all of that and more is priced into inflation-linked bond and derivative markets, as well as in commodities. Only a massive and inexplicable plunge in core inflation could render the market-based forecasts correct – and there is no sign of that. Housing inflation continues to rise, and the soonest we can see that peaking is late next year. Getting core inflation to decline appreciably while housing inflation is 2.6% and rising is very unlikely! Accordingly, we see inflation-linked assets as extremely cheap currently.

A Busy Quarter – But Why?

December 11, 2014 2 comments

Serendipity often plays a role when I am considering a blog post. In this case, I wasn’t even planning a post but was updating old spreadsheets for current data to see how things have developed. In the past, I have documented how NYSE Composite volume has been falling fairly steadily since at least 2006. It is difficult to tell whether this is important or not, since some of this is due to the fact that more trading occurs off of the NYSE these days. Still, there was a significant drop-off in 2010 and 2011 and 2012 which seemed more than coincidental (2012 total volume was about half of the volume traded in 2008, in terms of shares, and probably lower than that in terms of volume).

In 2013, volume fell a small amount further. But I was interested to see that in 2014, NYSE volumes look to be just about exactly the same as they were in 2013 – for the first time in a long while, volumes have not declined.

But what was even more interesting to me was the pattern of volume over the course of the year. I put together the following chart to compare the rolling-20-trading-day volume for last year and this year.

2014volYou can easily see the increase in volume in the “taper tantrum” of May/June 2013, and the summer lull in both years. You can also see how volumes recovered in September and then fade into year end. But what stands out is how the summer was significantly quieter than in 2013, but since the end of September volumes have been quite high.

For fun, I decided to look at the data for 2006-2013 in its entirety (that’s all the data that I have). For each day, I computed the share of the year’s total volume and then averaged that across all eight years. By taking percentage of the total, I removed any tendency to overweight 2006’s much higher volume compared to 2013…it was the pattern I was looking for. Then, I computed a rolling-20-day sum. The line in blue below is the percentage of the year’s volume represented by any 20-day window ending on the day in question (since there are roughly 12.5 such windows in a year, we would expect 8% = 1/12.5 in a steady line if there was no seasonality). I then did the same thing for 2014 (but adjusting for the fact that we don’t know the year’s total volume yet).

seasonalvolSeveral things jump out as interesting. First is that there seems to be a general pattern that volumes generally decline after June. The summer volume swoon is mainly in August, there is a flurry of trading in September and early October, and then volume ebbs from there. Second, and more interesting at the moment, is that volumes in 2014 haven’t picked up just compared to 2013, but are quite a bit higher than the norm, and even quite a bit higher than for most of the rest of this year! By contrast, in 2013 the pattern was fairly normal except for the spike around the taper tantrum.

What causes me to scratch my head is the implication. There is no clear cause I can think of that would trigger a rise in equity trading volumes since mid-September. The end of the Fed’s taper was becoming clear, but I don’t know why that would trigger higher equity volumes. There haven’t been any unusual geopolitical events (at least, no more unusual than in any other year).

I am reluctant to declare this as yet another sign of a frothy and overbought equity market, with swelling participation at the highs. But I am open to the possibility.

Categories: Stock Market Tags: ,

Growth-Sapping Effect of the Minimum Wage

December 10, 2014 1 comment

I just saw this interesting article in Econbrowser called “New estimates of the effects of the minimum wage.” It is both good news, and bad news.

It is good news because it clarifies a debate about the effect of the minimum wage which has been raging for a long time, but without much actual data. This article summarizes a clever approach by a couple of academic economists to examine the actual effects of increasing the minimum wage. The research produces solid numbers and confirms some theories about the effects of the minimum wage.

The bad news is that the effect of the minimum wage is just what theory says it should be, but liberal politicians have insisted isn’t true in practice. And that’s a net negative effect on overall welfare, albeit divided between winners and losers. However, even that ought to be good news, because this analysis also means that we can reverse the policy and reap immediate gains in consumer welfare.

First, the theory: microeconomics tells us that an increase in the minimum wage, if it is above the equilibrium wage for some types of labor, should decrease employment while increasing the wages of those who actually retain their jobs. (The usual argument for increasing the minimum wage is that the people who earn minimum wage aren’t making enough to live on, and supporters tend to forget that if people lose their jobs because the minimum wage is raised, then those people are making even less.) We often say things are “Econ 101,” but this really is Econ 101 in the sense that it is taught in every introductory economics class. There is no excuse not to know this:

sdoflaborIn the chart above, the supply of labor is S and the demand for labor is D. In the absence of a floor (minimum wage), the clearing wage and quantity of jobs is at the intersection; at a minimum wage of a, however, there is a shortage of jobs equal to c-b. If the minimum wage is raised to a’, then the shortage of jobs increases to c’-b’. The question for society is whether the increase in joblessness is an acceptable cost to accept, in order to increase the minimum wage from a to a’. (Of course, the political calculation might also include the fact that people who become unemployed will be supported by the welfare state, and potentially vote to preserve and expand those public institutions that constitute it).

The problem for those who argue against the minimum wage, or for it being increased, is that they can point out this economic truism until they are blue in the face, while the other side simply says “nuh-uh” and denies it is true with the same fervor that they insist that Obamacare has actually lowered premiums and deductibles. The façade only cracks, maybe, when actual data is presented that shows the argument to be bankrupt.

This academic study does that cleverly, by examining changes in employment and wages in states where the federal minimum wage was binding (because the state minimum wage was lower, or non-existent) and states where it was not binding (because the state minimum wage was higher, so the federal minimum wage didn’t matter). Their conclusion:

“Over the late 2000s, the average effective minimum wage rose by 30 percent across the United States. We estimate that these minimum wage increases reduced the national employment-to-population ratio by 0.7 percentage point.”

That’s the sterile conclusion. Now let’s count the cost. Between July 2007 and December 2009, the national employment-to-population ratio (which is similar to, but not the same as, the labor force participation rate) declined from 62.7% to 58.3%; it has since risen to 59.2%. As the chart below (source: Bloomberg) shows, the labor force participation rate (in yellow) shows a more gradual decline but no recovery – as has been well-documented.

labor

Now, some numbers. In November, the Civilian noninstitutional population (the denominator for the employment-to-population rate) was reported by the Bureau of Labor Statistics (BLS) to be 248,844,000. That means that if the authors are correct, the minimum wage has boosted the wages of unemployed workers at the bottom of the scale at the cost of about 1.74 million jobs (0.007 * 248,844,000).

Imagine what having another 1.74 million workers would do for GDP? Do you think it could make a difference for one of the worst recoveries on record?

It probably isn’t fair to assume that all of those 1.74 million workers is currently “unemployed” by the BLS definition. Many of them are likely not looking for work, in which case they would not be counted as unemployed. It is interesting to note, although surely spurious, that the series “Not in Labor Force, Want a Job Now” is about 1.7 million higher than would be expected given the unemployment rate (see chart, source BLS).

wannajobAlternatively, we could consider what it would mean to the Unemployment Rate if those 1.74 million workers were employed. This means they would also be in the Civilian Labor Force, so the participation rate (see above) would be 63.5% rather than 62.8%. If instead of coming from the “Not in Labor Force, Want a Job Now” group they came from the “Unemployed” group, the Unemployment Rate would be 4.7% instead of 5.8%. (Personally, I think that most of them are probably in the former category, as the Unemployment Rate has declined at approximately the rate we would expect from past recoveries, despite tepid GDP growth.) That is not inconsistent, of course, if GDP growth is lower because the labor force is simply smaller than it should be – and that is exactly the implication of this bit of research.

Again, the good news is that we can help the country and the downtrodden “structurally” unemployed with the same simple policy: reverse all increases in the Minimum Wage that have happened since 2007.

Summary of My Post-CPI Tweets

November 20, 2014 Leave a comment

Below is a summary of my post-CPI tweets. You can follow me @inflation_guy.

  • CPI +0.0%, +0.2% on core. Above expectations.
  • Core 0.203% before the rounding to 1 decimal place. So this didn’t “round up” to 0.2%. Y/y core at 1.82%, versus 1.7% expectations.
  • Today’s winners include Treasury, who is auctioning a mess of TIPS later.
  • Today’s losers include everyone shorting infl expectations last few months. Keep in mind median CPI > 2.2% so this is not THAT shocking.
  • Core services +2.5%, core goods -0.2%. Both higher (y/y basis) than last month.
  • Fed will be considered a “winner” here since y/y core moves back toward tgt. But in fact losers b/c median already near tgt & rising.
  • Accel major groups: Housing, Apparel, Medical, Recreation, Other. Decel: Transp, Educ/Communication. Unch: Food/Bev.
  • ex motor fuel, Transportation went from 0.6% y/y to 0.7% y/y.
  • Housing: primary rents 3.34% from 3.29%. OER 2.72% from 2.71%. Lodging away from home was big mover at 8.4% from 5.0% (but small weight).
  • Within medical care, medicinal drugs decelerated from 3.08% to 2.77%; but hospital & related svcs rose to 3.91% from 3.47%.
  • Core CPI ex-housing still rose, from 0.88% (a ten-year low) to 0.95%.
  • Primary rents to us look like they should still be accelerating, and are behind pace a bit.
  • Really, nothing soothing at all about this CPI print, unless you were hoping to get inflation “back to target.”
  • Pretty feeble response in inflation markets to upside CPI surprise, but that’s likely because of the looming auction.

After several months of below-trend and below-expectations prints in core inflation, core inflation got back on track today. I must admit that I was beginning to get a big concerned given the multiple months of downside surprise (especially in September, when August’s core inflation figure printed 0.0%), but the solidity of Median CPI has always suggested that we should be getting close to 0.2% prints every month and so a catch-up was due.

It is also possible that median inflation could converge downward to core inflation, but quantitatively we would only expect that if the reasons for core inflation’s decline were that categories which tend to lead were heading lower. In this case, that wasn’t what was happening: most of what was happening to core inflation was self-inflicted, caused by sequester effects that pushed down medical care. So it was always more likely that core inflation would begin to converge higher than the other way around.

Some Fed speakers have recently been voicing concern about the possibility of an unwelcome decline in inflation from these levels. I am flummoxed about those remarks – surely, Federal Reserve economists are aware of median inflation and understand that there is absolutely no evidence that prices broadly are increasing more slowly than they were last year. No evidence whatsoever. But perhaps I should not malign Fed economists when the speakers may have other agendas – for example, the desire to keep interest rates as low as possible lest asset markets correct and cause a messy situation, and therefore to find reasons to ignore any signs that inflation is already at or near their target with upwards momentum.

Our forecast for median inflation has been slowly declining since the beginning of the year, when we expected something from 2.8%-3.4%. As of September, our forecast was 2.5%-2.8%. Median CPI today rose 0.21%, pushing the y/y figure to 2.29%. That’s the highest level since the crisis, just beating out the high from earlier this year and probably signaling a further increase. Our September forecast will not be far wrong.

coremed

Dollar Rally Does Not Demand Deflation – Duh

November 6, 2014 2 comments

There are many funny stories out about disinflation these days. The meme has gotten amazing momentum, even more than it usually does at this time of year (see my post last month, “Seasonal Allergies“).  One of the most amusing has been the idea that the decision by the Bank of Japan to greatly increase its quantitative easing would be disinflationary in the U.S., because the yen would decline so sharply against the dollar, and dollar strength is generally assumed to be disinflationary.

The misunderstanding of the dollar effect is amazing, considering how easy it is to disprove. Sure, I understand the alarm at the dollar’s recent robust strength. Of course, such a large and rapid move must be disinflationary, right? Because who could forget the inflationary spiral of 2002-2008 in this country, when the value of the dollar fell 25%?

ustrbroa

For the record, when the dollar hit its high in February 2002, core inflation was at 2.6%. It declined to 1.1% in 2003, before rebounding to 2.9% in 2006 and was at 2.3% in April 2008, when the dollar reached its pre-crisis low. That is, the dollar’s protracted and large decline caused essentially no meaningful change in core inflation. Indeed, without the housing bubble, core inflation would have declined markedly over this period.

Now, headline inflation rose during that period, because energy prices rose. This may or may not be the result of the dollar, or the causality may run at least partly the other way (because the dollar was cheaper, and oil is priced in dollars, oil got comparatively cheaper in foreign currencies, leading to greater demand). But what is very clear is that the underlying rate of inflation was not impacted by the dollar.

The bifurcation of inflation into core inflation and energy inflation (or food and energy inflation, if you like, but most of the volatility comes from energy inflation) is a critical point for both investors and policymakers. Much ink has recently been spilled about how the Saudi decision to lower the price of oil to better compete with U.S. shale supply, and the burgeoning shale supply itself, is disinflationary. But it isn’t, and it is important to understand why. Inflation is a rate of change measure, and more to the point a change in prices is not inflation per se unless it is persistent. Policymakers don’t focus on core inflation because they don’t care about food or energy or think that we don’t buy them; they focus on core inflation because it is more persistent than food or energy inflation.

So if gasoline prices aren’t merely in their usual seasonal dip, but actually continue lower for another year, it will result in headline inflation that is lower than core inflation over that period. But once it reaches a new equilibrium level, that downward pressure on headline inflation will abate, and it will re-converge with core.

Oil prices, in fact, are almost always a growth story rather than an inflation story, and some of the big monetary policy crack-ups of the past have occurred when the Fed addressed oil price spikes (plunges) with tighter (looser) monetary policy. In fact, if any policy response is warranted it would probably be the opposite of this, since higher oil prices cause slower broad economic growth and lower oil prices cause faster broad economic growth. (However, long time readers will know that I don’t believe monetary policy can affect growth significantly anyway.)

Back, briefly, to the BOJ balance sheet expansion story. This was a very significant event for global inflation, assuming as always that the body follows through with their stated intention. Money printing anywhere causes the equilibrium level of nominal prices globally to rise. To the extent that this inflation is to be felt idiosyncratically only in Japan, then the decline of the currency will offset the effect of this global increase in prices so that ex-Japan prices are steady while prices in Japan rise…which is the BOJ’s stated intent. Movements in foreign exchange are best understood as allocating global inflation between trading partners. However, for money-printing in Japan to lead to disinflation ex-Japan, the movement in the currency would have to over-react to the money printing. If markets are perfectly efficient, in other words, the movement in currency should cause the BOJ’s idiosyncratic actions to be felt only within Japan. There are arbitrage opportunities otherwise (although it is very slow and risky arbitrage – better thought of as arbitrage in an economic sense than in a trading sense).

Of course, if the BOJ money-printing is not idiosyncratic – if other central banks are also printing – then prices should rise around the world and currencies shouldn’t move. This is why the Fed was able to get away with increasing M2 significantly without cratering the dollar: everyone was doing it. What is interesting is that the global price level has not yet fully reflected the rise in the global money supply, because of the decline in global money velocity (which is due in turn to the decline in global interest rates). This is the story that is currently being written, and will be the big story of the next few years.

Summary of My Post-CPI Tweets

October 22, 2014 Leave a comment

The following is a summary of my post-CPI tweets. You can follow me @inflation_guy (or follow the tweets on the main page at http://mikeashton.wordpress.com)

  • Core CPI +0.14%, close to rounding to +0.2%. An 0.2% would have caused a panic in TIPS, where there have been far more sellers recently.
  • y/y core to 1.73%, again almost rounding to 1.8% versus 1.7% expected. This just barely qualifies as being “as expected”, in other words.
  • Core services fell to 2.4%, but core goods rose to -0.3% y/y.
  • OER re-accelerated to 2.71% from 2.68% y/y. It will go higher.
  • really interesting that core goods did not weaken MORE given dollar strength. $ strength is overplayed by inflation bears.
  • Apparel went to 0.5% y/y from 0.0%. That’s the category probably most sensitive directly to dollar movements b/c apparel is all overseas.
  • Accel major groups: Food/Bev, Apparel, Recreation (24.1% of basket). Decel: Housing, Transp, Med Care, Educ/Comm (72.5%).
  • Though note that in housing, Primary rents rose from 3.18% to 3.29%, and OER from 2.68% to 2.71%, so weakness is mostly household energy.
  • That’s a new high for primary rental inflation. Lodging away from home also went to new high, 5.04% y/y. But it’s choppier.
  • Airfares continued to decelerate, -3.01% from -2.71%. Ebola scares can’t have helped that category, which most expected to rebound.
  • But these days, airfares are very highly correlated to fuel prices (wasn’t always the case). [ed note: see chart below]
  • In Medical Care, pharmaceuticals rose to 3.08% from 2.72%. But the medical services pieces decelerated.
  • Decel in med services is the surprise these days as the passage of the sequester cause positive base effects.
  • The weakness in med services holds down core PCE, too. Median CPI continues to be a better measure as a result.
  • College tuition and fees 3.36% from 3.32%. Still low compared to where it’s been. Strong markets help colleges hold down tuitions.
  • Core CPI ex-housing partly as a result of continued medical care weakness is down to a new low 0.877% from 0.911%.
  • That continues to be the horse race: housing versus a wide variety of other things not inflating. Yet.

We may hear about how this CPI report shows that there is “still no inflation,” but the simple fact is that the report was a little stronger-than-expected, that shelter inflation continues to accelerate with no end in sight, and that there was no large effect seen in core inflation from the strength of the dollar. The dollar has an evident effect on energy commodities, and a lesser effect on other commodities, but once you get to finished goods it takes a larger FX move or one longer in duration than the modest dollar rally we have had so far to cause meaningful movements in inflation.

The dollar’s strength, reflecting in energy weakness, also shows up in some categories where we don’t fully appreciate the link to energy. The airfares connection is always one of my favorites to show. Prior to 2004, there was basically no correlation between airfares and jet fuel prices (vertical part of the chart below). After 2004, the correlation went to basically 1.0 (see chart, source Enduring Investments).

jetfuel

The real conundrum in the CPI right now is the medical care piece. We always knew there would be difficulties in extracting what is really going on in medical care once Obamacare kicked in, because many of the costs of that program don’t show up immediately as consumer costs. But the main effect in the data all last year was the effect of the sequester on Medicare payments, which pushed down Medical Care inflation from over 4% in mid-2012 to 2% in 2013. But as the sequester passed out of the data, Medical Care CPI rose to nearly 3% earlier this year…and then slipped, abruptly, back to the lows (see chart, source Bloomberg).

medcareyoy

Is it possible that Obamacare is really restraining consumer inflation for medical care? Sure, it is possible. But there is far too much noise at this point to know what is happening in that component. And it really matters, because the overweighting of medical care and underweighting of housing in core PCE is the main reason that the Fed-favored price index shows 1.5% while median CPI is at 2.2%, within a snick of the highs since the crisis (see chart, source Bloomberg – note median CPI isn’t out yet for September).

pcemedian

From a markets perspective, the TIPS market (and the commodities market, for that matter) have been pricing in a pernicious disinflation and/or deflationary pressure. It is simply not there. And so, even with a print that couldn’t reach 0.2% on core, and even heading into a big auction tomorrow, inflation breakevens are rallying nicely, up 3.5-4.5bps across the board. Imagine what they would have done with a print that was a bona fide strong print!

Seasonal Allergies

October 14, 2014 8 comments

Come get your commodities and inflation swaps here! Big discount on inflation protection! Come get them while you can! These deals won’t last long!

Like the guy hawking hangover cures at a frat party, sometimes I feel like I am in the right place, but just a bit early. That entrepreneur knows that hangover cures are often needed after a party, and the people at the party also know that they’ll need hangover cures on the morrow, but sales of hangover cures are just not popular at frat parties.

The ‘disinflation party’ is in full swing, and it is being expressed in all the normal ways: beat-down of energy commodities, which today collectively lost 3.2% as front WTI Crude futures dropped to a 2-year low (see chart, source Bloomberg),

front_crude

…10-year breakevens dropped to a 3-year low (see chart, source Bloomberg),

10y_breaks

…and 1-year inflation swaps made their more-or-less annual foray into sub-1% territory.

1ycpiswaps

So it helps to remember that none of the recent thrashing is particularly new or different.

What is remarkable is that this sort of thing happens just about every year, with fair regularity. Take a look at the chart of 10-year breakevens again. See the spike down in late 2010, late 2011, and roughly mid-2013. It might help to compare it to the chart of front Crude, which has a similar pattern. What happens is that oil prices follow a regular seasonal pattern, and as a result inflation expectations follow the same pattern. What is incredible is that this pattern happens with 10-year breakevens, even though the effect of spot oil prices on 10-year inflation expectations ought to be approximately nil.

What I can tell you is that in 12 of the last 15 years, 10-year TIPS yields have fallen in the 30 days after October 15th, and in 11 of the past 15 years, 10-year breakevens were higher in the subsequent 30 days.

Now, a lot of that is simply a carry dynamic. If you own TIPS right now, inflation accretion is poor because of the low prints that are normal for this time of year. Over time, as new buyers have to endure less of that poor carry, TIPS prices rise naturally. But what happens in heading into the poor-carry period is that lots of investors dump TIPS because of the impending poor inflation accretion. And the poor accretion is due largely to the seasonal movement in energy prices. The following chart (source: Enduring Investments) shows the BLS assumed seasonality in correcting the CPI tendencies, and the actual realized seasonal pattern over the last decade. The tendency is pronounced, and it leads directly to the seasonality in real yields and breakevens.

seasonal

This year, as you can tell from some of the charts, the disinflation party is rocking harder than it has for a few years. Part of this is the weakening of inflation dynamics in Europe, part is the fear that some investors have that the end of QE will instantly collapse money supply growth and lead to deflation, and part of it this year is the weird (and frustrating) tendency for breakevens to have a high correlation with stocks when equities decline but a low correlation when they rally.

But in any event, it is a good time to stock up on the “cure” you know you will need later. According to our proprietary measure, 10-year real yields are about 47bps too high relative to nominal yields (and we feel that you express this trade through breakevens rather than outright TIPS ownership, although actual trade construction can be more nuanced). They haven’t been significantly more mispriced than that since the crisis, and besides the 2008 example they haven’t been cheaper since the early days (pre-2003) when TIPS were not yet widely owned in institutional portfolios. Absent a catastrophe, they will not get much cheaper. (Importantly, our valuation metric has generally “beaten the forwards” in that the snap-back when it happens is much faster than the carry dynamic fades).

So don’t get all excited about “declining inflation expectations.” There is not much going on here that is at all unusual for this time of year.

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