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Posts Tagged ‘TIPS’

A Relatively Good Deal Doesn’t Mean It’s A Good Deal

January 10, 2013 7 comments

I suspect that everyone has ‘default activities’ that they automatically turn to when nothing else is working. For example, when I can’t sleep and I’ve tried everything, I go downstairs and have a bowl of cereal. Some folks hit the gym when they’re frustrated. Others go shopping when they’re depressed.

And apparently, some people buy stocks when they’re not turned on by anything else.

There wasn’t any outrageously positive news today that sent the S&P +0.8% on the day. Initial Claims (371k) was slightly higher than expected (but I advocate ignoring that release in late December and most of January). The dollar dropped sharply against the Euro. I initially thought that this was because the President nominated as Treasury Secretary someone with no financial markets experience at all but a solid resumé of hard-nosed negotiations with Congress, but the Euro gained against all major currencies so it was perhaps due more to the fact that ECB President Draghi didn’t ease further at the policy meeting held today (though they were not expected to). Bloomberg blamed a better-than-expected rise in Chinese exports, but the miss was well within the usual variance for a volatile number so that seems unlikely to me.

I am not entirely kidding about the frustration that “there’s nothing else to invest in.” I was just working today on a chart for a keynote presentation I have been asked to give at the Inside Indexing conference in Boston in April (See the link here, although most of the information on the site is still the 2012 data). I have previously run this chart, showing Enduring Investments’  projected 10-year annualized real returns and risks (this is as of year-end 2012).

proj102012

The slope of that line indicates that the current tradeoff of risk for return is 2.7:1. That is, for a 1% higher expected annualized real return, you will have to accept a 2.7% increase in the annualized standard deviation of annuitized real returns (the “right” measure of risk, as it measures the variance in the long-term real purchasing power of the investment). Now, here’s the chart as of April 23, 2003, using all the same methodology:

proj102003

The slope of the line back then was 9.1:1. That is, in 2003 you needed to take more than three times as much risk to add 1% in expected real return to your portfolio.

But notice something else also that is very important. The change in the slope of the line didn’t come because expected equity or commodity index returns got better. Indeed, those two asset classes have roughly the same forward expected returns as they did back then, although slightly different risks the way we figure it. What happened is that the expected real returns to Treasuries, TIPS, and Corporate Bonds all fell precipitously.

Of course, this comes as no surprise to anyone, because we’ve all watched the Fed push interest rates down so far that we need extra decimal places. But I think comparing these charts you can understand a fundamental verity: people are not buying stocks because they expect awesome returns going forward (hopefully, anyway, because they’re not going to get them). They’re buying stocks because there’s less reward to buying less-risky asset classes. Which is, after all, what the Fed was trying to do (this is called the “portfolio balance channel” in monetary policymaker parlance: force people to take more risk than they want, because it’s a relatively good deal even if it’s not a good deal in an absolute sense).

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A few other notes about today’s news:

Inflation markets were abuzz today, with inflation-linked bonds outpacing their nominal counterparts in many countries, because the UK’s ONS announced that it has decided not to change the RPI that applies to Gilt linkers (inflation-linked bonds, like TIPS). The ONS (similar to our BLS) has been studying how to make certain important technical corrections to the way the RPI is calculated to make it more accurate; these changes would have had the effect of lowering the RPI significantly. As a consequence, these bonds have been trading at higher real yields, reflecting the fact that if the ONS chose to change the RPI formulation, the yield on the bond would have to be higher to compensate investors for that change if the same value was to be delivered. That is, instead of a yield of (for example) 1% added to expected inflation of 2.5%, the yield would rise to 1.5% to reflect the expectation that measured inflation would be at 2.0%. Many investors thought it was very likely that the ONS would choose one of several options for restating RPI that would have had such a deleterious effect on the bonds.

In the event, the ONS made the wise decision that it would be unfair to change the terms of the bonds retroactively by making a significant change to the RPI, so they will release a second index called the RPIJ, which will now be the benchmark index and featured in ONS releases. But they will also continue to calculate the RPI and the existing bonds will continue to track RPI.

This is a great relief to inflation-linked bondholders the world over, because it sets a very important precedent. The U.S. Treasury has long said that if the BLS made a material change to the way CPI was calculated, it would plan to continue paying on the basis of the old-formulation CPI (if it was still available) or a suitable alternative, but many investors from time to time have worried about whether they would do that in practice. It will be harder to do so with the ONS precedent.

Because investors had thought the ONS was leaning the other way, Gilt linkers rallied a bunch. For example, the UKTI 1.25%-11/2055 rallied 10 points on the day (the yield fell by about 20bps), which is an enormous move at the long end. The 5-year linker (Nov 2017) yield fell 35bps. This is likely to have a spillover effect in US TIPS, since the latter now look much better on a relative value basis than they did previously. Anyone who was long UK linkers yesterday is probably considering 30 year TIPS at a pickup of 42bps.

Finally, in Fed news Esther George, the President of the Kansas City Fed (replacing Thomas Hoenig) was on the tape today. “Fed’s George Says Low Rates Risk Stoking Inflation Surge,” said Bloomberg. No kidding? (See here for Market News’ coverage of the same speech). At the very least, said George, the asset purchases will “almost certainly increase the risk of complicating the FOMC’s exit strategy.” Neither of those statements ought to be the least bit surprising or controversial, but it’s unusual to hear a Fed official state these things so bluntly. But she may have crossed the line with this one, which might get her ostracized at the next FOMC meeting:

Like others, I am concerned about the high rate of unemployment, but I recognize that monetary policy, by contributing to financial imbalances and instability, can just as easily aggravate unemployment as heal it.

Keep speaking truth to power, Ms. George!

Incredible Inflation Bond Bargain

September 24, 2012 22 comments

The economic data continues to drip weaker. Today’s Chicago Fed index was the lowest since 2009, and while the Dallas Fed index rose, it remains negative. These aren’t major indicators, but the general tone of data recently has been weak and nothing recently stands out as positive…except for Existing Home Sales, which raises other issues as noted last week. A friend in the southwest U.S. describes the local housing market in Phoenix as “definitely bubblicious” and passed along this link, describing how rental properties in Phoenix are seeing aggressive bidding from would-be renters.

Now, economic activity is also not exactly falling off a cliff, and some Americans insist that the economy is doing just great (these seem to be the Obama voters but I can’t tell which way the causation runs – are they Obama voters because they think the economy is doing well, or do they think the economy is doing well because they are Obama voters and that’s the story?). But to listen to Fed speakers, you would think economic collapse is imminent. Last week, Minnesota Fed President Kocherlakota[1] advocated keeping monetary policy extraordinarily accommodative until the unemployment rate gets down to 5.5% or until the medium-term outlook for inflation rises above 2.25% (on core PCE). Today, San Francisco Fed President Williams said that he expects the Fed to end asset purchases “before late 2014” (which, for those of you scoring at home, would imply the Fed has about a trillion dollars to go) and shouldn’t raise rates until mid-2015.  I wonder what it is that Fed officials are forced to check at the door: their brains, or their optimism?

No wonder that inflation-linked bonds are so expensive these days!

Which brings me, actually, to the main topic I wanted to discuss today. A reader asked me the other day about I-series savings bonds from the U.S. Treasury. For those of you who aren’t familiar with them, I-bonds are like regular savings bonds except that they pay a real interest rate. That is, instead of getting a fixed coupon, you get a fixed coupon plus inflation, which is added to the principal and compounded until the bond is redeemed. You can buy them on Treasury Direct and keep them in electronic form, and in fact that’s the best way to buy them. You can buy up to $10,000 per Social Security number per year.

And that limit turns out to be a good thing, because if it weren’t for that limit hedge funds would be going nuts on series I bonds right now. Because the people who created I bonds never contemplated a negative real interest rate, or else thought the marketing angle of selling bonds at a negative real interest rate would be too bad, the fixed part of the I bond coupon is floored at 0%. This is significant, since the market rate for a 5-year TIPS bond right now is -1.59%. The coupon rate on the I-bond is set for the next six months of new sales (the fixed coupon stays the same for the life of any given bond) every May and November, and typically is set very close to the 5-year TIPS rate (see chart below, source Treasury Direct and Bloomberg).

Notice, though, that at the far right-hand part of the chart the last few I-bonds issued have had coupons of 0%, since the actual TIPS rate has been considerably below that. And that means that if you are going to buy TIPS, then before you spend a single dollar on the April-2017 TIPS you should buy your full $10,000 limit on I-bonds, because you save 1.59% compounded for at least 5 years. That’s an extra 8.2% total return on your money over that period![2]

Occasionally, there can be good deals when the TIPS market moves between the setting of a coupon and the next coupon set. When the current series coupon was set at zero, back in May 2012, the advantage was only about 125bps and it’s now 159bps. But the current advantage is in good measure structural, rather than due to timing. As a consequence of that structural mistake (not allowing a negative real coupon), combined with the TIPS market’s rally since May, the current spread is actually the highest ever seen for the program (see chart below, source Treasury Direct and Bloomberg).

I don’t regularly recommend specific trade ideas in this (public) space, for a whole host of regulatory reasons, but I can say this: look into series I-bonds unless you (a) don’t care about inflation, (b) feel like you need to take lots more risk, (c) feel comfortable that if you wait long enough, you’ll get a better investment opportunity in inflation-linked bonds, or (d) have so much money that $10,000 per member of your household, per year, simply isn’t meaningful.

And if it’s case (d), then please write because I need more friends like you!


[1] Kocherlakota is described by some as a hawk, but he can most accurately be described as ‘confused.’ He once explained that the Fed might have to raise interest rates, even if inflation expectations were low, to force them higher, getting the causality exactly backward.

[2] Note that if you do not intend to hold the I-bond for at least 5 years, there is a penalty associated with early redemption – you lose some interest accrual. Even with that, it’s not a terrible deal given how cheap these are now, and most investors should have some inflation protection in their portfolios to diversify the risk of all of those investments (equities, nominal bonds) that do poorly in inflationary environments. So, for the buy-and-hold part of your portfolio, these are terrific.

TIPS Are No Longer Cheap, But Still Preferable

September 18, 2012 3 comments

TIPS have gone from being rich on an absolute basis, but cheap against nominal bonds, to (still) rich on an absolute basis, but fair versus nominal bonds as nominal yields have risen. That statement is based, however, on a static equilibrium – given where nominal yields are now, after a 40bp selloff since July, real yields have fallen slightly (see chart, source Bloomberg – nominal yields in yellow, real yields in white) and are about right.

I have previously documented this move, pointing out the rise in breakevens and/or inflation swaps. However, because I was traveling I didn’t write anything following Friday’s skyrocketing breakevens, which followed through on Monday to within a couple of basis points of all-time highs (see chart, source Bloomberg).

That leap seemed exceptionally surprising to some, given the weakness of core CPI on Friday. But inflation expectations on Friday were still reacting to the Fed’s open-ended QE move, which had moved 10-year breakevens to near 2.50% on Thursday. After sleeping on it, many investors realized what we realized immediately: there is nothing deflationary about buying bonds without limit, using money printed for the purpose. The Fed professes to be concerned about the negative tail risk to growth (which they can do nothing about), and ignores the positive tail risk to inflation (which they could do something about, if they chose). It is not at all surprising that breakevens leapt.

As I said, these recent gyrations have moved TIPS to being approximately fair value relative to nominal bonds, given the yield of nominal bonds. But the further question is whether those nominal yields are themselves at fair value, or are on the way to higher or lower levels.

A reasonable question to interpose here is this: is this as good as it gets for bonds? What could be better than unlimited Fed buying? Well…I suppose unlimited buying in Treasuries, as opposed to mortgages, would be better, but with 10-year yields at 1.81% one would think that both a considerable amount of buying and a considerable amount of bad economic news is priced in. To be sure, the news continues to be bad; Friday’s -10.41 print in the Empire Manufacturing Survey was the lowest since the dip in 2008-09. Lower than the “cash for clunkers” hangover in 2010. Lower than the post-Japanese-tsunami drag in 2011.

But consider this: in the throes of a much worse crisis (especially demographically), and with the Japanese central bank making only timid efforts to resist deflation – and certainly not buying every bond in sight, as the Fed is – the average yield of 10-year Japanese government bonds (JGBs) from 1997-2007 was 1.51% (see chart, source Bloomberg).

Even if you take the crisis-on-a-crisis period of post-2008 for Japan, the average 10-year yield is about 1.15% – and that’s with deflation in full bloom and the central bank until the last year or so doing little to fight it.

In Japan, core inflation is at -0.6% over the last 12 months, and 10-year yields are at 0.81%. Our core inflation is 1.3% higher and our nominal yields only 1% higher. There is a lot of disinflation and/or Fed buying that is already in the price. I am not saying that we ought to be selling nominal bonds here; I’ve gotten burned on that call in the past, and anyway we are in the middle of the strongest bullish seasonal period of the year for bonds. But the Fed just added to the length of the possible “high inflation tail” outcome – and I fail to see what the offsetting bullish tail is. I can’t imagine why anyone would buy nominal bonds at these levels, given what the Fed and their pals at other central banks are doing.

But if nominal yields do rise further, this means that TIPS yields will eventually start to rise as well. I still prefer TIPS to nominals, and I still want to be long breakeven inflation, but admittedly it is a more difficult trade at these levels than it was back on August 7th, when I first noted that our Fisher model indicated a short position in TIPS and a long position in breakevens.

I say this, going into a TIPS auction tomorrow with 10-year TIPS yields near all-time lows and 10-year breakevens as I noted near all-time highs. It’s not going to feel like a bargain for anyone, but a year from now, it may seem like it.

Now, make no mistake: the core inflation print on Friday of +0.052% was a definite surprise on the weak side. But it wasn’t quite as weak as it looked. In fact, thanks to Housing and Transportation, 62% of the CPI major subgroups saw their year-on-year rates of change rise, while only 38% (Food/Beverages, Apparel, Recreation, Education/Communication, and Medical Care) saw those rates decline. Much of the weakness in core inflation came from apparel (which is interesting and worth watching to see if it continues) and large moves in used cars and airline fares. Moreover, as I observed last week, the year-ago comparisons get much easier for the next four months, so that the current 1.9% core inflation print is likely to be the lowest for this year. If it’s not, then we’ll need to re-assess what is going on, but for now nothing has changed about my forecast. Do note that the Cleveland Fed’s Median CPI was unchanged again up at a 2.3% y/y rate of change, reinforcing the fact that the core decline over the last few months has been driven by some outlier price movements rather than by a shift in the central moment of the distribution.

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