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%?
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.
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),
…10-year breakevens dropped to a 3-year low (see chart, source Bloomberg),
…and 1-year inflation swaps made their more-or-less annual foray into sub-1% territory.
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.
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.
The stock market, the bond market, the commodities markets (to a lesser extent), FX markets – they are all experiencing a marked increase in volatility.
Some observers want to call this bearish for equities, mainly because they already are bearish. This is a very bad reason. While really bad equity returns almost always occur coincident with a rise in volatility – the old maxim is that stocks go ‘up on the staircase and down on the escalator’ – that does not mean that volatility causes bad returns. Or, put another way, there are also periods of increased volatility that do not precede and are not coincident with bad returns.
However, there actually is a reason that increased volatility might lead to poor short- to medium-term returns, that isn’t based on technical analysis or spurious correlations. Moreover, a relatively new phenomenon (the rise of so-called ‘risk-parity’ strategies) is starting to institutionalize what was already a somewhat natural response to volatility.
In ‘risk-parity’ strategies, the weight of an asset class (or a security within an asset class, sometimes) is inversely proportional to the risk it adds to the portfolio. Generally speaking, “risk” here is defined as variance, because it is easy to estimate and there are markets where symmetrical variance trades – i.e., options markets. But what this means is that when volatility (sometimes realized volatility, and sometimes option “implied” volatility) rises in stocks, then risk parity strategies tend to be shedding equities because they look riskier, and vice-versa. Right now, risk parity strategies are likely to be overweight equities because of the long period of low realized and implied volatility (even though the valuation measures imply quite high risk in the sense most of us mean it, in terms of the probability of return shortfall). Risk parity strategies are probably superior to ‘return-chasing’ methodologies, but by being ‘risk-chasing’ they end up doing something fairly similar when they are all operating together.
Note that while risk-parity strategies are comparatively new – well, not exactly because it is an oldish idea, but they have only recently become a big fad – this general phenomenon is not. The natural response to greater equity market volatility is to pare back exposure; when your broker statement starts to swing around wildly it makes you nervous and so you may start to take some profits. This is also true of other asset classes but it seems to me to be especially true in equities. Nobody who gets involved in commodities is surprised at volatility: the asset class suffers from a midguided belief that it is terribly volatile even though commodity indices are just about exactly as volatile as equity indices over time. But equity investors, contrariwise, seem perennially surprised at 2% moves.
So, while the recent volatility doesn’t mean that a move lower in equities is assured, it increases the probability of such because risk-parity strategies (and other investors reacting nervously to overweights in their equity exposure) will begin to scale back positions in the asset class in favor of positions in other asset classes, probably mostly bonds and commodities. At this point it would be good for me to point out that only the very short-term volatility measures have moved up dramatically; the VIX is well off its bottom but only up to 18.8 and it has been there numerous times in the last few years (see chart, source Bloomberg). But the longer the volatility continues like we have seen it for the last week or two, the bigger the chances that the asset-allocation boxes start to make important shifts (and the quant hedge fund boxes will probably move a bit before those asset allocation boxes do).
As an aside, the tendency for asset allocation shifts to follow volatility shifts is not the reason that the VIX displays a strong inverse directionality. Neither is the main reason for this inverse directionality because the VIX is a “fear gauge.” The main reason is that the VIX weights near-the-money options more heavily than out-of-the-money options. Because options skews almost always imply more downside volatility for stocks than upside volatility, when the market declines it tends to bring more “high volatility” strikes into play and so part of the VIX increase in a down market is simply mechanical.
I am not calling for a sharp decline in stocks, nor for an extended decline in stocks. My position and view is as it has long been, that the prospect for attractive real returns from equities over the next 5-10 years is quite small and beaten handily by commodities’ prospective returns at that end of the risk spectrum. I don’t think that most investors (me included!) should swing asset allocations around frequently in response to technical indicators or such things as “momentum”, but rather should focus on evaluating expected long-term returns (which are somewhat predictable) and invest for value. And I must admit I also think that “risk-parity” is a clever marketing gimmick but a pretty absurd way to assemble a portfolio for almost everyone. My point here is to highlight one little-considered aspect of herd behavior, and how that herd behavior may have become more institutionalized as late, and to consider the risks that herd behavior may create.
 This in turn is not due so much from the tendency of markets to have more downside volatility than upside volatility, but from the fact that buying protective puts and selling “covered” calls are both considered “conservative” options strategies. So, out-of-the-money puts tend to be too expensive and out-of-the-money calls too rich.
The inflation market offers such wonderful opportunities for profit since so few people understand the dynamics of inflation, much less of the inflation market.
One of the things which continually fascinates me is how the inflation trade has become sort of a “risk on” kind of trade, in that when the market is pricing in better growth expectations, reflected in rising equity prices, inflation expectations move with the same rhythm. The chart below (source: Bloomberg) shows the 10-year inflation breakeven rate versus the S&P 500 index. Note how closely they ebb and flow together, at least until the latest swoon in inflation expectations.
Your knee-jerk reaction might be that this is a spurious correlation caused by the fact that (a) bond yields tend to rise when growth expectations rise and (b) when bond yields rise, the components of bond yields – including both real rates and expected inflation – tend to rise. But look at the chart below (source: Bloomberg), covering the same period but this time charting stocks versus real yields.
If anything, real yields ought to be more correlated to movements in equities than inflation expectations, since presumably real economic growth is directly related to the real growth rates embedded in equity prices. But to my eyes at least, the correlation between real interest rates and equity prices, for which there is a plausible causal explanation, doesn’t look nearly as good as the relationship between stocks and inflation expectations.
It doesn’t make any sense that long-term inflation expectations should be so closely related to equity prices. I know I have mentioned before – in fact, regular readers are probably sick of me pointing it out – that there is no causal relationship between growth and inflation. Really, it is worse than that: one really needs to torture the data to find any connection at all, causal or not. The chart below (source: Bloomberg) shows quarterly real GDP in yellow against core inflation in white.
I’ve pointed out before that the big recession in ’08-09 saw almost no deceleration in core inflation (and none at all if you remove housing from core inflation), but it’s hard to find a connection anywhere. The next chart (source: Bloomberg) makes the point a different way, simply plotting core inflation (y-axis) against real GDP (x-axis) quarterly back to 1980.
In case anyone out there is protesting that there should be a lagged relationship between growth and inflation, I am happy to report that I was able to get an r-squared as higher as 0.257 with a lag of 12 quarters. Unfortunately, the lag goes the wrong way: high inflation precedes high growth, not vice-versa. And I don’t know anyone who proffers a reasonable explanation of a causality running in that direction. Lags the other way fail to produce any r-squared over 0.1.
So, how to explain the fact that since the end of August we have seen 10-year real rates rise 29 basis points while 10-year breakevens were falling 12bps (producing a net rise in nominal rates of only 17bps)? The explanation is simple: the market is wrong to treat breakevens as a “risk on/risk off” sort of trade. Breakevens have cheapened far too much. I don’t know if that means that TIPS yields have risen too much, or nominal yields have risen too little (I rather expect the former), but the difference is too narrow. The short end of the US curve (1 year inflation swaps are at 1.44%) implies either that core inflation will decline markedly from its already-depressed level well below median inflation, or that energy prices will decline sharply and much further than implied by gasoline futures.
I think that one of the reasons US inflation has been under pressure is that it is currently at a very large spread versus European inflation, and earlier this month it was at the highest level in at least a decade (see chart, source Enduring Investments).
This may look like an appealing short, perhaps, but based on our internal analysis and some historical relationships we track we actually believe the spread is too low by about 50bps. And think about it this way: if Europe really is in the process of inheriting Japan’s lost decade, then 10-year expectations for the US ought to be much, much higher than in Europe. I don’t really think Europe will end up there, because the ECB seems to be trying to do the right thing, but it is not unreasonable to think that there should be a hefty premium to US inflation over Europe.
 Of course, the correlation of levels won’t be very good because stocks have an upward bias over time while inflation expectations do not. To run the correlation, you’d have to de-trend stocks but I’m trying to make a visceral point here rather than a quantitative one.
While we wait for our Employment Report tomorrow, there is plenty of excitement overseas.
The dollar continued to strengthen today, with the dollar index reaching the highest level since the middle of last year (see chart, source Bloomberg).
As with the rest of the dollar’s strengthening move, it was really not any of our own doing. The dollar is simply, and I suspect very temporarily, the best house in a bad neighborhood right now. In the UK, the Scots are about to vote for independence, or not, but it will be a close vote regardless. In Japan, the Yen is weakening again as the Bank of Japan continues to ease and Kuroda continues to jawbone against his currency.
In Europe this morning, the ECB surprised many observers by cutting its benchmark rate to the low, low rate of just 5 basis points (0.05%), and lowered the deposit rate to -0.2%…meaning that if a bank wants to leave money sitting at the ECB, it is forced to pay the ECB to hold it. A negative deposit rate is akin to the Fed setting interest on excess reserves at a negative figure, something that makes great sense if the point of quantitative easing is to get money into the economy. In the Fed’s case, it turns out that the real point was to de-lever the banks forcibly, so it didn’t care that the reserves were sitting inert, but in the ECB’s case they would really like to see inflation higher (core inflation for the whole Eurozone is under 1%) so it is important that any increase in the balance sheet of the central bank is reflected in actual currency in circulation.
Right now, the negative deposit rate isn’t so important since the ECB holds negligible deposits. But the negative deposit rate was step one; step two is to gin up the quantitative easing again. ECB President Draghi had promised several months ago to do so with ‘targeted LTRO’, and today he delivered by saying that the ECB has decided to begin TLTRO in October. The ECB will “purchase a broad portfolio of simple and transparent securities” even though some observers have noted that there aren’t a lot of asset-backed securities in the market to buy (but trust Wall Street on this: if there is a buyer of a few hundred billion Euros’ worth of such securities, those securities will be issued. Wall Street isn’t good at everything, but they’re darn good at finding ways to satisfy a motivated, huge buyer. (See “subprime MBS”).
This is significant, as I said it was when Draghi first mentioned this back in June. It is significant if they follow through, and at least at this point it appears they mean to do so. Now, Europe still needs to fight against the dampening effect on money velocity that lower interest rates are having, but at least they recognize the need to get M2 money growth above the 2.7% y/y rate it is at presently (which is, itself, above the 1.9% rate of the year ended April). Money growth in Europe is currently the lowest in the world, and – surprise! – deflation is the biggest threat in Europe. Go figure.
How does this affect inflation in the US?
Changes in the global money supply contributes to a global inflation process that underpins inflation rates around the world. The best way to think about the fluctuations in exchange rates, with respect to inflation, is that they allocate global inflation between countries (or, alternatively, you can think of inflation as being “global” plus “idiosyncratic”, where a country’s idiosyncratic inflationary or disinflationary policies affect the domestic inflation rate and the exchange rate with other countries). So, the ECB’s aggressive easing (when it happens) will have two main effects. First, it will tend to push up average inflation globally compared to what it would otherwise have been. Second, it will tend to weaken the Euro and strengthen the dollar so that inflation in Europe should rise relative to US inflation – all else being equal, which of course it is not.
With respect to this latter effect, I need to take pains to point out that it is a small effect, or rather than the relative movements in the currency need to be a lot bigger to be worth worrying about. A stronger dollar, in short, is not going to put much pressure on US inflation to be lower. The chart below (source: Enduring Investments) shows a proxy we use for core commodities inflation, ex-medical, against the broad trade-weighted dollar lagged 9 months.
You can see that core commodities respond broadly to the dollar’s strength or weakness. A 5% rise (decline) in the dollar causes, nine months later, a 1% decline (rise) in core commodities inflation, ex-medical care commodities. Core ex-medical care commodities represents about 18% of the consumption basket, and the dollar’s effect outside of that part of the basket is indeterminate at best, so we can say that a 5% rise in the dollar causes inflation to decline about 0.18%.
In short, don’t waste a lot of time worrying that the 4% rise in the dollar this year will lead to deflation any time soon. Against that 18% of the consumption basket, we have 57% of the basket (core services) inflating at 2.6%, and over half of that consists of primary and owners’ equivalent rents, which are rising at 3.3% and 2.7% respectively and have a lot of upward momentum. Unless the dollar shoots dramatically higher, it should not affect overall prices very much.
Back to school! It is the beginning of September, post-Labor Day, and students everywhere are back to school.
It is the time of year when investors, too, tend to be schooled – as bond markets tend to strengthen and equity markets to weaken (relative to the overall drift). It doesn’t happen every year, but the tendency in fixed income markets is strong enough that, as a rule, I demand much stronger reasons to sell bonds in September and October than during the rest of the year.
This year, we appear to be in for a special treat. We all get to learn new acronyms, like ISIS, and Americans are learning where Ukraine is on a map of the world. What fun.
Monetary policymakers tend to be resistant to further lessons, since after all they have had so many years of book learning that, darn it, they should know enough by now! And yet – there is so much about economics and monetary policy that we just don’t know; so much that isn’t knowable; and so much that we know with great confidence but just isn’t so.
However, I have been delighted to find that recently, the subject of money velocity has been appearing more frequently in policy circles. To a monetarist, velocity is one of a very small handful of things that matter, and its absence from discussions among the learned has been a terrible sign that monetarism was not merely in retreat, but almost extinct. And yet, the predictions of monetarism have been borne out time and time again (that is, the actual predictions, not the idea that printing money causes economic growth – a prediction that presupposes a high degree of money illusion is at work), while the predictions of Keynesian economists have only worked once the parameters are revised post-hoc to fit the crisis. Increased money supply growth got Japan out of its deflationary spiral – as predicted. None of the Keynesian solutions deployed over the last two decades have worked, but the first attempt at serious money-printing worked. (Although it remains to be seen if the BOJ will keep its pedal to the metal; it certainly hasn’t yet “doubled the money supply” as it had pledged to do).
High money growth – that is, transactional money and not inert reserves – always accompanies high inflation. For a time, money growth may be offset by declining money velocity, but we also know quite a bit about what causes money velocity to move. Last year I cited a rare paper by a central banker (Samuel Reynard at the Swiss National Bank) that really had insight on these almost-forgotten tenets of monetarism. And this year, I am delighted to note that some economists at the St. Louis Fed have published a brief note entitled “What Does Money Velocity Tell Us about Low Inflation in the U.S.?” While the authors, Yi Wen and Maria Arias, mistakenly focus on the velocity of base money, and thus reach an incorrect conclusion that individuals are “hoarding” money (when it in fact is sitting in bank reserves, untouched), it is nevertheless the right topic and the right question, and that’s most of the battle.
I have previously shown the chart of interest rates and money velocity, so let me show it again.
This is important, because it’s the single biggest risk to a significant inflation accident. While the low vacancy rate and the rapid growth in housing prices will continue to push rents higher, bringing median and/or core inflation above 3% by early next year, we can live with 3%. The risk for much worse inflation is all tied to a rebound in monetary velocity. It bears repeating. From 2008 to 2013, money growth was rapid but declining money velocity (tied to interest rate declines, mainly) restrained inflation. If money growth remains at the same level but money velocity merely stabilizes, it is consistent with inflation of 3%-4%. But if money velocity reverses even a part of its post-crisis decline, then inflation could move appreciably higher. Since Q2 of 2008, the velocity of M2 has fallen at a 3.76% annualized rate; were that to reverse, with the same money supply growth, then the 3-4% inflation becomes 6.75%-7.75% inflation, which I think we would all agree is a bad thing.
Now, the unfortunate thing is that models of velocity that incorporate interest rates and certain other factors already indicate that money velocity should be rising. The chart below shows our proprietary model of money velocity; as you can see, since mid-2013 there has been a large and growing gap between what the model implies and where money velocity has actually been recorded. This might well mean that the model is wrong. But we should also take it as indicating the risk of a rise in velocity is real, whether it is a 1% or 2% rise per year, or a 15% snap-back over a shorter period of time.
As I always admonish, that’s a big picture concern, and not something to trade tomorrow. I would be gradually accumulating positions in inflation swaps, caps, breakevens, and broad commodity indices. There is time before people start to get really concerned. But to my mind, what is interesting is that the central bankers are now at least starting to reconsider velocity.