Note: The following blog post originally appeared on March 28th, 2010 and is part of a continuing year-end ‘best of’ series, calling up old posts that some readers may have not seen before. I have removed some of the references to then-current market movements and otherwise cut the article down to the interesting bits. You can read the original post here.
Some bond bears were probably also scared by the fact that CNBC asked the question on Friday, “Time To Sell Bonds To Buy Stocks?” (Remind me when they last asked whether it was time to sell stocks to buy…anything?) They’re half right this time, I think, but I don’t like having them as company either. Balancing the Groucho effect (“I don’t want to belong to any club that would accept people like me as a member”) is the Holiday Inn Express effect (in which people develop amazing abilities unrelated to their backgrounds: “Are you a doctor?” “No, but I stayed at a Holiday Inn Express last night”). Barron’s, specifically Michael Santoli, who writes the “Streetwise” column, sought to explain why rising yields are good for stocks. When equity guys are busy telling the bond vigilantes why they’re not scared of them…they’re scared of them.
During a day in which there was little in the way of economic data, several Fed speakers were on the tape. While it is ordinarily very important to listen attentively to comments from Fed officials, these days it isn’t so crucial because we know what conditions will lead to meaningful tightening and they (much lower unemployment rate, some sign of broad core inflation including housing) aren’t going to happen any time soon. Why? Dr. Bernanke is fighting a desperate rear guard action against those people who reasonably question whether the Fed has been all it’s cracked up to be. The threat is real; Fed Governor Kevin Warsh on Friday stated that Fed credibility would suffer if independence was lost. Although this statement raises other questions (namely, “what credibility??), it is indicative of the FOMC’s mood. If you think Bernanke is going to tighten rates meaningfully when Unemployment is near 10%…or 9%…or 8%…and risk having the Fed’s independence stripped, I think you ought to think again. Of course, this means that the de facto independence of the Fed is questionable, but anyone who thinks that this is a fight the Fed should pick shortly after the bottom of the worst recession in at least 30 and maybe 80 years, please raise your hand. I didn’t think so.
A Word About Current Value In Long TIPS
When investors are thinking about what assets to include in their portfolios, they obviously care about both risk and return. Of course, the problem is that they care about a priori risk and return, which are unknowable, and so tend to populate portfolio allocation simulations with estimates of long-run returns that are no better than guesses (we tend to have a better sense of long-run variances, although what causes problems there is that the distribution is not normal). This is why equities are so dominant in many portfolios, despite their evident short-term risk: generally, investors make one of three key errors in looking at long-run equity returns:
- They use long-run historical nominal returns to form the estimate. Investors shouldn’t care about nominal returns at all, so this is clearly incorrect.
- They use long-run historical real returns. This is better, but it neglects the fact that most historical periods which terminate in the last decade-plus will also reflect multiple expansion as a source of return. There is no good reason to expect that the multiple expansion of the last eighty years will repeat over the next eighty.
- They use a tortured interpretation of the Capital Asset Pricing Model to back out high expected returns for equities. “Stocks are riskier; therefore, they should have a higher return.” The CAPM isn’t meant to be a causal model but rather an observation about how capital assets should be priced. If riskiness implies more return, then lottery tickets should be the best investment.
But we can look at long-term data in a more thoughtful way and get a better sense for what a fair return to equities is, in the long run. Brad Cornell and Rob Arnott wrote a short article (“The ‘Basic Speed Law’ for Capital Markets Returns“) that pointed out three important long-term truisms. First, the long-run growth rate of per-capita GDP in the U.S., a measure closely related to productivity growth, has been around 2% for the last 100 years. Second, if the real economy is growing around 2% per capita in the long run, then earnings in the corporate sector must also be limited to roughly that growth (since otherwise it would soon become larger than the economy itself). And third, if the growth of earnings is limited similarly, then stock price index growth must be limited to something similar as well, net of valuation changes.
The version of the chart which appears below is sourced from Census, BEA, and Robert J Shiller data, and updated through the end of 2009. Over the last 80 years, the compounded growth rate of real per capita GDP has been 2.1%; for real earnings it is 2.6%; and for stock prices it is 1.8%. However, those rates are computed using arbitrary end points – December 1929 and December 2009. A better way is to run an exponential regression, and on the chart the straight lines are the results of that regression (the line appears straight because the axes are loglinear, so the regression line is linear in log space). The growth rates then are 2.25% for real per capita GDP, 1.74% for real earnings (n.b., if you take out 2008Q4-2009Q3, the coefficient is 1.95%), and 2.87% for the real stock price growth rate.
Now, 2.87% as a long-run real growth rate for equities doesn’t sound great, but it’s actually even exaggerated because over that period, equity multiples expanded from 13.3x earnings to 21.6x earnings, so a bunch of that return is coming from multiple expansion that may not repeat. If the current multiple is fair (I think it’s high, but let’s be generous), then the long-run expected return to equities ought to be similar to the long-run expected growth in earnings, which is limited to the long-run growth in GDP per capita. Or, roughly, 2-2.25% (There really isn’t a lot of difference here, actually; real GDP uses the GDP deflator to measure price inflation, while real earnings uses CPI; the latter is generally about 0.25% or so higher, so these are essentially both 2%, if you use CPI, or 2.25%, if you want to use the deflator.)
That’s what you can expect to get from equities in the truly long-run, plus dividends – of 1.8% on the S&P right now. With that long-run growth, of course, comes a ton of volatility. Meanwhile, you can get a 30-year real yield of 2.17% from TIPS, with much less volatility (and no volatility at a horizon equal to the duration of the bond). Moreover, remember TIPS pay based on CPI, which is the “faster” of the two inflation measures used above.
So, unless you are into market timing, TIPS are currently priced to produce a long-run real return equal to stocks, with less volatility. That’s a decent deal! If we get a big rate sell-off, that deal may get better still, but while the short end of the TIPS curve doesn’t look terribly attractive the long end remains reasonable.
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This will be my last “live” post of 2013. As such, I want to thank all of you who have taken the time to read my articles, recommend them, re-tweet them, and re-blog them. Thanks, too, for your generous and insightful comments and reactions to my writing. One of the key reasons for writing this column (other than for the greater glory of Enduring Investments and to evangelize for the thoughtful use of inflation products by individual and institutional investors alike) is to force me to crystallize my thinking, and to test that thinking in the marketplace of ideas to find obvious flaws and blind spots. Those weaknesses are legion, and it’s only by knowing where they are that I can avoid being hurt by them.
In my writing, I try to propose the ‘right questions,’ and I don’t claim to have all the right answers. I am especially flattered by those readers who frequently disagree with my conclusions, but keep reading anyway – that suggests to me that I am at least asking good questions.
So thank you all. May you have a blessed holiday season and a happy new year. And, if you find yourself with time to spare over the next few weeks, stop by this blog or check your email (if you have signed up) as I will be re-blogging some of my (subjectively considered) “best” articles from the last four years. Included in that list is an article on long-run returns to equities, one on Yellen’s defense of large-scale asset purchases, an article on the Phillips Curve, one on why CPI isn’t a bogus construct of a vast governmental conspiracy, and so on. Because I don’t expect some of the places where this column is ‘syndicated’ to post the re-blogs, you should consider going to the source site to sign up for these post, or follow me @inflation_guy on Twitter.
And now, on to my portfolio projections as of December 13th, 2013.
Last year, I said “it seems likely…that 2013 will be a better year in terms of economic growth.” It seems that will probably end up being the case, marginally, but it is less likely that 2014 improves measurably in terms of most economic variables on 2013 and there is probably a better chance that it falls short. This expansion is at least four years old. Initial Claims have fallen from 650k per week in early 2009 to a pace of just barely more than half that (335k) in the most-recent 26 weeks. About the best that we can hope for, plausibly, is for the current pace of improvement to continue. The table below illustrates the regularity of this improvement over the last four years, using the widely-followed metric of the Unemployment Rate:
Sure, I know that there are arguments to be made about whether the Unemployment Rate captures the actual degree of pain in the jobs market. It plainly does not. But you can pick any one of a dozen other indicators and they all will show roughly the same pattern – slow, steady improvement. There is no doubt that things are better now than they were four years ago, and no doubt that they are still worse than four years before that. My point is simply that we have been on the mend for four years.
Now, perhaps this expansion will last much longer than the typical expansion. But I don’t find terribly compelling the notion that the expansion will last longer because the recession was deeper. Was this recession deeper because the previous expansion was longer? If so, then the argument is circular. If not, then why would that connection only work in one direction? What I know is that the Treasury has spent the last four years running up large deficits to support the economy, and the Fed has nailed interest rates at zero and flooded the economy with liquidity. Those two things will at best be repeated in 2014, not increased; and there is a decent chance that one or the other is reversed. Another 0.8% improvement in the Unemployment Rate would put it at 6.2%, and I expect inflation to head higher as well. A taper will be called for; indeed, it should never have been necessary because policy is far too loose as it is. Whether or not an extremely dovish Fed Chairman will actually acquiesce to taper is an open question, but economically speaking it is already overdue and certainly will appear that way by the middle of the year, absent a crack-up somewhere.
Global threats to growth do abound. European growth is sluggish because of the condition of the financial system and the pressures on the Euro (but they think growth is sluggish because money isn’t free enough). UK growth has been improving, but much of that – as in the U.S. – has been on the back of housing markets that are improving too quickly to make me comfortable. Chinese growth has recently been downshifting. Japanese growth has been irregularly improving but enormous challenges persist there. Globally, the bright spot is a modest retreat in Brent Crude prices and lower prices of refined products (although Natural Gas prices seem to be on the rise again despite what was supposed to be a domestic glut). Some observers think that a lessening of tensions with Iran and recovery of capacity in Libya, along with increasing US production of crude, could push these prices lower and provide a following wind to global growth, but I am less sanguine that geopolitical tensions will remain relaxed for long and, in any event, depending on a calm Iran as the linchpin of 2014 optimism seems pretty cavalier to me.
Note that the muddled growth picture contains some elements of risk to price inflation. The ECB has been kicking around the idea of doing true QE or experimenting with negative deposit rates. The UK housing boom, like ours, keeps the upward pressure on measures of core inflation. There is no sign of an end to Japanese QE, and the PBOC seems willing to let the renmimbi rise more rapidly than it has in the past. And all of these global risks to domestic price inflation are in addition to the internally-generated pressures from rapid housing price growth in the United States.
The good news on inflation domestically is that M2 money growth has slackened from the 8%-10% pace of last year to more like 6%-8% (see chart, source Bloomberg). This is still too fast unless money velocity continues to slide, but it is certainly an improvement. But the bad news is that money growth remains rapid in the UK and is accelerating in Japan. The only place it is flagging, in Europe, has a central bank that is anxious not to be last place on the global inflation scale. I expect core inflation (and median inflation) in the U.S. to rise throughout 2014 and for core inflation to end up above 3% for the year.
Now, I have just made a number of near-term forecasts but I need to change gears when looking at the long-term projections. In what follows, I make no effort to predict the 3-month, 6-month, or 12-month returns of any market. Indeed, although I will present long-term risk and return outlooks, and they are presented as point estimates, I want to make it very clear that these are not predictions but rather statements of relative risk and return possibilities. For many types of instruments, the error bars around the average annual performance are so large as to make point estimates (in my view) nearly useless. The numbers come from models of how markets behave when they are priced “like they are now” in terms of several important metrics. They are not prescient. However, that is what investing is really all about: not making the “right” bet in terms of whether you can call the next card off the deck, but making the “right” bet with respect to the odds offered by the game, and betting the right amount given the odds and the edge.
I also will not make portfolio allocation recommendations here. The optimal portfolio allocation for you depends on more variables than I have at my disposal: your age, your career opportunities, your lifestyle, your goals, any insurance portfolio and your risk tolerance, to name just a few.
What I will do here, though, is to give top-down estimates of the long-run returns and risks of some broad asset classes, and make some general observations. I don’t analyze every possible asset class. For this exercise, I limit the universe to stocks, TIPS, nominal bonds (both long Treasury and corporate bonds), commodity indices and (since many of us already own it) residential real estate. My estimates and some notations about the calculations are in the table below.
|Inflation||2.50%||Current 10y CPI Swaps|
|TIPS||0.68%||Current 10y TIPS. This is not at equilibrium, but it is what we can lock in today. It is the highest rate available at year-end since 2010.|
|Treasuries||0.37%||Nominal bonds and inflation-linked bonds ought to have the same a priori expectation, but Treasuries trade rich to TIPS because of their value as repo collateral. Current 10y nominal rate is 2.87%, implying 0.37% real.|
|T-Bills||-0.50%||Is less than for longer Treasuries because of liquidity preference.|
|Corp Bonds||-0.69%||Corporate bonds earn a spread that should compensate for expected credit losses. A simple regression of Moody’s “A”-Rated Corporate yields versus Treasury yields suggests the former are about 45bps rich to what they should be for this level of Treasury yields.|
|Stocks||1.54%||2.25% long-term real growth + 1.83% dividend yield – 2.54% per annum valuation convergence 2/3 of the way from current 24.3 Shiller P/E to the long-run mean. Note that I am using long-run growth at equilibrium, not what TIPS are implying. This is the worst prospective 10 year real return we have seen in stocks since December 2007. Now, to be fair in 1999 we did get to almost -2%, which would imply up to another 35-40% upside to stocks before we reached an equivalent height of bubbliness. That is a 35-40% that I am happy to miss.|
|Commodity Index||6.26%||Various researchers have found that commodity futures indices have a long-run diversification return of about 3.5%. To this we add 1-month LIBOR to represent the return on the collateral behind the futures, and a ‘relative value’ factor to reflect the performance (relative to the expected model) of hard assets relative to currency.|
|Real Estate (Residential)||-0.19%||The long-run real return of residential real estate is around +0.50%. Current metrics have Existing Home Sales median prices at 3.79x median income, versus a long-term average of 3.55x. Converging to the mean over 10 years would imply an 0.69% per annum drag to the real return. This is the first time since 2008 that housing prices have offered a negative real return on a forward-looking basis.|
The results, using historical volatilities calculated over the last 10 years (and put in terms of ‘real annuitized income,’ a term that means essentially the variance compared to a fixed 10-year real annuity, which in this analysis would be the risk-free instrument), are plotted below. (Source: Enduring Investments).
Return as a function of risk is, as one would expect, positive. For each 0.33% additional real return expectation, an investor must accept a 1% higher standard deviation of annuitized real income. However, note that this is only such a positive trade-off because of the effect of commodities and TIPS. If you remove those two asset classes, which are the cheap high-risk and the cheap low-risk asset classes, respectively, then the tradeoff is worse. The other assets lie much more closely to the resulting line, which is flatter: you only gain 0.19% in additional real return for each 1% increment of real risk. Accordingly, I think that the best overall investment portfolio using public securities – which has inflation protection as an added benefit – is a barbell of broad-based commodity indices and TIPS.
TIPS by themselves are not particularly cheap; it is only in the context of other low-risk asset classes that they appear so. Our Fisher model is long inflation expectations and flat real rates, which merely says that TIPS are strongly preferable to nominal rates but not a fabulous investment in themselves (although 10-year TIPS yields are better now than they have been for a couple of years). Our four-asset model remains heavily weighted towards commodity indices; and our metals and miners model is skewed heavily towards industrial metals (50%, e.g. DBB) with a neutral weight in precious metals (24%, e.g. GLD) and underweight positions in gold miners (8%, e.g. GDX) and industrial miners (17%, e.g. PICK). (Disclosure: We have long positions in each of the ETFs mentioned.)
Feel free to send me a message (best through the Enduring website http://www.enduringinvestments.com ) or tweet (@inflation_guy) to ask about any of these models and strategies. In the new year, I plan to offer an email “course”, tentatively entitled “Characteristics of Inflation-Protecting Asset Classes,” that will discuss how these different assets behave with respect to inflation and give some thoughts on how to put an arm’s-length valuation on them. Keep an eye out for the announcement of that course. And in the meantime, have a happy holiday season and a merry new year!
In one of those “what could possibly go wrong with that plan” moments – which are becoming all too frequent these days – the New York Times this weekend reported that there is “growing concern inside and outside the Fed that inflation is not rising fast enough.”
At some level, this is not exactly new thinking. For decades, economists have argued that “price stability” really means inflation of something just slightly over 0%, because it is assumed to be quite hard to get out of a deflationary spiral. in my view, that’s silly, because simply adding a zero to the currency in everyone’s pocket is a guaranteed way to get out of deflation. It may be that since nudging inflation higher is harder than kicking it higher, the costs of mild deflation are higher than the costs of mild inflation, but I think the jury is out on that question since it isn’t something we have ever experienced. But in any event, this is the reason that inflation in the neighborhood of 2%, rather than 0%, has been the Fed’s implicit or explicit target for a long time.
To the extent that discussion stays academic, it’s not worrisome. Navel-gazing is an occupational hazard of being a professional economist, after all. But now, there are louder and more frequent voices arguing that 2% is too low a target. To see how urgent a problem this is, I submit the following chart, which shows median CPI, along with a horizontal line at 2.25% (roughly equivalent to a 2% target on PCE). Wow, I can see the reason for panic. We are nearly 0.2% below that! And we got within 0.6% of deflation in 2010, in the aftermath of the worst credit crisis in almost 100 years.
I am all for the idea that mild inflation serves to lubricate the gears of commerce, but we should remember that when the CFO of Costco says he likes rising inflation because in that circumstance “the retailer is generally able to expand its profit margins,” that’s good for the equity market perhaps but not as good for the consumer!
It always amazes me how sketchy is the understanding of inflation in a capital markets context by members of the Fed. In the aforementioned article, Chicago Fed President Evans is quoted saying “If inflation is lower than expected, then debt financing is more burdensome than borrowers expected. Problems of debt overhang become that much worse for the economy.” This is absolutely true, but almost completely irrelevant in the current context. Inflation has been lower than a priori expectations since about 1980, which is why a long-nominal-bond position has routinely outperformed inflation. But currently, as the chart below illustrates, 10-year inflation breakevens are at 2.19%. Fully 72% of all 10-year periods since 1914 have seen compounded inflation above that level.
Ten-year inflation swaps, a better measure of inflation expectations, are at 2.52%, which still doesn’t sound like a horrible bet for borrowers. If inflation comes in above 2.52%, the borrower of 10-year fixed-rate money wins; if it comes in below 2.52%, the borrower loses. This is one reason that it is so rare to see corporations issue inflation-indexed debt…they like that bet.
Finally, the article explains that higher inflation allows workers to get higher wages, and gives the example of teachers in Anchorage, Alaska, who just agreed to a contract giving them 1% pay increases for each of the next three years. Since inflation is likely to be above that, the article says, they will be probably receiving a pay cut in real terms. This is absolutely true. (It is also the exact opposite position of the debtor, in that the teachers will do better in real terms if deflation actually happened. Sometimes I just wish the authors of these articles would be consistent.) But this circumstance certainly isn’t helped by inflation; since wage increases tend to trail inflation, real wages tend to lag in inflationary upticks.
None of this represents deep insight from this author. It merely represents that I have at least a rudimentary understanding of how inflation works, and a respect for the damage which inflation can cause to economies, workers, and savers. The fact that this is increasingly rare these days is probably cyclical, and unfortunately is probably a minimum condition for setting up this next inflation debacle. In that context, and with more Federal Reserve economists openly musing about needing to target higher inflation, does 2.19% breakeven sound like a bad deal?
I haven’t written recently because it is hard to figure out what to do here. Market action at this point seemingly has little to do with fundamentals, and isn’t even in “risk on/risk off” mode because no one seems to be sure how the government shutdown affects risk (the debt ceiling debate is another issue, which I will discuss later).
I often get comments to the effect that “political uncertainty is a fact of life,” or “the Fed always manipulates markets,” implying that we cannot simply refuse to invest because markets aren’t trading cleanly off of economic fundamentals (which don’t directly translate into market action even in the best of times anyway). This is true, but I always hearken back to the notion that uncertainty implies a smaller bet size (a long time ago I wrote an article in which I discussed the implications of the Kelly Criterion for thinking about how one invests). When the economic signals are clear but the market isn’t pricing them properly, then you have a great edge and the market is giving you good odds, and most of your chips should be on the table. When the economic signals aren’t clear, or when stochastic political events are likely to overwhelm them, then your bet should be small because your edge is lower even if you are getting good odds.
In this case, of course, no matter what market you are talking about it isn’t at all clear how the debate (perhaps calling it a “debate” is generous) about the continuing resolution to fund government operations, the ACA, and the debt ceiling will be resolved.
We can speculate about what various outcomes might mean to the markets, but even here our analysis is fraught with uncertainty. Would an extended shutdown be good for equity markets because it would imply a greater chance of lower ACA costs and a lengthier period of Fed quantitative easing? Or would it be bad because of the short-term impact on growth as government spending is delayed? Would bonds rally because there would be no incremental supply, or sell off because of the implied risk of default? A lengthy government closure might be bad for the dollar because it implies more monetary ease, but might be good because it represents “fiscal discipline” (admittedly, in this case it’s discipline in the fetishistic sense rather than in the self-control sense). The only thing I am certain about is the uncertainty, and that spells a smaller bet.
Retail investors are especially at a disadvantage, because of the huge amount of misinformation that is out there about likely scenarios and the results of various outcomes. This misinformation is often unwittingly disseminated by media outlets, but I suspect it is rarely unwittingly initiated by the original sources.
For example, a recent New York Times blog was pretty good at discussing the possible outcomes, but flunked on at least one aspect when it stated what would happen to the economy as a result of a federal default. I don’t mean to pick on the Times here, and in general it is a good article. But at one point the writer said that a default could cause a spike in Treasury yields (likely true), but then continued “The price tag on a huge range of other debt products is benchmarked to the cost of Treasuries. That means a spike in the federal government’s borrowing costs would translate into pricier mortgages, car loans and corporate borrowing costs.”
Well, that’s wrong. It’s not offensively wrong, but it’s wrong (and I’m pointing it out partly as an example of how even simple stuff is confused right now). The interest rate on any nominal debt instrument consists of several components: the real cost of money, a premium for expected inflation, and a premium for the riskiness of the credit. Normally, with Treasuries we can say the credit spread is effectively zero, so that we refer to the spread that a corporate bond trades over Treasuries as “the” credit spread because that spread minus zero equals that spread. But there is no reason to think that spread would remain constant if the Treasury’s credit was diminished, any more than it would remain constant if the corporate’s credit was diminished. If Treasury rates spiked because the government’s perceived credit spread was no longer zero, then unless that also affected the perceived credit of, say, Caterpillar then there is no theoretical reason that CAT yields should also rise.
In any event, a federal default is not going to happen unless someone in the Administration wants it to happen. The government’s $2.9 trillion in revenues is quite a bit more than is needed to pay the $300bln or so in interest costs per year, so unless the Treasury simply decided to default (see an excellent article here by my friends at TF Market Advisors) it isn’t going to happen. The Treasury has made some mystifying statements about how they don’t have the capability to pay some expenses and not others, but in the worst case someone can sit down and manually wire the money to every holder. So that’s nonsense that is meant to scare us.
So I don’t have any decent “trading opinions” on the basis of the government shutdown. What I do believe is that this is an unmitigated positive for inflation (positive in the sense of pushing it higher), and thus for breakevens and inflation swaps. The longer the government stays shut, the longer quantitative easing will be in force as the Fed attempts to counteract the short-term contraction of economic activity (the fact that monetary policy is ineffective at affecting growth rates never seems to enter their minds); furthermore a long shutdown will more likely to push the dollar lower in my opinion – although, as I said above, I can argue the reverse position as well. On the other hand, if the Republicans cave quickly, as is likely in my view, and the ACA goes into effect, prices for consumer-purchased medical care will rise rapidly. This is less a statement about whether the ACA will push aggregate health care costs higher, although I believe that it will. It’s more an observation that controlled prices in the government-purchased sector will produce higher prices outside of the controls, and it is this latter group that will be sampled for consumer prices (since the price the government purchases at is not a “consumer” price). Since it is the Medical Care subgroup of CPI that has been pressing core CPI to be lower than median CPI, any rebound in Medical Care inflation will push aggregate core inflation higher.
Was that said in a confusing-enough manner?
TIPS should do well while the government is shut, because there is ongoing growth in demand for TIPS while the supply will be drying up. Unlike with the nominal Treasury market, there is no corporate inflation-linked bond sector that can replace the inflation exposure (although there should be) demanded by investors, so TIPS will tend to outperform nominal bonds in the event that both sets of auctions are canceled.
 There are other costs, such as the discount to the interest rate that the Treasury pays as a result of the status of Treasuries as superior collateral in repo and similar exchanges, but they are not relevant to this point.
 There may be a practical argument that there might be a substitution effect, but that’s also saying that investors would bet the selloff in Treasuries makes them a better risk-adjusted bet than CAT bonds. However, if the Treasury’s credit spread moved permanently higher, it would not affect the equilibrium bond yield of a corporate bond.
Everyone expected markets to provide a lot of late-day volatility today, and so they did. The Fed apparently doesn’t mind surprising the market with a non-consensus outcome when that surprise gooses stocks and bonds higher. Here are some (fairly unstructured) thoughts about today’s declaration from the Fed that there will be no “taper” in its QE program yet:
- This has nothing to do with the fact that there was a minor wiggle in the Employment data, some weakness in Retail Sales, and some other disappointments this month. If that is now the standard…that the Fed plans to expand its balance sheet without bound as long as growth is not smashing the cover off the ball, then we are truly lost for QE will never, ever end. This month’s numbers were all within the normal variation for economic data, which do in fact vary even when the underlying economy is not. The old standard was “ameliorate a deep recession.” Then Greenspan turned that to “resist even a mild recession.” And now, is the standard “robust growth no matter what the long-term cost?” I don’t think so, and so I reject the notion that the failure to begin the taper has anything to do with the growth numbers.
- Similarly, the inflation numbers cannot be the reason. Core inflation is now rising, and the Fed has previously recognized that some of the decline in inflation has been due to transient effects of the sequester. Median inflation has remained steady at 2.1%, which is basically the Fed’s long-term target. The cost of 10-year deflation floors in the market are at the lowest level since they began to trade in 2009 (see chart, source Bloomberg and BGC Partners – the price is in up-front basis points). So it isn’t a lingering fear of deflation that has the Fed concerned.
- The Fed speakers over the last month have had ample opportunity to shoot down the idea that taper would start at this meeting, which has been the consensus for a long time. None of them did so, implying that the Fed was comfortable with that consensus. But something changed in the last few days, and that is that the odds-on next Fed Chairman went from being Larry Summers to being Janet Yellen, who happened to be in the meeting today. Does this change the dynamic? Absolutely, since one reason Bernanke has started thinking and talking about tapering is so as to leave as clean a slate as possible so that the next Chairman wouldn’t have to start his term by tightening (sorry, I mean “reducing accommodation”) and scaring asset markets. Once Summers withdrew his name, Yellen’s vote got automatically much more important and the urgency to start the taper much less (since Yellen doesn’t believe there are any important costs to QE). Indeed, in his post-meeting presser Bernanke noted that the “first step” on a taper is “possible this year.” That is far to the dovish side of what the Street was expecting, but consistent with the notion that Yellen’s opinion will carry a heavy weight unless someone else is appointed to the post.
- Yellen said last June that the Fed’s objective is a quick return to full employment, and that Fed action might be justified “to insure against adverse shocks [emphasis mine],” or even if the Fed concludes that the recovery “is unlikely to proceed at a satisfactory pace.” So, perhaps I need to reconsider my point #1 above. Maybe that is the standard now.
- If in fact QE has no cost, then there is no reason to ever stop it. In fact, it should be accelerated. Most Fed officials seem recently to be coming to the realization that there is highly unlikely to be a costless economic remedy, even if they are not sure what the costs are or think they can be contained. Those people clearly have no voice any more, even though it appeared that those views in the last few months were gaining currency (no pun intended, since the dollar dropped to the lowest level since February after the announcement today – a Fed that was edging however slowly to being more-hawkish than average was good for the dollar; a weak, more-dovish than average central bank will be worse for the dollar all else equal). This is pedal-to-the-metal time.
- TIPS got a lot more expensive today, with the 10-year rallying 20bps to 0.475% and breakevens up 4.5bps one day before the Treasury auctions another slug of them. The auction ought still to go well, because caution has been thrown to the wind by our beloved central bankers. This is also good for commodities, and they rose today led by precious and industrial metals. Is it good for equities? Well…
- Equity analysts are like puppies. They completely forget what happened 5 minutes ago and every experience is brand new. There is never any context. So stocks shot higher today, with the S&P gaining 1.2%, because of the dovish Fed and lower interest rates. But over the last few months, as the taper grew closer and interest rates shot higher, all equities did was move to new highs. So, higher interest rates and a (relatively) hawkish Fed doesn’t hurt stock prices, but lower interest rates and a dovish Fed helps them? This may be why the Fed thinks that buying bonds keeps interest rates low and selling bonds doesn’t raise them. It’s a strange market-based notion of a perpetual motion machine. For goodness’ sake, let’s crank interest rates down 200bps, back up 200bps, down 200bps, and keep doing that and the stock market will be at 1,000,000 before you know it. Prosperity! But in fact it is probably more like a bicycle pump. Pushing down inflates the tire, pulling up doesn’t deflate it. It seems costless. However, if you keep doing that, eventually the tire will pop.
- Speaking of the perpetual motion machine, I enjoyed this little gem from the FOMC statement:
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative…
Really? It hasn’t worked recently. Lest they forget: the taper hadn’t started yet, but until today it was busy being discounted in the bond market. I don’t expect that merely continuing to buy bonds into the SOMA will push rates much lower again. We all know that this game ends, and we know how it ends. With 10-year notes at 2.70% I wouldn’t be selling them, but I also wouldn’t expect a massive rally to unfold. I would hold long positions in September and October, because those are the right months in which to hold bonds (especially with debt ceiling fight #2, Syria, Italy’s government disintegrating, and Germany’s election), but if the market gave me 2.45% to sell, I would sell.
 Note, though, that no person who has ever held the office of Fed Vice-Chairman has later been appointed to be Chairman…although Donald Kohn, since he was Vice-Chairman from 2006-2010, would also represent a departure from this same tradition. However, he was not in the room.
The great news today is that mortgage delinquencies dropped to their lowest level in five years. Look at the chart (source: Bloomberg)! Doesn’t it look great?
This was actually a bit surprising to me. With the Unemployment Rate doing about what it usually does in recoveries, and the economy adding something a bit shy of 200,000 new jobs per month, and with interest rates low and housing prices rising, you would think that delinquencies would have improved much more than they have.
Pretty much all of the delinquency data looks the same way. Here is a chart of new foreclosure actions as a (seasonally-adjusted) percentage of total loans.
Is this a symptom of the “part-time America” phenomenon, in which all of these new jobs are being generated as part-time work, so that the improvement in the lot of the average worker is not paralleling the improvement in the jobs or unemployment rate numbers? (I’m not disputing that such a phenomenon exists; in fact I think it does. I am asking whether this is a symptom of that, or if there is another cause?) In any event, it isn’t a very good sign, and is one reason that even once QE ends, the Fed will endeavor to keep rates low for a very long time.
By the way, it also makes me wonder whether the celebrated move of institutional investors into the private residential real estate market is having a smaller effect than many people think it is. If there were big players looking to buy bank REO on the offered side, then wouldn’t you think banks would be accelerating foreclosures and that the delinquencies would be dropping faster (as homeowners either get into the foreclosure process, whereupon they aren’t in the delinquency stats, or get serious about becoming current)? I don’t know the answer.
Here is a technical point for institutional investors in inflation-indexed bonds and/or swaps – something worth watching for.
There has been much concern in some quarters recently about the coming increase in demand for high-quality collateral to back swaps under Dodd-Frank regulations. One way this could manifest in the inflation markets is to narrow the spread between inflation “breakevens” and inflation swaps. As the chart below (Source: Enduring Investments) illustrates, the inflation swaps curve is always above the “breakeven” curve. In theory, both curves should be measuring the same thing: aggregate inflation expectations over some period.And, in fact, they do. But while the inflation swaps market is a relatively-pure measure of inflation expectations, breakevens have some idiosyncrasies that make them less useful for this purpose. Predominant among these idiosyncrasies is the fact that nominal Treasury bonds act in the market as if they are very, very good collateral and so often trade at “special” financing rates. That is, when you buy a Treasury bond you not only buy a stream of cash flows, but you pay a little extra for it since you can borrow against it at attractive rates sometimes (if you are an investor who does not utilize the bonds for collateral, then you are paying for this value for no reason). However, TIPS are much more likely to be “general” collateral, and to offer no special financing advantage. There is no fundamental reason for this: TIPS are Treasuries, and are just as valuable as collateral to post as margin as are nominal Treasuries. There just isn’t a deep short base, and the main owners of TIPS are inflation-linked bond funds that actively repo them out so that they are rarely in short supply. It is unusual, although no longer unprecedented, to see a TIPS issue trade special.
The consequence of this is that Treasury yields are lower than they would otherwise be, by the amount of the “specialness option,” and TIPS yields are not affected by the same phenomenon. Therefore, breakevens are lower than they would otherwise be.
If, in fact, there becomes a shortage of “good” collateral to use to post as swaps margin, one place I would expect that to show up would be in the TIPS market. I would expect that TIPS issues would begin to go on special more-frequently, and to start to behave like the good collateral they are. The consequence of that would be to cause TIPS yields to decline relative to nominal yields as they gain the “specialness option,”, and for breakevens to rise towards inflation swap levels. (As an aside, that would also cause TIPS asset swaps to richen of course).
As I said, this is a technical point and not something the non-institutional investor needs to worry about.
 I am bound to include this notice with any online use of the article: “This article was originally published in The Euromoney Derivatives & Risk Management Handbook 2008/09. For further information, please visit www.euromoney-yearbooks.com/handbooks.”
 Frankly, I need to update this paper and get it published, but the last time I submitted it I had one referee tell me “this is wrong” and the second referee said “this is obvious” so I decided in frustration to let it drift.
Before I descend into the mundane discussion of economies and markets, let me first congratulate the Duke and Duchess of Cambridge on the birth of their son. In watching the pictures of the royals leaving the hospital with their child, I was struck at the fact that when his wife passes off the child, Prince William looks as uncomfortable holding a baby as most first-time fathers are. He did, however, have more luck with the mechanics of the car seat…as, again, most new fathers do.
However, when he drives home, he won’t have to worry about the rising cost of housing, and probably doesn’t fret much about whether his child will be able to afford a comfortable life in an inflationary future. “Will my son be better off than I am?” is a question for non-royals!
I have no idea what the rents are for a Kensington Palace apartment, but I will bet they are rent-controlled. Meanwhile, housing prices in the U.S. continue to rise rapidly. Today’s announcement of the FHA Home Price Index suggested prices have risen 7.3% over the last year (the fourth month in a row over 7%), while the median price of a home in the Existing Home Sales report yesterday was 13.2% above the year-ago level (see chart).
Aside from inflation, however, where the future trajectory is clear, the performance of the economy is probably best characterized by the word “muddled” (thank you, John Mauldin). Last Thursday, the Philly Fed index was published at 19.8 – a two-year high – versus expectations for 8.0; on Monday the Chicago Fed index showed -0.13 versus expectations for flat, and today the Richmond Fed index was -11 (the second-worst since 2009) versus expectations for +9.
And, in the meantime, Microsoft (MSFT) and Google (GOOG) missed earnings badly and Detroit declared bankruptcy. Apple (AAPL) is just out with earnings and pulled the old trick of “beat on current earnings, match on revenues, but guide lower for next quarter.” The current consensus for Q2 GDP (the advance estimate is due out next week) is a mere 1.3%.
With all of this, equity prices are doing well with stocks up 5.4% for the month. Bond yields are fairly flat, with 10-year yields up 4bps from the end of June, but TIPS are doing relatively well (10y real yields -14bps; 10y breakevens +18bps). And even the DJ-UBS Commodity index is +4.3%. Gold is up nearly 10%.
Three weeks do not a turn in sentiment make, but I do find it interesting that real estate, inflation breakevens, gold, and commodities generally are all enjoying a renaissance right after inflation-linked bonds and commodities were buried in late June, with large outflows especially from TIPS funds (the shares outstanding of the TIP ETF went from 183 million at year-end, to 165 million in late May, to just 139 million now). It got so bad that my company reached out to customers in late June with a thorough explanation and presentation of why we thought the market was ‘getting it wrong.” Investors were throwing out the baby with the bathwater.
To be sure, I think real yields, breakevens, and nominal yields will eventually be much higher. But if nominal yields can simply avoid breaking higher for the next few weeks, I think the stage will be set for a fixed-income rally into September and October. As I have written before, in the aftermath of a convexity event such as we have just seen, a “cool down” period of a few weeks is usually necessary to work off the bad positions induced and trapped by the market’s sudden slide. Once these positions are worked off, I think the weak economic growth and weakening corporate internals will pressure stocks lower and the stock and bond markets will get back into some semblance of what static-equilibrium types think of as “fair value” relative to one another.
Even so, I think that commodities, breakevens, and even gold might have already seen the worst of their markets. In this suspicion I have been wrong before. Money velocity in Q2 will have declined further (probably to about 1.50 from 1.53 in Q1), but I think it will be higher – or at least not much lower – in Q3. And once velocity turns, time has run out. I am reminded of an old quote from Milton Friedman, from his book Money Mischief: Episodes in Monetary History.
“When the helicopter starts dropping money in a steady stream – or, more generally, when the quantity of money starts unexpectedly to rise more rapidly – it takes time for people to catch on to what is happening. Initially, they let actual balances exceed long-run desired balances, partly out of inertia; partly because they may take initial price rises as a harbinger of subsequent price declines, an anticipation that raises desired balances; and partly because the initial impact of increased money balances may be on output rather than on prices, which further raises desired balances. Then, as people catch on, prices must for a time rise even more rapidly, to undo an initial increase in real balances as well as to produce a long-run decline.” (p.36)
When this happens, stocks will take a beating. But it may be the final beating in this long, drawn out, secular bear. I guess it is far too early to say that, but I recently saw two news items that I have long been waiting for. The first is that CNBC is having ratings “issues,” and it is starting to get bad enough that the producers are thinking about “tinkering with primetime.” The second, which is clearly related, is that Maria Bartriromo is thinking of leaving business news to take her inestimable talents elsewhere.
As with commodities and inflation breakevens recently, a sine qua non for the start of a new bull market of substantial magnitude – not a 100% rally from the lows, but a 100% rally above the old highs – is that everyone stops thinking that stocks are smart and exciting investments, that they are “where it’s at,” and that all the cool people are buying stocks. And I have never been able to figure out how an environment sufficiently depressing to germinate a new bull market can occur if the cheerleaders are televised 24/7. Honestly, I had just about given up. While we still need cheap valuations and rotten sentiment to start a bull market (and we are very far from both of those standards in equities), a move towards general indifference among investors would be a good start.
 As the quote marks suggest, I don’t think that they will be right when you hear people declare that “stocks now offer good value relative to bonds again.” I think the people who use the “Fed model” tend to overprice stocks generally…and they tend to be much more diligent disciples of the model when yields are falling than when they are rising. When yields rise, they tend to say that stocks are better values than bonds because bond yields are going to rise, while when yields are low they tend to say that stocks are better values than bonds because of the current level of bond yields.
The beatings are continuing, and apparently morale really does improve with such treatment. Consumer Confidence for June vaulted to the highest level since early 2008, at 81.4 handily beating the 75.1 consensus. Both “present situation” and “expectations” advanced markedly, although the “Jobs Hard to Get” subindex barely budged. It is unclear what caused the sharp increase, since gasoline prices (one of the key drivers, along with employment) also didn’t move much and equity prices had been steadily gaining for some time. It may be that the rise in home prices is finally lifting the spirits of consumers, or it may be that credit is finally trickling down to the average consumer.
Whatever the cause, it is not likely to prevent the rise in money velocity that is likely under way, driven by the rise in interest rates. Between the rise in home prices – the Case-Shiller home price index rose a bubble-like 12.05% over the year ended April, and Existing Home Sales median prices have advanced a remarkable 14.1% faster than core inflation (a near record, as the chart below shows) over the year ended in May. (Lagged 18 months, such a performance suggests about a 3.9% rise in Owners’ Equivalent Rent for 2014).
The nonsense about deflation is incredible to me. Euro M2 growth hasn’t been this high (4.73% for year ended April) since August of 2009. Japanese M2 growth hasn’t been this rapid (3.4% for year ended May) since May 2002. US money supply is “only” growing at 6.5% or so, down from its highs but still far too fast for a sluggishly-growing economy to avoid inflation unless velocity continues to decline. But you don’t have to be a monetarist to be concerned about these things. You only need to be able to see home prices.
Core inflation in the US is being held down by core goods, as I have recently noted. In particular, CPI for Medical Care just recorded its lowest year-on-year rise since 1972, and Prescription Drugs (1.32% of CPI and an important part of core goods) declined on a y/y basis for the first time since 1973. The chart below (source: Bloomberg) illustrates that as recently as last August, that category was rising at a 4.0% pace.
Now, I suspect that this has something to do with Obamacare, but no one seems to know the full impact of the law. Keep in mind that Medical Care in CPI excludes government spending on medical care. So, one possible narrative is that the really sick people are leaving for Obamacare while the healthy people are continuing to consume non-governmental health care services. This would be a composition effect and would imply that we should start looking at CPI ex-medical for a cleaner view of general price trends. I have no idea if this is what is happening, but I am skeptical that prescription meds are about to decline in price for an extended period of time!
But that’s the bet: either core inflation is going to go up, driven by things like housing, or it’s going to go down, driven by things like prescription medication. Place your bets.
Equity prices recovered today, but bond prices continued to slide into the long, dark night. For a really incredible picture, look at the chart below (source: Bloomberg), which shows the multi-decade decline in 10-year yields on a log scale, culminating in the celebrated breakout below that channel. Incredibly, the recent selloff has yields back to the midpoint of the channel and not outrageously far from a breakout on the other side!
Incidentally, students of bond market history may be interested to know that the selloff has now reached the status of the worst ever bond market selloff (of 90 days or less) in percentage terms. Since May 2nd, 10-year yields have risen from 1.626% to 2.609%, a 98.3bp selloff which means that yields have risen 60.5% in less than two months.
And we are probably not done yet. I wrote about a month ago about the “convexity trade,” and I made the seemingly absurd remark that “This means the bond market is very vulnerable to a convexity trade to higher yields, especially once the ball gets rolling. The recent move to new high yields for the last 12 months could trigger such a phenomenon. If it does, then we will see 10-year note rates above 3% in fairly short order.”[emphasis in original] Incredibly, here we are with 10-year yields at 2.61%, up 60bps over the last month, and that statement doesn’t seem quite so crazy. As I said: I have seen it before! And indeed, the convexity trade is partly to blame for what we are seeing. I asked one old colleague today about convexity selling, and here was his response:
“massive – the REITs are forced deleveraging and there are other forced hands as well. The real money guys are too large and haven’t even sold yet – no liquidity for them. The muni market has basically crashed and at 5% yields in muni there is huge extension risk on a large amount of bonds: something like $750bln in bonds go from 10-year to 30-year maturities as you cross 5%.” (name withheld)
Now, I am not a muni expert so I have no idea what index it is I am waiting to see cross 5%. But the convexity trade is indeed happening.
Lots of bad things have happened to the market, but they really aren’t big bad things. In fact, I move that we stop using the term “perfect storm” to mean “modestly bad luck, but I had a lot of leverage.” The Fed was never going to be aggressively easy forever, and as various speakers have pointed out recently they didn’t exactly promise to be aggressively tightening any time soon. There is bad news on the inflation front, but the market is clearly not reacting to that. Some ETFs have had some liquidity issues, and emerging markets have tumbled, and there was a liquidity squeeze in China. But these are hardly end-of-the-world developments. What makes this a really bad month is the excess leverage, combined with the diminished risk appetite among primary dealers who have been warned against taking too much “proprietary risk.”
And markets are mispriced. Three-year inflation swaps imply that core inflation will be only 1.9% compounded for the next three years (the 1-year swap implied 1.6%; the 2y implies 1.75%). That is more than a little bit silly. While I have not been amazed that the convexity trade drove yields very high, and probably will drive them higher, it has surprised me that inflation swaps and inflation breakevens have continued to decline. Still, investors who paid heed to our admonition to be long breakevens rather than TIPS have done quite a bit better, as the chart below (source Bloomberg), normalized to February 25th (the date of one of our quarterly outlook pieces) illustrates.
As the bond selloff extends, I don’t think TIPS will continue to underperform nominal bonds. I believe breakevens, already at low levels (the 10-year breakeven, at 1.97%, is lower than any actual 10-year inflation experience since 1958-1968), will be hard to push much lower, especially in a rising-yield environment.
I have been quasi-vacationing this week on the Continent, and trying to follow the news and the markets. This will be a brief comment but I wanted to make a couple of quick notes:
1. I did not, and I still do not, understand why there was such a violent (and negative) reaction to the Fed’s statement and Bernanke’s suggestion that the “taper” may start later this year and end in mid-2014. There are all kinds of reasons not to freak out about that. First, it was approximately what was expected (although two weeks ago there were many who thought absurdly that the Fed would begin a taper at this meeting). Second, the taper is contingent on growth continuing to strengthen, and there are scant signs of that. Third, as Bullard showed today there is far from a consensus on whether Bernanke’s time frame is going to work out – and, while ordinarily the Fed Chairman’s vote is the only one that matters, in this case he is not going to be present for the end of the taper so what really matters is who is selected to replace him. Fourth, QE isn’t doing anything right now, except artificially depressing long Treasury yields. It is probably pressuring money supply growth, but not very much. The only thing that further QE will do is make the exit that much more difficult.
That said, the violent reactions to the Fed statement are prima facie evidence of what critics of the QE policy (me, for one) have always said: we have no idea how rates and markets will react when the Fed finishes and unwinds this policy, regardless of Bernanke’s assurances. The harsh reaction (quite a bit more than I expected, especially with such a tepid adjustment to the expected trajectory) is great evidence of how over-dependent the market is on the view that the Fed’s support makes losses extremely difficult. And, I will say again, this would be so much easier if the Fed wasn’t telegraphing everything, because then investors would have invested with much more caution. The reaction this week was partly due to the shock of actually hearing the Fed mention a date for the first time.
2. Speaking of investing with much more caution, the amazing stress in certain ETFs that has accompanied significant but not exactly dramatic moves in (for example) emerging markets should blare two huge lessons to investors. The first is that you can’t increase liquidity of a pool of assets by putting them in an ETF wrapper. A pile of illiquid securities, or securities that can become illiquid in a crisis, are not more liquid because you can get a quotation every second. An ETF consisting of emerging markets bonds is never going to be more liquid than the underlying emerging markets bonds (although it may be more granular, and there are other ETF advantages…but not liquidity). An ETF consisting of commodity futures, by contrast, will be tremendously liquid because the underlying commodity markets are tremendously liquid. The second lesson is more subtle, and that is that an ETF of less-liquid securities is, in a crisis, only as liquid as the least liquid element. If you present an ETF to me for redemption and there is 1% of it that I can’t get any bid on, then the best you’re going to get is a quote at 99% of the “fair” market price. And that is especially true these days, since dealers and market-makers are capital-constrained and can’t merely take those illiquid positions on the books.
3. There is a lot of dry tinder around in the world today, and never for a minute suppose that they are not related. Stress begets stress. Two million people protesting in Brazil are doing so partly because of economic stress. Tight money market rates in China (persistent since if the central bank adds too much liquidity it will cause the CNY to depreciate) is a partial consequence of economic stress. A return of Greece from the frying pan to the fire: economic stress. And so on. This is not a safer world for all of the QE.
4. Finally, remember that growth and inflation are not related in any meaningful way. Median home prices rose more than 15% over the last year according to a report this week, and not because of great economic results. Money velocity is rising with interest rates although we may not see the results for some months. Inflation, which got a boost in the US this week with a strong CPI report (see my brief comments here), surprised on the high side in the EU and UK. TIPS yields are at +0.56% in the 10-year sector and 10-year breakevens are at 1.92%. There is absolutely no reason to own Treasuries rather than TIPS at this point. The 10-year expected real return of stocks is now less than 1.5% per annum above 10-year TIPS, and there is absolutely no reason to own equities rather than TIPS. Are TIPS cheap on an absolute basis? No. But they are screamingly cheap on a relative basis in an environment of rising inflation (and nothing the central banks can do about it – at least those who aren’t actively trying to boost it). Long-time readers will know I have been tepid at best about TIPS for some time. But, while 0.56% isn’t ridiculously cheap (and they could still get there!), our models are already maxed out on breakeven exposure and are starting to add to outright long exposure in TIPS.