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Seasonal Allergies

October 14, 2014 8 comments

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

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

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

front_crude

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

10y_breaks

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

1ycpiswaps

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

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

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

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

seasonal

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

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

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

Why So Many Inflation Market Haters All of a Sudden?

September 25, 2014 6 comments

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.[1] 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.

beistocks

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.

realplusspx

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.

coreandgdptimeseries

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.

gdpcoreinflationregression

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).

USCPIHICPxt

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.

[1] 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.

Hot Button Issue: Rant Warning

We all have our hot button issues. It will not surprise you, probably, to learn that mine involves inflation. For the rant which follows, I apologize.

Reasonable people, smart people, learned people, can disagree on how precisely the Consumer Price Index captures the inflation in consumer prices. And indeed, over the one hundred years that the CPI has been published such disagreements have been played out among academics, politicians, labor leaders, and others. The debates have raged and many changes – some large, some small; some politically-driven, most not – have occurred in how prices have been collected and the index calculated. If you are interested, really interested, in the century-long history of the CPI, you can read a couple of histories here and here.

If someone is not interested in how CPI is calculated, in how and why changes were made in the methodological approach to calculating price change, then that’s fine. But if a person can’t spend the time to learn the very basics of this hundred-year debate, during which changes were made in the CPI with much public input, not in a smoky back room somewhere, then I wonder why such a person would spend time spewing conspiracy theories on the internet about how the CPI doesn’t include food and energy (um…it does), about how the CPI underestimates prices because it doesn’t account for changes in quality and quantity (um…it does), or about how sneaky methodological changes have caused the CPI to be understated by 7% per year for thirty years.

Recently, the CFA Institute’s monthly magazine for CFA Charterholders was duped into accepting an article that brings together some of the dumbest theories into one place. At some level, the article asks the “interesting” question about whether a consumer price index should include asset prices. Interesting, perhaps, but asked-and-answered: assets are not consumer goods but stores of value. If you are not consuming something, then why would you ever expect it to be included in a consumer price index? You might argue that we should include asset prices into some other sort of index that measures price increases. But we already do. They are called asset price indices, and you know them by names like the S&P 500, the NCREIF, and so on.

Worse, the magazine gives a great big stage to the person who has singlehandedly done more to confuse and anger people, to poison the well of knowledge about inflation, and to stir up the conspiracy theorists about inflation, than anyone else in the world – and all because he is selling an ‘analysis’ product to those people. I won’t mention his name here because I don’t want to advertise his product, but he claims that the CPI is understated by “about 7 percentage points each year.”

That this is being published in a magazine of the CFA Institute is almost enough for me to renounce my membership. It is offensively idiotic to claim that the CPI may be understated by 7% per year, and simple math (which CFA Charterholders were once required to be able to perform) can prove that. If inflation has risen at a pace of around 2.5% per year over the last 30 years, it implies the price level has risen about 110% (1.025^30-1). This seems more or less right. But if inflation had really been 9.5% per year, as claimed, then the cost of the average consumption basket would have risen about 1422% (1.095^30-1).

Can that be right? Well, Real Median Household Income, using the CPI to deflate nominal household income, has risen about 13% over the last 30 years. http://en.wikipedia.org/wiki/File:Median_US_household_income.png But if we use the 9.5%-per-year CPI number, then real median household income has actually fallen 84%. If this was true, we would be living in absolute Third-World squalor compared to how things were in the salad days of 1984. You don’t have to be an economist to know the difference between a slightly-better standard of living and one in which you can afford 1/6th of what you could previously afford. You just need a brain.

Any person who does even rudimentary research on the CPI – say, visiting http://www.inflationinfo.com and reading some of the hundreds of papers gathered there, or perusing the BLS website, or speaking with an actual inflation expert – cannot possibly think that this guy is anything other than a nut or a shill. It is a tragedy that the CFA Institute would publish such trash, and it tarnishes the CFA Institute brand. Let’s hope they publish an apologetic retraction in the next issue.

I also like to point out, when I am in rant mode over this (and, as an aside, let me thank the tolerant reader for allowing me to rant – this allows me to forever point people to this link when they bring up this guy), that if the CPI=9.5% number is right then you must also believe a bunch of other ridiculous things:

First: MIT is in on the conspiracy. The Billion Prices Project, which uses very different methodology from the BLS, figures inflation to be about the same as the BLS does. (Digressing for a bit, I think it’s also interesting that the BPP index has tracked Median CPI much better than headline CPI over the last year, when headline CPI has been dragged lower by one-off changes in medical care prices).

Second: Consumers consistently underestimate inflation, or else are serially optimistic about how it is likely to decline from 9.5% to something much lower. The University of Michigan survey of year-ahead inflation expectations – and every other consumer survey of inflation expectations – is much closer to reported inflation than to the shill’s numbers (see chart below, source Bloomberg). I’ve written elsewhere about why consumers might perceive slightly higher inflation than really occurs, but I cannot come up with a theory that explains why consumers would always say it’s much lower than what they are in fact seeing. Maybe we’re all stupid except for this guy with the website.

michinfl

Third, and related to the prior point: Investors who pour money into inflation-indexed bonds must be complete morons, because they are locking up money for ten years at what is “really” -9% real yields (meaning that they are surrendering 62% of the real purchasing power of their wealth, rather than spending it immediately). We don’t see this behavior in countries where it is known that the official index is manipulated. For example, we know that in Argentina the inflation data really is rigged, and in September of last year long-dated inflation-linked bonds in Argentina were showing real yields of more than 20%. In recent months, the government of Argentina has begun to release figures that are much more realistic and real yields have plunged to around 10% as investors are giving the data more credibility. The upshot is that we have bona fide evidence that investors will base their demanded real yields on the difference between the inflation index they are being paid on and the inflation they think they are actually seeing. The fact that we don’t see TIPS real yields around 6% or 7% is evidence that investors are either really stupid, or they believe the CPI is at least approximately right.

Fourth, and related to that point: if inflation has really being running at 9.5%, then every asset is a losing proposition. There is no way to protect yourself against inflation. You’re not really getting wealthy as you ride stocks higher; you’re only losing more slowly. Since there is no asset class that has returned 10% over a long period of time, we are all doomed. The money is all going away. Especially housing, and real goods like hard commodities – there is nothing you can do that is much worse than holding real stuff, which is only going up in price a couple of percent per year over time while inflation is (apparently) ravaging everything we know and love. There is no winning strategy. Of course, the good news is that it turns out that the U.S. government is being extremely fiscally responsible, with the real deficit falling by 5% or more every year. Right.

I really should not let this bother me. It is good for me, as an investor with a brain, when mindless zombie minions follow this guy and do dumb things in the market. But I can’t help it. The Internet could be a tool for great good, allowing people access to accurate, timely information and the opportunity to learn things that they couldn’t otherwise. It allows this author to come into your mailbox, or onto your screen, to try to educate or illuminate or amuse you. But there is also so much detritus, so much rubbish, so much terribly erroneous information out there that does real harm to those who consume it. And perhaps this is why I get so exercised about this issue: I absolutely believe that people have a right to say and to believe whatever they want, no matter how stupid or dangerous. I am simply aghast, and deeply saddened, that so many people are so credulous that they believe what they read, without critical thought of their own. Everyone has a right to his/her opinion, but they are not all equally valid. There is no FDA for the Internet, so snake-oil salesmen run rampant among their eager marks.

I want my readers to think. If you all agree with me, then I know you’re not all thinking! Look, it is perfectly reasonable to suggest that some minor improvements can be made to CPI. The number has been tweaked and improved for a hundred years, and it will be tweaked and improved some more in the future. It is in my opinion not reasonable to suppose that the number is completely made up and/or drastically incorrect. And that’s my opinion.

Categories: CPI, Good One, Rant, TIPS Tags: ,

Global cc: on a Note About Inflation Confusions

I haven’t written in a couple of weeks – a combination of quiet markets, and a lack of intersection between stuff that’s interesting to write about and my having time to write – but I thought I would “global cc” everyone on something I just wrote in a private email about some common misconceptions regarding the CPI:

A friend and longtime reader (name withheld) writes:

 

Mike,

I thought you might find these interesting….

davidstockmanscontracorner.com/memo-to-d…
davidstockmanscontracorner.com/inside-th…

 

My response is below:

Thanks. Unfortunately Stockman doesn’t understand what he’s talking about. He understands better than most, but then he starts saying how the BLS asks homeowners what their homes would rent for…which they do, but only to determine weights, every couple of years, not to determine OER. It says this very clear in a paper on the BLS website called “Treatment of Owner-Occupied Housing in the CPI:

“To obtain the expenditure weights for the market basket…Homeowners are asked the often-cited question:

If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?

This is the only place where the answers to this question is used; in determining the share of the market basket. We do not use this question in measuring the change in the price of shelter services.”

For that purpose – calculating inflation itself – a survey of actual rents is used. I can understand how the casual observer doesn’t ‘get’ this, but there’s no excuse for Stockman not to know, especially if he is railing about the CPI…he should take some time to understand its main piece.

In short, Stockman writes a good populist screed, but he avoids the main questions:

1. Is headline inflation a better predictor of future inflation than core inflation? Answer: No, even if we can now realize that the rise in energy prices was a permanent feature of the decade ended in 2010, it tells us exactly nothing about whether those are likely to persist. The Fed uses core CPI not because they don’t think people use cars (whenever a columnist uses that silly argument, I know they’re just writing to please a certain audience), but because core CPI is persistent statistically in a way that headline is not. In fact, some Fed statisticians prefer median, or trimmed-mean, neither of which proscribes any particular category. So whining about how the Fed doesn’t include the particular brand of inflation that concerns you misunderstands how and why policymakers actually use measures of inflation in policymaking.

2. Suppose the CPI represents a miserable mis-estimation of actual inflation. Then, pray tell, why does a trillion-dollar market based on that index get priced as if it is accurate? In Argentina, where the inflation numbers are made up, the inflation-linked bonds trade very cheap because they will pay off in a number that is assumed to be too low. And the bond yields are too high by roughly the amount that inflation is assumed to be understated in the future. Markets are efficient, especially big markets. How did the Fed manage to convince at least $1T in private money to misprice the bond market?

3. If the CPI is so wrong, so manipulated, then why to measures of inflation that the government has nothing to do with, like the Billion Prices Project, come up with the same number?

It’s nice that Stockman has a following. And he’s gotten the following partly by ranting about a number people love to hate. That gets him read, but it doesn’t make him right.

Categories: CPI, Good One, Quick One, TIPS Tags: , ,

Ex-Communication Policy

March 19, 2014 6 comments

Well, I guess it would be hard to have a clearer sign that investors are over their skis than to have the Fed drop the portion of their communique that was most-binding – in a move that was fully anticipated by almost everyone and telegraphed ahead of time by NY Fed President Dudley – and watch markets decline anyway.

To be sure, the stock market didn’t exactly plunge, but bonds took a serious hit and TIPS were smacked even worse. TIPS were mainly under pressure because there is an auction scheduled for tomorrow and it was dangerous to set up prior to the Fed meeting, not because there was something secretly hawkish about the Fed’s statement. Indeed, they took pains to say that “a highly accommodative stance of monetary policy remains appropriate,” and apparently they desire for policy to remain highly accommodative for longer relative to the unemployment threshold than they had previously expressed.

The next Fed tightening (let us pretend for a moment that the taper is not a tightening – it obviously is, but let’s pretend that we’re only talking about overnight interest rates) was never tied to a calendar, and it would be ridiculous to do so. But it seems that maybe some investors had fallen in love with the idea that the Fed would keep rates at zero throughout 2015 regardless of how strong or how weak the economy was at that time, so that when the Fed’s members projected that rates might reach 1% by the end of 2015 – be still, my heart! – these investors had a conniption.

Now, I fully expect the Fed to tighten too little, and too late. I also expect that economic growth will be sufficiently weak that we won’t see interest rates rise in 2015 despite inflation readings that will be borderline problematic at that time. But that view is predicated on my view of the economy and my assessment of the FOMC members’ spines, not on something they said. You should largely ignore any Fed communication unless it regards the very next meeting. They don’t know any better than you do what the economy is going to be doing by then. If they did, they would only need one meeting a year rather than eight. Focus on what the economy is likely to be doing, and you’ll probably be right more often than they are.

Arguably, this was not the right theory when the Fed was simply pinning rates far from the free-market level, but as the Fed’s boot comes off the market’s throat we can start acting like investors again rather than a blind, sycophantic robot army of CNBC-watching stock-buying machines.

Now, I said above that “the stock market didn’t exactly plunge,” and that is true. On the statement, it dropped a mere 0.3% or so. The market later set back as much as 1%, with bonds taking additional damage, when Chairman Yellen said that “considerable period” (as in “a considerable period between the end of QE and the first rate increase) might mean six months.

Does that tell you anything about the staying power of equity investors, that a nuance of six months rather than, say, nine or twelve months of low rates, causes the market to spill 1%? There are a lot of people in the market today who don’t look to own companies, but rather look to rent them. And a short-term rental, at that, and even then only because they are renting them with money borrowed cheaply. For the market’s exquisite rally to unravel, we don’t need the Fed to actually raise rates; we need markets to begin to discount higher rates. And this, they seem to be doing. Watch carefully if 10-year TIPS rates get back above 0.80% – the December peak – and look for higher ground if those real yields exceed 1%. We’re at 0.60% right now.

Stocks will probably bounce over the next few days as Fed speakers try and downplay the importance of the statement and of Yellen’s press conference remarks (rhetorical question: how effective is a communication strategy if you have to re-explain what you were communicating)? If they do not bounce, that ought also to be taken as a bad sign. Of course, I continue to believe that there are many more paths leading to bad outcomes for equities (and bonds!) than there are paths leading to good outcomes. Meanwhile, commodity markets were roughly unchanged in aggregate today…

Do Floating-Rate Notes (FRNs) Protect Against Inflation?

February 1, 2014 Leave a comment

Since the Treasury this week auctioned floating-rate notes (FRNs) for the first time, it seems that it is probably the right time for a brief discussion of whether FRNs protect against inflation.

The short answer is that FRNs protect against inflation slightly more than fixed-rate bonds, but not nearly as well as true TIPS-style bonds. This also goes, incidentally, for CPI-linked floaters that pay back par at maturity.

However, there are a number of advisors who advocate FRNs as an inflation hedge; my purpose here is to illustrate why this is not correct.

There are reasonable-sounding arguments to be made about the utility of FRNs as an inflation hedge. Where central bankers employ a Taylor-Rule-based approach, it is plausible to argue that short rates ought to be made to track inflation fairly explicitly, and even to outperform when inflation is rising as policymakers seek to establish positive real rates. And indeed, history shows this to be the case as LIBOR tracks CPI with some reasonable fidelity (the correlation between month-end 3m Libor and contemporaneous Y/Y CPI is 0.59 since 1985, see chart below, data sourced from Bloomberg).

liborcpi

It bears noting that the correlation of Libor with forward-looking inflation is not as strong, but these are still reasonable correlations for financial markets.

The correlation between inflation and T-Bills has a much longer history, and a higher correlation (0.69) as a result of tracking well through the ‘80s inflation (see chart below, source Bloomberg and Economagic.com).

tbillscpi

And, of course, the contemporaneous correlation of CPI to itself, if we are thinking about CPI-linked bonds, is 1.0 although the more-relevant correlation, given the lags involved with the way CPI floaters are structured, of last year’s CPI to next year’s CPI is only 0.63.

Still, these are good correlations, and might lead you to argue that FRNs are likely good hedges for inflation. Simulations of LIBOR-based bonds compared to inflation outcomes also appear to support the conclusion that these bonds are suitable alternatives to inflation-linked bonds (ILBs) like TIPS. I simulated the performance of two 10-year bonds:

Bond 1: Pays 1y Libor+100, 10y swaps at 2.5%.

Bond 2: Pays an annual TIPS-style coupon of 1.5%, with expected inflation at 2.0%.

Note that both bonds have an a priori expected nominal return of 3.5%, and an a priori expected real return of 1.5%.

I generated 250 random paths for inflation and correlated LIBOR outcomes. I took normalized inflation volatility to be 1.0%, in line with current markets for 10-year caps, and normalized LIBOR volatility to be 1.0% (about 6.25bp/day but it doesn’t make sense to be less than inflation, if LIBOR isn’t pegged anyway) with a correlation of 0.7, with means of 2% for expected inflation and 2.5% for expected LIBOR and no memory. For each path, I calculated the IRR of both bonds, and the results of this simulation are shown in the chart below.

nominalcorrs

You can see that the simulation produced a chart that seems to suggest that the nominal internal rates of return of nominal bonds and of inflation-linked bonds (like TIPS) are highly correlated, with a mean of about 3.5% in each case and a correlation of about 0.7 (which is the same as an r-squared, indicated on the chart, of 0.49).

Plugged into a mean-variance optimization routine, the allocation to one or the other will be largely influenced by the correlation of the particular bond returns with other parts of the investor’s portfolio. It should also be noted that the LIBOR-based bond may be more liquid in some cases than the TIPS-style bond, and that there may be opportunities for credit alpha if the analyst can select issuers that are trading at spreads which more than compensate for expected default losses.

The analysis so far certainly appears to validate the hypothesis that LIBOR bonds are nearly-equivalent inflation hedges, and perhaps even superior in certain ways, to explicitly indexed bonds. The simulation seems to suggest that LIBOR bonds should behave quite similarly to inflation-linked bonds. Since we know that inflation-linked bonds are good inflation hedges, it follows (or does it?) that FRNs are good inflation hedges, and so they are a reasonable substitute for TIPS. Right?

However, we are missing a crucial part of the story. Investors do not, in fact, seek to maximize nominal returns subject to limiting nominal risks, but rather seek to maximize real return subject to limiting real risks.[1]

If we run the same simulation, but this time calculate the Real IRRs, rather than the nominal IRRs, a very different picture emerges. It is summarized in the chart below.

realirrs

The simulation produced the assumed equivalent average real returns of 1.5% for both the LIBOR bond and the TIPS-style bond. But the real story here is the relative variance. The TIPS-style bond had zero variance around the expected return, while the LIBOR bond had a non-zero variance. When these characteristics are fed into a mean-variance optimizer, the TIPS-style bond is likely to completely dominate the LIBOR bond as long as the investor isn’t risk-seeking. This significantly raises the hurdle for the expected return required if an investor is going to include LIBOR-based bonds in an inflation-aware portfolio.

So what is happening here? The problem is that while the coupons in this case are both roughly inflation-protected, since LIBOR (it is assumed) is highly correlated to inflation, there is a serious difference in the value of the capital returned at the maturity of the bond. In one case, the principal is fully inflation-protected: if there has been 25% inflation, then the inflation-linked bond will return $125 on an initial $100 investment. But the LIBOR-based bond in this case, and in all other cases, returns only $100. That $100 is worth, in real terms, a widely varying amount (I should note that the only reason the real IRR of the LIBOR-based bond is as constrained as it appears to be in this simulation is because I gave the process no memory – that is, I can’t get a 5% compounded inflation rate, but will usually get something close to the 2% assumed figure. So, in reality, the performance in real terms of a LIBOR bond is going to be even more variable than this simulation suggests.

The resolution of the conundrum is, therefore, this: if you have a floating rate annuity, with no terminal value, then that is passably decent protection for an inflation-linked annuity. But as soon as you add the principal paid at maturity, the TIPS-style bond dominates a similar LIBOR bond. “Hooray! I got a 15% coupon! Boo! That means my principal is worth 15% less!”

The moral of the story is that if your advisor doesn’t understand this nuance, they don’t understand how inflation operates on nominal values in an investor’s portfolio. I am sorry if that sounds harsh, but what is even worse than the fact that so many advisors don’t know this is that many of those advisors don’t know that they don’t know it!


[1] N.b. Of course, they seek to maximize after-tax real returns and risks, but since the tax treatments of ILBs and Libor floaters are essentially identical we can abstract from this detail.

RE-BLOG: Groucho And Holiday Inn Express

December 17, 2013 1 comment

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.

I hope you like 2%, because that’s what you’re gettin’.

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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Categories: Good One, TIPS
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