Archive
Telling Stories About TIPS
It always bugs me a bit when a market event that happens for one cause is attributed to another cause merely to advance an easy narrative. The awful 5y TIPS auction yesterday and subsequent flush of TIPS breakevens is being attributed to a “fading of inflation concerns.” There may be some fading of inflation concerns, although as I demonstrated in my last article expectations for core inflation haven’t been fading.
But the main reasons the auction failed were far simpler. Prime among these is that the 5-year TIPS have always had more problems being sold, because people who want inflation protection tend to primarily want long inflation protection. In the last couple of years, I’ve had discussions with many institutional investors who expressed interest when I discussed a 50-year inflation-linked bond. But the 5y TIPS are mainly of interest to (a) indexers and (b) foreign central banks. As such, they are prone to occasional disasters when the central banks don’t show up, dealer risk-taking appetite is low, and market momentum is such that dealers don’t feel like warehousing the auction risk until the indexes are rebalanced at month-end and the indexers come for the paper. This isn’t to say that I expected this to be a bad auction, because the last few auctions of all kinds have been pretty normal (that is, more like normal Treasury auctions than like TIPS auctions of old). But it’s not surprising to me that it happened. And it has nothing to do with inflation fears fading, except that some buyers perhaps figured they could buy at better levels later because of the market narrative about inflation fears fading.
And today, we’re seeing a big bounce-back in breakevens so far. What does that do to the narrative?
(As an aside, and for disclosure, our Fisher model identified TIPS as exceptionally cheap compared with nominal bonds after the auction and went fully long breakevens on the close.)
Preparedness
The sine qua non for a disaster is that no one is worrying about the disaster. Earthquakes are less damaging in Tokyo than the same earthquake would be in New York, because in Tokyo buildings are designed to be earthquake-resistant. This is also true in markets; if investors are guarded about purchasing equities because of all the bad things that can happen, then prices of equities will be very low and it will be difficult to effect a true crash in such a circumstance.
The opposite doesn’t necessarily follow in the physical world (if you don’t prepare for an earthquake, it doesn’t increase…so far as we know…the probability of it happening), but it occasionally does in the financial world. I pointed out in January the work by Arnott and Wu which indicates that a company which enjoys “top dog status” in terms of having the greatest market capitalization in its sector tends to underperform the average company in the market by 5% per year for a decade. This is largely because investors in such companies are not prepared for adverse surprises, so that any such surprises tend to be taken poorly. Similarly, problems in Cyprus had an outsized effect on markets because (remarkably) no one was prepared for there to be problems in Cyprus that the rest of the Eurozone wouldn’t simply write a check to cover.
By this standard, inflation is growing more dangerous by the day, as more and more investors and pundits start talking – incredibly – about deflation. St. Louis Federal Reserve President Bullard today told an audience at the Hyman Minsky Conference in New York that it is “too early” to worry about deflation. That statement must hit most readers of this column as hysterically funny, given how many readers typically complain that the CPI is far lower than their personal experience of inflation. Bullard also noted that he favors an increase in the pace of QE if inflation falls further. Since core inflation is currently at 1.9%, Bullard is essentially putting a floor on inflation near where we once thought the ceiling was.
I read somewhere today that the recent declines in copper and gold are “signs of deflation.” I disagree. At best, they are signs of fears of deflation, right? But even that, I don’t buy. While breakevens in the TIPS market have declined recently, they are still not particularly low by any historical standard (see chart of 10y BEI, source Bloomberg). Moreover, a not-insignificant part of that decline represents a direct response to energy’s retracement and isn’t a reaction to a softer opinion about core inflation.
In fact, the core inflation implied by the 1-year inflation swap, once energy is extracted, is above the current level of core inflation and near the highs that have been seen since early 2011 (see chart, source Enduring Investments).
So I suspect, rather, that the causality runs the other way: the decline in copper and gold has caused an increase in chatter and vocal concern about deflation. But the people who are investing directly on whether deflation will happen aren’t seeing it. This is somewhat comforting, as it’s the people with actual money (rather than pundits and economists) who determine whether their institutions are ready.
Now, to the extent that the increased chatter actually leads to renewed relaxation in inflation expectations (ex-energy), it sets the stage for worse damage when it inevitably happens. Inflation, like earthquakes, is more injurious when societal institutions have not prepared for it. Median inflation in the U.S. over the last decade is about 2.5%. But in South Africa, it is 5.7%. In the U.S., a 5.7% inflation rate would cause major havoc, but South Africans would be amused at that since they deal every day with that pace of price change (as did Americans, in the 1980s). In Turkey, median inflation has been about 9.5%, but there again the society has adapted to it. To the extent that there is any fear in the U.S. about inflation rising to 5% or to 10%, institutions will prepare for it, and they will eventually learn to deal with it. It’s the shift to that new reality that can be especially painful.
The rest of the week has only minor economic data releases, with the Philly Fed report on Thursday (Consensus: 3.0 vs 2.0 last) the most important of them. A few Fed speakers will be on the tape. But the real market concern is concern in the market: the VIX has risen to 16.5 after having receded slightly on Tuesday; the dollar today retraced all of Tuesday’s decline and then some. Gold and commodities have not fallen further after the washout on Monday, but neither have they rejected the lower levels and rallied back. The S&P has support at 1540 or so but below that level there could be a substantial further fall. All of these markets have potential for important moves, and in the meantime there is the potential for renewed headlines out of Cyprus where there is consternation over the new demands from the EU. The trader in me would guess (stress: guess) at further weakness in equities, an attempt made by energy markets to hold near these levels, a halting rally into resting sell orders in precious metals markets, steady nominal bond markets but with some rebound higher in long breakevens. But here are the problems: (1) these are all connected – so I could easily miss on every one of these guesses; (2) any big move will affect sentiment on the others, so that there are copious feedback loops; (3) much of what happens will depend on the next quantum of news to hit the screens, and (4) Wall Street is less and less in a position to take risk and maintain orderly markets, as it has in the past. We might even simply tread water into the weekend and take our volatility on Monday. But I’m fairly convinced that more volatility is coming before markets calm down again.
But that’s not a problem, if you’re prepared for it!
.
Do you want to discuss any of this with me directly? To sign up for my free office hours, click here and pick a date and time.
Big Trade, Little Door
In ordinary times, the terrorist attack at the finish line of the Boston Marathon (officials are being careful not to call it “terrorism,” but I’m not an official so I can operate in the reality sphere) would absolutely trump anything that happened in the markets today and, in fact, would likely have been the cause of any market movement that actually occurred. That’s because most of the time markets echo the framework of the rest of reality: most of the universe is space, and most market activity is just empty noise.
This is the reason that traders who are continuously transacting in the markets are called “noise traders.”
But on Monday, there was plenty of market action and it had nothing to do with Boston, nor with the slightly-earlier ultimatum from North Korea to South Korea, which stated that military action would “start immediately.” (N.b.: There were many losers today, but one of them surely must be reckoned as Kim Jong-un. A tin-pot dictator makes a threat, and is almost immediately knocked off the front page of the New York Times by events in Boston. That must really annoy him.)
Before the attack in Boston, however, there was already plenty of financial pain. The carnage in the precious metals pits came right on cue after the negative sell-side reports of late last week had a chance to work on the psyches of investors. Gold fell 10%, and silver nearly 14%. This represents the worst two-day fall in gold in thirty years. And, while yesterday I pointed out that the commodity “super-cycle” certainly doesn’t look like one, I can understand how the picture of gold in real terms looks like it may be completing something big (see chart of gold expressed in December 2012 dollars using CPI, source Bloomberg).
There is considerable concern tonight that these losses may provoke selling in related markets as investors raise funds to meet margin calls. This is possible, although significant thumpings in the past in precious metals (it isn’t like this is the first time we’ve seen volatility in a commodity) didn’t provoke dramatic related-market action. To be sure, the avalanche is much more loaded now than it has been in the past, with equity markets sharply overvalued and investors already reaching a level of disgust with commodities. But I don’t think it goes too far. (Those may be my famous last words!)
What happened in gold and silver is a function of the big trade/little door syndrome, more than anything else. News outlets blamed the weak data yesterday in the U.S. and the small miss in Chinese GDP (7.7% versus 8.0% expected, but keep in mind that we all know these are made-up numbers) for setting off the wave of selling, but that’s just the latest straw. The break of technical levels on Friday, combined with the suddenly-burning desire of hedgies to not be the last one through the little door, is what led to such a dramatic move today. It may well continue until everyone who wants to get through the little door has done so. Or, it may not – but I would admonish an investor who wants to buy gold here to think like a trader rather than a playground monitor: don’t try to break up the fight. If the hedgies want to eat each other in a fight to get to the door, let them.
And, incidentally, remember that the big trade/little door syndrome is not limited to gold and silver. Think about equity exposures too. If you’re long by policy, fine. But if you’re long stocks and feeling uncomfortable about it, then “sell down to the sleeping point” at least.
The irony of the timing of the gold rout is potentially juicy, with CPI tomorrow. The decline in precious metals is happening partly because so many investors are abruptly convinced that inflation has truly been defeated. It is incredible to me that this belief is so widespread, but perhaps this is the sine qua non for the next washout in financial markets and the setup for the long-awaited up-move in commodities (for, although the “super-cycle” is evidently just now ending according to some observers, commodities prices have been in general decline for the last two years).
Growth is falling short of expectations, but that doesn’t have any implications for inflation. Tomorrow’s CPI is forecast to be flat and +0.2% on core, holding core inflation constant at 2.0%. Sentiment appears to be favoring a shortfall in those figures, but it is my belief that we are on the cusp of the next sustained move higher in core inflation, to be led by housing. Remember that the last two CPI figures haven’t exactly been soothing. Two months ago, core inflation was +0.3% when the market was expecting +0.2%. Last month, all eight major subgroups of CPI accelerated on a year-on-year basis, the first time that has ever happened since the current 8 subgroups have been in existence. I am loathe to pick the month where we’re going to see Owners’ Equivalent Rent finally break higher, because econometric lags are not written in stone. But it ought to be soon.
When it happens, expect sell-side economists and pundits of all stripes, to say nothing of the Federal Reserve, to downplay the significance of it. I wouldn’t expect a sudden rally in commodities or a rebound in breakevens (10-year breakevens are at the lows of the year, mainly because rates on the whole are declining – 10y TIPS yields are also within 3bps of the year’s low), but it might help stop the bleeding.
Breaking Open the Piggy Bank
We have one month in the books in 2013 already; my, how time flies when you’re having fun! But the fun may not last much longer.
I have spent lots of time, over the last year, answering the question “why hasn’t inflation responded to QE?” My response has been that it has: core inflation rose from 0.6% to 2.3% from October 2010 to January 2012, rising for a record-tying fifteen consecutive months – a feat that last happened in 1973-74, as official prices adjusted to catch up for being frozen during wage and price controls. By a bunch of measures, that was an acceleration of core inflation that was unprecedented in modern U.S. economic history. As I wrote at the time (in “Inflation: As ‘Contained’ As An Arrow From A Bow“), the only reason to defer panic was that Housing inflation was overdue to level out and decelerate. Fortunately, it did.
But, as I’ve written extensively recently, that blessing has been rescinded and the question of “why hasn’t inflation responded to QE” will shortly be moot. In the next couple of months, core inflation will begin to re-accelerate, driven by the pass-through of rising home prices into rents. In our view, the best we can hope for is that core inflation only reaches 2.6% this year. Absent a change from the historical relationship between home prices and rents, some 40% of the core consumption basket is going to be rising at 3.5% or better by late this year.
So, when will markets get a whiff of this?
We are primarily motivated by valuations, and we are patient investors. Moreover, we think it makes more sense to focus effort on valuation work, because if your valuation work isn’t pretty good then timing isn’t going to matter much. But nevertheless, it is helpful to look for signs and signals that indicate time may be drawing short. So I’d like to go all ‘techie’ for a few minutes and show three charts that suggest markets are preparing for a new, higher-inflation reality.
The first one is the dollar index (see chart, source Bloomberg). This one is interesting, because I am not convinced that U.S. QE will cause a uniquely American inflation. After all, everybody’s doing it. This chart is technically of a head-and-shoulders pattern, but I’m just pointing to that trendline that keeps bringing in buyers.
A break below the current level (and as a trader, I’d be tentative until the September lows broke as well) projects to a test of the bottom end of a much bigger consolidation pattern that has been forming since the beginning of the crisis in 2008 (see next chart, source Bloomberg – the green oval is the area of detail in the prior chart). Below there be dragons.
Now, at the same time we have inflation breakevens (the compensation, in nominal bonds, for expected inflation – represented as the raw spread between the Treasury yield and the TIPS real yield). I’ve shown this uptrend in breakevens and/or inflation swaps in a number of ways recently, but the chart below (source: Bloomberg) shows a long-term view. In the last three months, the 5-year breakeven has risen about 35bps (and you get a similar picture from inflation swaps, but the data isn’t as clean that far back). Right now, bond investors are demanding a fairly high level of expected inflation compensation over TIPS and their guaranteed return of actual inflation. We’ve got a ways to go before we hit all-time highs on the 5y BEI, but the 10-year BEI is only about 22bps away from all-time highs.
Those prior charts haven’t yet broken out, and so while the timer is buzzing the alarm might ultimately not be set off. But in commodities, there are some interesting signs that the lows may be in even though sentiment remains very negative. The chart below (source: Bloomberg) illustrates that in January, the DJ-UBS commodity index gapped through trendline resistance not once, but twice.
In my experience, technical analysis of commodity indices is a fraught exercise, but commodities have quietly been doing quite well lately. Although the S&P rose 5% in January to only 2.4% for the DJ-UBS, that’s mostly due to the first trading day of the year. Since January 9th, the DJ-UBS is +3.7% while the total return of the S&P is only +2.6%. Surprised?
Now, the conventional wisdom is that stocks are a great place to hide if there is inflation. That conventional wisdom is wrong. Stocks may do okay if starting from modest valuations, but a rise of inflationary concerns (especially if accompanied by rising interest rates) while stocks are at high valuations would likely be less than generous to equity investors.
So, of course, retail investors have been breaking their piggy banks open to rush into stocks, in a rush not seen for many years. It is tragic, but it is the natural result of the Fed’s misguided[1] crusade to stimulate the economy via the portfolio balance channel (see my discussion and illustration of this topic here). Where does the retail investor turn, when he sees rising gasoline prices, rising home prices, and a shrinking paycheck due to higher withholding rates? The television is telling him that it’s time to jump aboard the equity train. Although he has been prudently suspicious of equity markets for much of the last decade, he is also aware that the cash he has in the bank is evaporating in real value.
And perhaps that’s why total savings deposits at all depository institutions (the main component of non-M1 M2) has fallen more in the last two weeks than in any two-week period…ever. About $115bln has fled from savings accounts in the last fortnight. Now, that’s a volatile series, and it might mean nothing unless we happened to see it show up somewhere.
Like, perhaps, here?
The chart above (source: ICI, via Bloomberg) shows the net new cash flows into equity funds, which just happen to be at the highest level over the past three weeks (about $30bln) of any time during the period of data available on Bloomberg.
Again, it isn’t because the future suddenly looks bright. Initial Claims today was 368k, above expectations and unfortunately putting a big dent in the notion that the ‘Claims data over the last few weeks was signaling a meaningful shift in the rate of new claims. The number is probably still going to go lower, but it is likely to be a drift, not a break. And we will see a similar story tomorrow, probably, when the Payrolls figure (Consensus: 165k) and Unemployment Rate (Consensus: 7.8%, but I think it might tick up to 7.9%) will paint the same sort of picture. No, people are not reaching for their wallets to invest in stocks because they are suddenly flush. More likely, it’s because they’re frustrated and confused; they feel they’re being left behind. Perhaps there is a bit of desperation, if retirement is getting further away as the cost of retirement rises and take-home pay stagnates.
In any event, what you do not want to see, four years and 125% above the S&P lows, is people taking money out of savings to put into stocks. If you are not one of the people putting money in, then consider being one of the people taking your profits out – and looking to those markets that actually do tend to keep up or outperform inflation. I hasten to remind readers that they don’t ring a bell at the top of the market, and so one ought to be careful to rely too much on the “signs” and “timing signals” suggested above. But the sharp-pencil work suggests that core inflation is going to head back up in the next 2-3 months; in my opinion, you don’t necessarily need signs to position for that – you need excuses.
.
[1] One is tempted to say ‘evil,’ but I don’t believe the Fed actually is anticipating the pain they are likely to cause to the little guy. Indeed, they may believe that the impact of their actions may fall disproportionally on the rich: an economist at the Federal Reserve Bank of St. Louis recently co-published a paper entitled “Understanding the Distributional Impact of Long-Run Inflation,” which concludes in part that “When money is the only asset, a faster rate of monetary expansion acts as a progressive tax that lowers wealth inequality; when bonds can be traded, wealth inequality is less affected by inflation because the rich hold more illiquid portfolios than the poor.” [emphasis added]
Option-Like Payoffs
It seems we have a lot of option-like payoffs looming in the next few months.
By that I mean that we have a number of events that are likely to result in either-or (binary) outcomes. Think of them as options that are going to either finish in the money or out of the money. For example, either President Obama will win re-election, or he won’t. Either the Bush tax rates will be extended, or they won’t.
Those two are truly option-like, in that they also have a fixed maturity. We will know in 33 days who the President for the next four years will be. While the Bush tax rates could always be extended retroactively to cover 2013 even if it takes until February to hammer out an agreement so that can happen, the deadline to make transactions that put income or capital gains into 2012 rather than 2013 is December 31st.
Now, what we know about options is that as you get closer to expiry and are “near the money,” your gamma increases. Gamma is a measure of how quickly the option’s delta changes – how quickly you go from feeling like a likely winner to a sure loser. An example will help. If you own $660 call options on AAPL (closing price today $666.80), and they expire in a year, then it’s probably roughly a coin flip whether those calls will end up in the money or not.[1] We would say the delta is about 0.5. If AAPL sells off to $650, then looking one year out it’s still probably pretty close to a coin flip – obviously slightly less likely, but not a bunch. Maybe 0.49 is your delta, meaning that you have something like a 1% worse chance of ending up in-the-money.
But if, on the other hand, the options are expiring at 4pm today, then your $660 call is looking pretty good when the stock is trading at $666.80 at 2pm. Your delta might be 0.95. But when, by 3pm, the stock drops to $650, your chances of winning have declined dramatically. Your delta is perhaps 0.02. Because these odds move much more dramatically, we say this option has more gamma. This is a function of both the time to maturity and the nearness of the strike to the current price.
Option traders, who try to manage their risk by delta-hedging an option, like gamma a lot if they’re long options, and dislike it immensely if they’re short options.[2] That’s because if they’re short, the hedge involves them buying into strength (aka “buy high”) and selling into weakness (aka “sell low”), and often leads to frenetic trading and on occasion, serious moves on expiry day.
Where am I going with this? An observation: as we get closer to these “option events,” if they are still not resolved one way or the other the markets will likely grow more volatile. Consider what happens to an equity investor thinking about the ‘fiscal cliff’ as year-end approaches and no deal has been struck on taxes. The investor is going to be increasingly concerned about selling stocks in which he has gains, to book those gains in 2012 in case the tax rates go up a lot. If it appears that Congress is starting to resolve some issues, then this selling pressure may relent and the markets rebound. This could go back and forth as often as the headlines change, and I will tell you that those headlines will get more frequent as the deadline draws nearer. This implies to me that market volatility will probably increase as we get closer to the election, and as we move into year-end, because of these option-like events.
There are other option-like events, although less certain in timing (Israel attacks Iran, or not. Spain asks for aid and gets it, or not. Greece defaults, or not). These will have less obvious “gamma effects,” although as long as in each case they have at least two plausible outcomes that could well happen, it will tend to contribute to volatility.
In other words, with the VIX is near the lows for the year options seem inexpensive to me.
I’m having these thoughts today because I’m watching the wild gyrations in gasoline, which was -12 cents at Wednesday’s lows (finishing -7 cents) and +14 cents today. November gas covered nearly the entire 2-month range in 2 days’ trading. More near to my heart, inflation breakevens have spiked for the last few days (+8bps today) after spending half of September retracing from a spike to touch all-time wides (see chart, source Bloomberg).
Note that this is the ten year breakeven, so it isn’t reacting here just to gasoline. And I am not aware that the outlook for growth has changed dramatically this week, nor any major money metric. What is going on? My only guess at the moment is: gamma. Small things, like a win for the Republican challenger in last night’s debate, can cause big changes in expectations, and this will become even more true as long as the race stays tight.
If we look at just that market, we could also mull the technical issues. A market that spikes to all-time highs is one thing. A market that spikes, retraces, and then rallies back to a new high would be quite another thing altogether, and might signal a new range for inflation expectations is being formed. And oh, my, would that be significant?
The equity market remains elevated, and rising inflation expectations will eventually take a toll on multiples. It always does. I don’t want to bet against equities while inflation is currently low and the Fed is trying to push the market higher, but I believe we have some volatility ahead. With implied volatilities so low on options right now, it may be worth buying puts.
[1] I am ignoring the important nuance that in this case, the forward price will be different than the spot price – it’s not important for my illustration, but you really want to compare the strike price to the forward price of AAPL, not the spot price. I make this footnote just so that readers familiar with option theory won’t think I don’t know what I’m talking about.
[2] Again, this isn’t quite true. An option trader knows that an option with a lot of gamma also has a lot of time decay, and vice versa. As a former options trader, I can tell you there is no more helpless feeling than being long gamma on expiration day and watching the market sit in a 2-tick range, knowing you’re going to lose all your time value with no delta-hedging gains, and nothing you can do about it.
Titanic Decisions
There is something very striking going on in the inflation markets, and among investors. It only recently struck me, after attending an inflation conference last week and then today participating in two discussions: one with the CIO of a large insurance company and one with a group of senior people at a large asset management firm.
If it were only that the senior people at the large asset management firm were reporting that “people are not concerned with inflation right now,” I would dismiss it. There are lots of things that investors and consumers are concerned about that the senior people at large asset management firms have no idea about. The anecdotal reports from the inflation dealers at the inflation conference carry more weight, because they’re at least focused on having that specific conversation with their clients. But the clincher was the discussion with an insurance company CIO, who reports they are definitely going to be putting on some small inflation hedges because they hedge possibilities, not probabilities, but that they actually think deflation is more of a threat here than inflation.
I want to first show a chart of rolling 10-year inflation in the Federal Reserve era (source: Enduring Investments), compared with the current level of 10-year inflation breakevens. With the exception of the Great Depression, when the Fed tightened policy as money velocity declined in a manifest error, inflation has almost never been below the current level on a compounded 10-year basis. And it has never, with that singular exception, been very far below the current level. Ergo, inflation insurance is very cheap, even though 10-year breakevens are not far from all-time highs (since TIPS began, in 1997).
The refrain is that “we might get inflation in a few years, and we’ll look to hedge then,” but I don’t see how that makes any sense if the cost to insure now is so all-fired low. It isn’t as if you’re giving up lots of high-yielding opportunities to buy this insurance. If the opportunities to increase return are very poor, shouldn’t one take advantage of cheap opportunities to reduce risk? It seems odd to me.
I am also flummoxed at this perspective in the context of both business risk and career risk. I alluded to this issue yesterday. Sure, maybe “we all know” that even though M2 has until recently been growing at rates that have only been associated with post-disaster Fed accommodations (after 9/11) or inflationary periods (1980s, 1970s), inflation won’t rise because Europe is a mess, but let’s briefly consider the alternative future history. Suppose that in five years, you are an investor or asset manager and sitting with a spouse or a client or a boss, and the price level has increased 50% from here. And the spouse/client/boss says “you know, Fred, we’re wondering why you didn’t load up on cheap inflation protection. I understand why you didn’t do it in 2009, but once the Fed started unlimited QE and every central bank in the world was doing similar things, didn’t you think it made sense to put on some protection? I mean, there’s always inflation when there’s too much money in the system.” What possible defense does Fred have? Is “our economists didn’t think that was going to happen” going to be a valid defense?
Now obviously, by no means is this sense universal, but it seems insanely widespread. It seems as if the intelligentsia has been persuaded that since all of the proletariat is concerned about inflation, but the smart people at the Fed are not, then they ought to bet with the Fed. I have news for these folks: the man on the street is far better at forecasting employment, and certainly no worse at forecasting inflation, than the bow-tied, blue-chip economist at a Wall Street firm or large insurance company – especially when that inflation view is adjusted for common perceptual errors that we can roughly quantify.
It’s generally true that today’s generation of investors thinks “bad inflation” is 3% and is frequently unconcerned. But in 2009 and 2010 and 2011, there were certainly investors who were beginning to get worried, which is why TIPS yields are way down here at -0.86% in the 10-year part of the curve. Nowadays, the refrain seems to be “we may need product for our retail clients,” but otherwise “remain calm, all is well.”
But I think that’s also what they told the people on board the Titanic. At some point, regardless of what the authorities are forecasting, investors need to grab for their life jackets or to head for the stairs anyway (and if I sound frustrated, it’s because we’re trying to hand people life preservers and they keep going back belowdecks). The worst thing that can happen if you’re wrong is that you’re feeling foolish, standing freezing on the deck of the ship and all really is well. The “Titanic Decision” matrix is below. I can tell you one thing: there is a single box there that I am pretty sure I want to avoid. What about you?
Model Abuse
A central bank is easing again! The only problem for U.S. market participants is that it isn’t the Fed that is easing, but the Bank of China, which last night dropped rates for the first time since 2008. This set markets up on a good tone heading into the day, and investors waited with breathless anticipation for Chairman Bernanke to echo his Jackson Hole speech and send us off to the races.
He didn’t. The Fed chief delivered what passes for moderation from the chief helicopter pilot, matching his comments somewhat obviously to ECB boss Mario Draghi’s comments from yesterday: the Fed is ready to act; long-term inflation expectations are well-anchored; but the U.S. budget trend is “clearly unsustainable” and must be put on a “sustainable path.” (Unremarked-upon was the fact that he contradicted himself when he called the so-called “fiscal cliff” at the beginning of next year “a significant threat.” Which is it? Are smaller deficits bad, or good? The answer is both – bad in the short run but really good in the long run – and the Chairman should say that. This just sounds intellectually sloppy. Then again, he is speaking to Congressmen, so using even using multisyllabic words is frowned upon.)
Any way you slice it, Bernanke did not deliver the promise of “more to come” that some investors anticipated.
Patience. Having played the stern paternal figure, Gentle Ben can now proceed to warm up the choppers. There is a growing chorus of other Fed voices in support of an ease, and in my opinion this is likely a somewhat intentional choreography in which the Chairman can appear to be persuaded by the others on the Committee to do what he wants to do. Chicago Fed President Evans today said bluntly on CNBC that “more accommodation would be good,” that he is very concerned about unemployment and doesn’t see evidence that inflation will rise (apparently he isn’t concerned with the lack of evidence that unemployment will fall due to monetary accommodation). San Francisco Fed President Yellen said yesterday at a speech in Boston that the Fed’s objective is a quick return to full employment (it seems like the Fed’s objective once contained something about price stability, didn’t it?), and that Fed action might be justified “to insure against adverse shocks,” or even if the Fed concludes that the recovery “is unlikely to proceed at a satisfactory pace.”
Really? That’s the bar now? The Fed eases if growth is merely “not satisfactory”? If that’s the answer, then get ready for an enormous amount of easing, because growth isn’t going to be “satisfactory” for quite a while even if the nation skirts a recession.
I always laugh at the assertion that “inflation expectations are well-anchored.” Yesterday I compared this phrase to the analysis that a house has “good auras” by ghost-hunters. (That’s probably not fair to ghost hunters, who may have some science to back up what they are doing as far as I know.) But the phrase also seems to mean whatever you want it to mean. We all know that short-term inflation expectations have plunged, but as I argued in a post this week that is mostly because of energy prices until quite recently. But for market-based measures of long-term inflation expectations, the measure that is popular among policymakers is the 5y, 5y forward inflation rate. Often they take this reading of “expectations” from the TIPS/Treasury breakeven curve, which is wrong, but if you’re using it to tell fortunes I guess it doesn’t matter if you use pigs’ knuckles or rat bones. However, I do think it’s worth tracking 5y, 5y forward inflation from the inflation swaps market, if only to look at what the policymakers are looking at. A chart of 5y, 5y forward inflation in the US, UK (both on the left axis) and Eurozone is shown below. (Source: Enduring Investments)
In case the point isn’t apparent, let me make it so. Euro “long-term inflation expectations” are near the lows over the last year. In the UK, that measure is plumbing new 12-month lows. But in the U.S., we’re stable if not rising. Since February 8th, 5y forward inflation is down 2bps in the U.S. but down 35bps in the UK and 49bps in Europe (which already had the lowest long-term measure of the three, near 2%, due to the prior credibility of the ECB as a Bundesbank-descended inflation fighter).
So which is “anchored?” Mario Draghi has the best argument, if this measure is useful for this purpose: Forward Euro inflation expectations are around 2% and have declined markedly recently. The UK has relatively high inflation expectations, but they’ve declined quite a bit, so that’s “anchored” to some extent…at least, there’s a drag on it. But in the U.S., forward inflation expectations are well above the Fed’s ~2.25% CPI target, and have been for quite some time. If anything, those expectations are actually rising but they’re certainly not declining. In any event, Draghi and Bernanke both call inflation expectations “anchored,” but market-based measures of this concept are showing totally different things.
.
Because I didn’t annoy enough equity bulls with my historical and quantitative observations about equity valuations and likely real returns[1] yesterday, I am going to use the tool I deployed yesterday in a manner for which it was absolutely not intended. I was reflecting on the fact that the method forecasts future 10-year returns, but it therefore takes ten years to get the scorecard back to see how things actually turned out. So why not, I thought, pretend that the future really did turn out so that the figures were perfectly accurate? What would the future history of the S&P look like in that case?
So what follows is a make-believe future price chart of the S&P 500. This is not a forecast. I am not even using rat bones.
What I did was take the 10-year real return forecast, (which as I’ve explained in the past takes the long-run real growth rate of the economy, adds dividends, and adds or subtracts most of the “pull to fair value” over the next ten years), and subtracted a 2% dividend to get the expected real index price appreciation. Then I assumed that the CPI index rose at the rate implied by the inflation swaps curve (I calculated the forward 1-month rates and accreted the CPI index by that rate each month, so roughly a 2.46% compounded rate over the whole period but around 1% in the beginning and more like 3% towards the end, as implied by the swaps curve). I took the real index price appreciation and added back inflation to get the nominal price appreciation, and voila! I have a hypothetical series which is the set of S&P index values that, if the projected real return forecast is realized and the inflation swaps curve is accurate, would occur in the future.
I am happy to report that based on this “method,” the S&P ought to break to new all-time highs sometime in 2016. (Please remember, this is not a forecast. It’s “for entertainment purposes only,” although the practical value of it is as a test to see if the 10-year-real-return-forecasting method produces predictions that aren’t necessarily ridiculous or overly morose. Frankly, it doesn’t seem so bad to me – the chart shows an initial 20% or so discontinuity since the current trailing 10-year return is about 2% higher than what the a priori forecast was in 2002, but then doubles over the next 10 years.
For investors that have been through a 15-year period in which the index went essentially nowhere, and actually fell appreciably in real terms, I would submit that’s not a horrible result. Yes, it’s slower than during the 1980s boom but the difference is we started that boom with stocks at very low valuations while we stand today at above-average valuations.
Let me repeat it one more time: this is not my forecast. I would certainly never forecast an actual path. It is simply the result of taking the forecasting model and essentially cranking it in reverse. And now everyone can tell me why this is stupid and implausible. Ready, go!
[1] Please do note the use of the term real return. To get the nominal return, add your expectations for inflation. But as investors, we don’t really care about the nominal return, but the returns in terms of how much additional stuff we get to consume, so I don’t normally worry about nominal returns, or look at them.
Cooler Than The Sun
In the long run, the market is a weighing machine.
It is imperative to keep that bit of Ben Graham advice always in mind whenever you invest. Day traders can ignore whether the market is a weighing machine in the long run, since they just look at the “voting” patterns and go along with price action. But those of us investors who make moves more deliberately can best add to our performance by simply avoiding assets that are expensive, even if they may become more so, and overweighting assets that are cheap, even if they may become more so.
If you’re a good market timer, then bless you – keep at it. But you have to be a pretty decent market timer to outperform a simple value investor in the long run. I do believe these market timers exist. I just don’t believe as many of them exist as think they exist.
This preface is of course a lead-in to the observation that the decline in equities recently, including today’s -1.5% slide, is anything but shocking. The dividend yield and price multiples, the Q ratio, the high margins that necessarily must be sustained to justify these levels – I’ve written about these. Stocks aren’t as overvalued as they have been at times in the past, but they aren’t a cheap asset. About the best thing you can say about them is that they’re cheap to Treasuries, but that’s like saying Venus must be a nice place to live because it’s cooler than the Sun.
While the proximate trigger for today’s whipping may have been the weak Philly Fed index, which fell (see Chart) to the lowest level since the odd spike last year versus expectations for an increase, the market has obviously been in retreat for a while. Moreover, the idea that there was a “payback” due after strong weather-related growth in the spring isn’t exactly an epiphany.
And, though it’s probably fair to say that almost everyone was surprised with how quickly the European situation unraveled again, the notion that the crisis was probably not over was a reasonably widely-held belief. Interest rates are low, which means you don’t gain much value to an investment by pushing the date of a negative cashflow further out…which is to say, whether Europe was going to implode in 2012 or 2013 or 2014 shouldn’t have colored your view of fundamental equity value very much. Only if you thought it was not going to implode should the value have changed significantly…but many of us essentially decided to be market-timers anyway, figuring we could always exit stocks before the mess started up again.
This sounds like ‘tough love,’ and maybe it is. I should be more sensitive to those of us – and of course it’s most of us – who are nursing our losses right now. I am long some equities, and though my market exposure is pretty flat because of put options I own, it isn’t fun to watch your stocks decline.
But if you’re a long-term investor, 8% from the highs shouldn’t bother you anyway. If you’re young, and have a lifetime of net investing into the market, you should be cheering for a 50% decline so you can invest in cheap companies! So buck up, it’s not so bad, yet. And stocks might turn around and rally tomorrow and set new highs in a week. All I am saying is that the likelihood of those highs being sustained for a year are pretty small.
The same value observation applies to other assets. In general, when something has gone up for a long time, you want to own less of it, not more – so 10-year Treasuries at 1.70% should not have you rushing to buy more (and if you own long-dated Treasuries, you shouldn’t own as many now as you did a week ago)!
The Treasury auctioned $13bln in 10-year TIPS today, though, at a record yield of -0.39%. What is more, the bidding was very strong, with a 3:1 bid-to-cover ratio and the awarded price was well through the market. Market participants were amazed at the strong bid for a harshly negative real yield, but why? The 10-year nominal Treasury has an implied real yield, based on 10-year inflation expectations extracted from inflation swaps, of -0.77%. Inflation ‘breakevens,’ which approximate the amount of inflation required to break even owning TIPS rather than nominal Treasuries, are around 2.1% and core inflation is at 2.3%. Historically, that doesn’t happen very much (see Chart).
It is unusual to compare current core inflation to 10-year inflation breakevens, but the rationale for doing so is this: if current inflation is at the same level, or higher, than the ‘breakeven’ number, then you are essentially “carrying” the inflation option for free. When you own TIPS rather than Treasuries (at least, at low levels of inflation like we have now), you want to consider both the expected level of inflation over the holding period as well as the range of possible outcomes for inflation. When inflation is low so that most of those “tail events” are higher inflation, then you should be willing to pay a bit more than your true expectation, because all of the crazy things that can happen are good for you. That’s essentially an “option value” to owning TIPS over Treasuries.
When the breakeven you are buying is far above current levels of inflation, then you’re losing a little bit on that bet every day – like time decay on an option. But when the breakeven you are buying is below the current level of inflation, you are getting the inflation option with free carry.
So I am not at all surprised that buyers lined up to buy $13bln of TIPS. After all, many accounts must own fixed income (I am not one of them, which is why I own neither TIPS nor Treasuries at the moment). What I am surprised about is that buyers keep lining up to buy nominal Treasuries at this level. Those buyers are lining up to book a vacation to the Sun. H
I hope they bring enough sunblock. Because I think they might get burned.
This Is Your Brain On Leverage
The event du jour on Tuesday was the release of the FOMC minutes from the March 13th meeting. There was almost nothing surprising in the minutes, although the market’s reaction suggested otherwise.
Prior to the release, there had been some very odd reports from respected sell-side shops (such as Goldman) that predicted the Fed was about to announce an extension of Operation Twist or some other policy initiative. Those reports were nonsensical. This was not an FOMC meeting; it was the release of minutes from a meeting several weeks ago. The Fed has never use the minutes as a way to announce new policy measures; not surprisingly, new policy measures that need to be announced are announced, either in the statement following the meeting or on rare occasions in a separate news release. It is a real head-scratcher to me why these economists in the last few days suddenly decided that the FOMC minutes might be the place we find out about an official new policy.
At best, the minutes occasionally reveal more concern, or less concern, about a particular economic variable than the market expected, or more interest or less interest about a particular policy tilt. The one quasi-surprise in these minutes was that the Fed explicitly stated that their description of the period of extremely low rates “at least” until mid-2014 was conditional:
“It was noted that the Committee’s forward guidance is conditional on economic developments, and members concurred that the date given in the statement would be subject to revision in response to significant changes in the economic outlook. “
In other words, it isn’t “at least” at all. Rates will be low until they need to be increased, which means it was complete idiocy to ever put a date in the statement to begin with. If it is a promise, it bound their hands unnecessarily; if it was not a promise, then (a) why say it at all, since the operating understanding is that the Fed will change rates when it feels conditions require, and (b) learn some English, and don’t put absolute phrases like “at least” in statements meant to be squishy on timeframe. I draw the almost inevitable conclusion that the Fed believed we cared about their forecast of economic conditions two years forward, as if they not only are not the worst economic forecasters out there, but actually are dramatically better than most other economists who feel that a 6-month forecast has pretty big error bars.
Either that, or the statement was never meant to do anything other than jack around with interest rates. Perhaps it shouldn’t be surprising that the Fed, and even the Chairman himself, are alternating between saying dovish things and saying hawkish things (or re-interpreting prior dovish statements to appear more hawkish). The Fed’s main tool right now is its “communications strategy,” in which it wants to talk down inflation expectations while also talking down interest rates. The former requires hawkish talk, while the latter requires dovish hints. While QE3 is probably still coming (although I don’t see a “sterilized Operation Twist,” which doesn’t really accomplish anything I can think of), it’s a decidedly more-difficult operation now when core inflation is at 2.2% and global inflation is rising than when it was at 0.6% and bottoming. Before, they didn’t mind if inflation expectations rose; that also suited their purpose. Now, though, it would damage the same purpose.
The reaction in the bond market was swift and violent although the ‘disappointment’ was small and insignificant. The severity of the move – 10-year rates rose 14bps in minutes – is a direct result of the Fed’s policy of pegging interest rates and trying to be very transparent. In short, rates are so stable that “2 basis points is the new 5 basis points.” With no market movement, traders and investors put on larger positions because they are confident that there won’t be violent moves with Sheriff Bernanke on the watch, and because to make any money at all from a trading position, trading size needs to be larger. When there actually is a market move, the move will tend to be more violent because positions are larger (and, because of the Volcker Rule, liquidity once the market leaves its safety zone grows thin quickly).
You can see this in the curve’s movements today. While the main change was that the FOMC made the unconditional rate pledge entirely conditional, 2-year rates moved only 4bps. But 5-year and longer rates rose 12-15bps on the announcement (the 10-year note is now at 2.30% again). Honestly, 2-year notes at 0.37% if the Fed isn’t promising to keep rates low seems a little rich to me (meaning that the yields are too low), if only because of the relative lengths of the up and downward tails (since the bearish tail is not truncated by the Fed promise!), although I happen to believe the economic situation is such that the Fed will end up honoring its pact despite inflation that will continue to accelerate.
Nonsensical was the trashing of TIPS today. Inflation-linked bonds fell just as far as nominal bonds, so that inflation breakevens were approximately flat on the day. That’s wild. It isn’t as if the inflation outlook depends on the next trillion in Fed-sponsored liquidity! The global spigots remain on, and the Fed has already done far more than enough to ensure inflation will keep rising unless money velocity rolls over again. 10-year breakevens have risen this year from 2.00% to a recent high of 2.45%; at the current level of 2.35% they remain an easy buy. 5-year breakevens at 2.06% are an even better deal, since headline inflation over the next year will be well above that level thanks to gasoline. You’re buying forward inflation there at a very cheap level, in my opinion. (Retail investors can’t directly access the short inflation part of the curve, although they can participate in a general rise in inflation expectations through the INFL ETN and the RINF ETF. I own small positions in both of those securities and have no plans to change that position in the near-term).
To be sure, negative real rates are not sustainable in the long run, and while the 10-year TIPS real rate of -0.07% is starting to look almost cheap compared to where it has traded in the last six months – and indeed, I think investors will scoop them up at 0%, and 30-year TIPS if they get to 1.0% – they probably won’t be there a year from now. But TIPS are still a better deal relative to nominals, so if you must own some fixed-income, I prefer to position in real rates.
Wednesday’s main release is ADP (Consensus: 206k from 216k). Although this report is losing its punch as it fails to track the Payrolls number well, in this case there may well be more attention paid to it than usual because the Employment Report will be released in thin market conditions this Friday during a half-session recognizing the Good Friday holiday. Accordingly, if ADP contains much of a surprise, you may well see an outsized-reaction.
