Central Banking Tragedy: The Case of Japan

May 22, 2018 5 comments

Today I want to talk about one of the real tragedies of monetary policy and inflation: Japan.

The tragedy is that the mystery of the deflation in Japan is no mystery at all. The cure also was no mystery. So the tragedy is that these were both treated as mysteries by the central bank, which stumbled on the right response and then stumbled right back out of it again.

The chart below shows the money supply and core inflation history of Japan going back into the 1990s. Core inflation is in red (I’ve interpolated through the sales-tax-induced spike) and M2 growth is in blue. The cause of the disinflation is pretty plain: between 1998 and 2013, year/year money growth in Japan never exceeded 4%. From 1999 to 2013, Japanese M2 rose 38% in aggregate; in the US it rose 138% over the same period. It is very hard to get inflation, especially in an environment of declining interest rates, if the money supply is increasing at or somewhat less than the rate of potential GDP growth.

However, in the middle of 2013 Japanese Prime Minister Shinzo Abe persuaded Bank of Japan governor Haruhiko Kuroda to promise to double the money supply in two years, by pursuing massive QE. Although that turned out to be an exaggeration, M2 growth did peek out from behind 4%, and inflation started to perk up as well. It wasn’t a lot, but inflation in 2013 reached new 14-year highs and the economy was officially out of deflation. While QE made very little sense, at least the QE2 and later versions, in the US where inflation was positive and money growth was adequate, it made a ton of sense in Japan. In fact, if Japan had been the only country pursuing QE, I can make the argument that the yen would have likely depreciated substantially and caused inflation in that country.

In the US, the central bank pursued QE and risked inflation to hopefully spur GDP growth. But in Japan, both of those were desirable outcome. There was no reason not to pursue QE in Japan.

But the Bank of Japan lost faith in the power of money growth to cause inflation. While the BoJ continued asset purchases, those purchases diminished and the rate of increase in the central bank’s balance sheet declined from roughly 50% y/y in 2014 to around 8% today (see Chart, source Bloomberg).

Instead, the Bank decided to deploy negative interest rates, dropping the policy rate to -0.10% from +0.10% in early 2016. They did this partly because it was a central bank fad in 2015 and 2016 to experiment with negative interest rates, despite the fact that we have no idea (and no guidance from theory) about what happens to monetary velocity at negative interest rates. I wrote the following in our quarterly piece on February 20, 2016 (and I think it’s been long enough that it’s fair to put it in the public domain as our customers have had plenty of time to read it in private!). I quote at length because, frankly, it was pretty good:

 “…the question of what happens to monetary velocity at negative interest rates is one worth considering since several central banks (the latest one being the Bank of Japan) are now implementing monetary policy with a negative policy rate.

“Why the Bank of Japan is doing so is beyond us. Abstracting from the sales-tax related hike, it has successfully eliminated deflation, driving core inflation from -1.5% to near +1.0% since mid-2010. It has done so, very simply, by working to accelerate money supply growth from the 1.5%-2.0% growth that was the standard in the late pre-crisis period to over 4% by 2014 and 2015.

“This isn’t rocket science; it’s monetary science.

“Now, recently money supply growth has begun to fall off, so the BoJ likely was concerned by that development and wanted to find a way to ensure that inflation doesn’t slip back. If that was their intention, then cutting rates was probably the wrong thing to do. As Friedman explained decades ago, and we have illustrated here repeatedly, money velocity is strongly tied to the level of interest rates. Lower interest rates imply less reason to not hold cash; ergo real cash balances rise and the inverse of the demand for real cash balances is velocity.

“But we said “probably” the wrong thing to do for one reason: we don’t really know whether this relationship holds when interest rates cross the negative bound. It may be the case that this relationship ceases to apply at negative rates even though Friedman’s idea is based on the relative difference between cash yielding zero and longer-term investments or consumption alternatives. The reason that velocity might behave differently at sub-zero rates is that people respond asymmetrically to losses and gains. That is, the pleasure of a gain is dominated by the pain of the same-sized loss, in most people. This cognitive bias may cause savers/investors to behave strikingly different if they are charged for deposits than if they are merely paid zero on those deposits (even if zero is lower than other available rates). In that case, we might see a spike in money velocity once rates go through zero as cash balances become hot-potatoes, just as they would if investment opportunities suddenly appeared. Now, we need to make several observations.

“First, there is no data to suggest this effect exists. What we have posited in the preceding paragraph is rank speculation. (But, unlike the various central banks, we’re not betting our entire monetary policy on that speculation).

“Second, while we don’t really think this effect exists, if it does exist then we would expect it to be a spot discontinuity in the relationship between rates and velocity. That is, the behavior should change between 0% and some negative rate, but then be somewhat linear thereafter. Cognitively, the reaction is both a general loss aversion, which is linear but no different at negative rates from zero, and a behavioral “endowment” reaction that is to the “taking” of money from a person and not necessarily related to the size of the theft.

“Third, if this effect does exist it still doesn’t mean that cutting rates to a negative rate was wise for the Bank of Japan. After all, quantitative easing has done a fine job of pushing up inflation, and so there is no reason to take a speculative gamble like this to keep inflation moving higher. Just do more of the same.

“Fourth: more likely, the BoJ is doing this because it believes that negative rates will stimulate growth. This is much more speculative than you might think, and we may be overgenerous in phrasing the point that way. In any case, any growth benefit would stem either from weakening the currency (which QE would also do, with less risk) or from provoking investment in more marginal ventures that become acceptable at lower financing rates. We call that malinvestment, and it isn’t a good thing.

“Inflation was moving higher in Japan. As long as QE continues (with, or without negative rates), then inflation should continue to move higher. But if the BoJ abandons its successful anti-deflation policy because it was not effective at increasing growth, then it is likely to end up with neither inflation nor growth.”

So, this is the tragedy. As the first chart above illustrates, increasing asset purchases seemed to increase the money supply and inflation; however, cutting interest rates had the evident effect of decreasing monetary velocity enough to push the Japanese economy back to near-deflation. It’s tragic, because they had the right policy and essentially for the right reasons, but changed it to the wrong policy for reasons that are tied to economic dogma which happens to be incorrect (that the act of lowering interest rates causes inflation).

It isn’t the only tragedy to be visited on global economies by too-smart-by-half central bankers, but it is one of the most tragic because they were on the right track before their buddies in the central bankers’ club persuaded them to change tack. It’s like the alcoholic who, having suffered into sobriety, is tempted by friends to have a ‘social drink’ and ends up back in the bottle. At this stage, there is no longer any way for this to end well.

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Categories: BOJ, Causes of Inflation, Japan

Summary of My Post-CPI Tweets (May 2018)

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guyPV and get this in real time, by going to PremoSocial. Or, sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments or Enduring Intellectual Properties. Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • OK, 20 minutes to CPI. Let’s get started.
  • Although chatter isn’t part of the CPI, it’s interesting to me as a CPI guy. The chatter seems less this month than last month (maybe because of two readings <0.2%). I guess no easy ‘cell phone story’ to latch onto.
  • Last month there was of course that talk about cell phones, and the jump in core did excite breakevens…a little. 10y breaks now at 2.18%, highest in 4 years. But, as I recently pointed out, You Haven’t Missed It.
  • Consensus expectations this month are for 0.19 on core or a little softer. Y/Y will rise to 2.2% if core m/m is 0.13 or above. Outlier of 0.23 would move us to 2.3% and be a surprise to many.
  • Average over last 6 months is 2.56% rate. I saw a funny article saying ‘but that’s due to cell phones.’ Of course, the m/m rate is not due to cell phones dropping off from March of last year. Median CPI is at 2.48%. So this is not the new normal. It’s the old normal.
  • No one is much more bullish than expecting an 0.2% every month…that’s a 2.4% annually; most economists see that as something close to the high of sustainable inflation. But again, that’s the old normal. It just seems new because it has been a LONG time since we’ve been higher.
  • They’re wrong on that! Just not sure how soon this all comes through.
  • So last month, in addition to the bump in core services y/y (because of cell phones), core goods also moved to -0.3% from -0.5% and -0.7% the prior mo. The lagged weakness in the dollar, along with the rise in goods prices caused by trucker shortages, should be showing up here.
  • Lodging Away from Home took a big y/y jump last month, but it’s a volatile category with a small weight. It’s usually an excuse to people who expected something different on the month.
  • I continue to watch medical care, which is important in core services. Doctor’s services still showing y/y inflation as of last report, but both Doctors Services and Hospital Services rose last mo.
  • 15 minutes until the number!
  • Buying in the interbank market for the monthly reset (for headline) is 250.68.
  • Very weak number. 0.10% on core CPI. y/y ticks up only slightly, to 2.12% from 2.11%.
  • Last 12. Surprising. Note that last April was 0.09% so might be some seasonal issue with April. Sometimes Easter plays havoc, and Easter was early. But that’s usually more a Europe thing.

  • Massive drop in CPI for Used Cars and Trucks. -1.59% m/m, taking y/y to -0.9 from +0.4. That’s odd – very different from what the surveys are saying.
  • The Mannheim Survey actually ticked UP this month.

  • I don’t usually start with Used Cars & Trucks but that jumped out. That’s 2% of the CPI so not negligible.
  • OER m/m was 0.33% vs 0.31% last mo. y/y rose to 3.36% vs 3.26%. Lodging away from home was 0.74% m/m, following 2.31% last mo. And Primary Rents accel to 3.69% y/y from 3.61%. Housing strong.
  • Medical Care 2.21% y/y vs 1.99%. Also strong. Apparel 0.77% vs 0.27%. Recreation 0.27% vs 0.61%, and “other” a little softer. But wow, could this all be used cars? It looks like a strong number on the internals.
  • 10-year Breakevens are down 2bps. But I think they’re going to come back. This doesn’t look like the weak print we saw at first. Although I’m still drilling.
  • CPI Medical. Should keep rising.

  • That’s driven by physician’s services, out of deflation. hospital services still trendless around 4.5%

  • But don’t let them tell you this is unusual. It’s a large jump for OER to be sure, but housing prices continue to accelerate higher. Not at all surprising to see rents and OER stop decelerating.

  • here’s OER vs our model.

  • The Housing major subcategory didn’t rise very much, because Household Energy was weak.
  • Also interesting is CPI Apparel, 0.77% y/y…highest since a burp in Jan-2017 but it hasn’t been sustainably above that level since 2013. However, weak dollar shows up here, and conflict with China?
  • College Tuition stable at 1.90%. I can’t stop staring at the Used Cars number. It’s like a…well…car wreck.
  • Wireless telephone services almost back inflating again!

  • Biggest declines on the month, in core categories of weight>1%: Public Transportation, then Used Cars & Trucks, then New Vehicles, then Recreation.
  • Biggest gainers: Women’s & Girls’ apparel, Household Furnishings and Operations. Not many upside outliers, in other words.
  • And folks, that means Median isn’t going to be as soft. My early guess is 0.22, bringing y/y to virtually match last February’s cycle high at 2.58% or so. That’s what’s really going on. Median category is housing so could be + or – small from my est.
  • Breakevens 1.25bps off the lows. It’ll probably keep going. This is not a weak number in my view.
  • Even CPI-leased cars decelerated. Someone hates cars this month.

  • Today’s report is brought to you by the Young & Restless.
  • Four pieces charts. Food & Energy flat

  • Core goods actually dropped a tenth. Culprit…I dunno…maybe CARS?!?

  • Core services less rent of shelter…stable at 2.32% y/y

  • And the big story on the upside – and less shocking than cars – rent of shelter.

  • Now, the core CPI figure – and the fact that the main upward move was from housing, which is underrepresented in core PCE – means the Fed has less urgency to tighten faster, for now. Median tells a different story.
  • This month, we rolled off an 0.09% from April 2017 and replaced it with an 0.10%. Next month, we will roll off an 0.08% from May 2017. And the next two months after that are 0.14%. Ergo, core will keep rising.
  • Should have gotten to 2.2% on core this month, and didn’t thanks to CARS. But will next month, and 2.3% the month after that, and 2.4% a month or two after that.
  • Markets are just about discounting CURRENT inflation (the chart shows CPI swaps, which aren’t biased lower like breakevens, and Median through last month). But still not discounting FUTURE inflation and no tail-risk premium to them either.

  • US #Inflation mkt pricing: 2018 2.2%;2019 2.2%;then 2.4%, 2.4%, 2.5%, 2.5%, 2.4%, 2.4%, 2.5%, 2.5%, & 2028:2.5%.
  • That’s all for now. Thanks for tuning in!

Today’s CPI report was a strong number masquerading as a weak number. The core figure was polluted by a large one-off move lower in inflation for cars – a move that is, moreover, not evident in private surveys. The fact that this is a one-off caused by an outlier was driven home a few hours later by the Cleveland Fed, who calculated the Median CPI at +0.24%, which pushed the y/y median CPI to 2.60%. That’s the highest level since January 2009, and it underscores that we are really seeing acceleration beyond merely retracing the cell phones and other one-off moves from 2017. On the upside of today’s report was housing, which took a surprising jump higher. But what was surprising was not the rise, but the magnitude of the jump. Housing prices continue to rise, and the rate of increase has been accelerating. There is no question that rising housing prices tend to pressure rents higher, and so the direction is not a one-off. Arguably, the one-month movement was “too much,” but it may have been retracing prior softness as well. The movement in rents took the series away from our model a touch, but there’s nothing saying our model is the “right” answer!

But the right answer overall is that inflation is accelerating. Some of this was simply baked in the cake as easy comparisons cause the y/y number to rise. But not all of it. The question going forward is whether inflation crests here, between 2.2%-2.4% on core CPI and 2.5%-2.7% on median, or carries further. My belief is that it has further to run.

Categories: CPI, Tweet Summary

My Ridiculously Specific Expectation for 10-year Interest Rates

I try to stay away from making predictions. I don’t see the upside. If I am right, then yay! But after the fact, predictions often look obvious (hindsight bias) and it is hard to get much credit for them. By the same token, if I am wrong then the ex post facto viewer shakes his head sadly at my obtuseness. Sure, I can make a prediction with a very high likelihood of being true – I predict that the team name of the 2019 Super Bowl winner will end in ‘s’ – but there’s no point in that. This is one of the reasons I think analysts should in general shy away from making correct predictions and instead focus on asking the correct questions.

But on occasion, I feel chippy and want to make predictions. So now I am going to make a ridiculously specific prediction. This prediction is certain to be incorrect; therefore, I just want to observe that it would be churlish of you to criticize me for its inaccuracy either before or after the fact.

Ten-year Treasury rates will break through 3% for good on May 10, and proceed over the next six weeks to 3.53%. As of this Thursday, year/year core CPI inflation is going to be 2.2% or 2.3%, and median CPI over 2.5% and nearing 9-year highs. At that level of current inflation, 3% nominal yields simply make no sense, especially with the economy – for now – growing above trend. Two percent growth with 2.5% inflation is 4.5%, isn’t it? There is also no reason for 10-year real yields to be below 1%, so when we get to that 3.53% target it will be 1.08% real and 2.45% expected inflation (breakevens).

As I said, inflation is going up, at least through the summer (and I think quite a bit beyond), and summer is traditionally a difficult time for the bond market (although less so in recent years). So I think the selloff will end by June 28th and we will chop around in a 16bp range – roughly the average range from the last two chop periods – until September 6th. Then we will have a nice little rally to 3.18% as economic reports start to show some softness and the Q3 GDP trackers start to point to a 1-handle report. Also, Democrats will continue to lead in the generic ballot polling, prompting fears that impeachment proceedings for the President will begin once the party takes Congress in the midterm elections. Stocks will do badly for the second half of the year, partly on growth concerns, partly on interest rate concerns and the inflation outlook, and partly on fear that impeachment could damage the Trump business-friendly environment. But stocks will not do so badly so quickly as to trigger a flight-to-quality flow into bonds. Price deterioration will be steady with the S&P 500 dropping to 2329 by November 6th, when 10-year yields will be at 3.23%.

On Election Day, returns will show that voters booted out a lot of Republicans, but a surprising number of old guard Democrats also lose their seats. The House flips to the Democrats, while Republicans retain a slim edge in the Senate. The Democrats surprise everyone by not selecting Nancy Pelosi to be the Speaker of the House, signaling that they have no desire to pursue impeachment against a President whose leadership and behavior they question but against whom no actual crime is alleged. (Moreover, Democrats realize that they would rather contest for the White House in 2020 against The Donald than against some other, less lampoonable Republican). Stocks rally into year-end, but bonds begin the next leg down. By early 2019, although the economy is recording its first quarter of the as-yet-unidentified recession, the Fed continues to tighten, core inflation exceeds 3%, 10-year bonds surpass 4.25%, and stocks resume a downtrend that lasts for much of that year and takes the S&P 500 to 1908.75. The curve never inverts as the Fed keeps chasing inflation higher.

Now, if I nail even 20% of that prediction you’ll be justifiably impressed. But the point of the exercise is less about laying markers on particular outcomes and more about imagining how the bond bear market – because that is what I believe we are now in – will unfold. While I don’t know if my conjecture about how the election and the run-up thereto will hold, I do think it is likely that the midterms will cause more than the usual amount of market turbulence. And this is in the context of markets that have already rediscovered their turbulence somewhat. Now, I may also be completely wrong about inflation, but the number of signposts we are seeing these days about capacity constraints in labor markets and some product markets (and even some commodity markets) indicate to me that this inflation scare is less jump-scare and more Gothic horror novel.

We will turn the next page on that novel this Thursday when the CPI is reported. To ‘listen’ to me read a few pages about inflation, be sure to sign up for my private Twitter feed at https://premosocial.com/inflation_guypv and follow my CPI tweets live (I am also starting to put more chart packages and other content on that feed, so sign up! Only $10 per month!)

Inflation and Corporate Margins

On Monday I was on the TD Ameritrade Network with OJ Renick to talk about the recent inflation data (you can see the clip here), money velocity, the ‘oh darn’ inflation strike, etcetera. But Oliver, as is his wont, asked me a question that I realized I hadn’t previously addressed before in this blog, and that was about inflation pressure on corporate profit margins.

On the program I said, as I have before in this space, that inflation has a strong tendency to compress the price multiples attached to profits (the P/E), so that even if margins are sustained in inflationary times it doesn’t mean equity prices will be. As an owner of a private business who expects to make most of the return via dividends, you care mostly about margins; as an owner of a share of stock you also care about the price other people will pay for that share. And the evidence is fairly unambiguous that inflation inside of a 1%-3% range (approximately) tends to produce the highest multiples – implying of course that, outside of that range, multiples are lower and therefore stock prices tend to adjust when the economy moves to a new inflation regime.

But is inflation good or bad for margins? The answer is much more complex than you would think. Higher inflation might be good for margins, since wage inputs are sticky and therefore producers of consumer goods can likely raise prices for their products before their input prices rise. On the other hand, higher inflation might be bad for margins if a highly-competitive product market keeps sellers from adjusting consumer prices to fully keep up with inflation in commodities inputs.

Of course, business are very heterogeneous. For some businesses, inflation is good; for some, inflation is bad. (I find that few businesses really know all of the ways they might benefit or be hurt by inflation, since it has been so long since they had to worry about inflation high enough to affect financial ratios on the balance sheet and income statement, for example). But as a first pass:

You may be exposed to inflation if… You may benefit from inflation if…
You have large OPEB liabilities You own significant intellectual property
You have a current (open) pension plan with employees still earning benefits, You own significant amounts of real estate
…especially if the workforce is large relative to the retiree population, and young You possess large ‘in the ground’ commodity reserves, especially precious or industrial metals
…especially if there is a COLA among plan benefits You own long-dated fixed-price concessions
…especially if the pension fund assets are primarily invested in nominal investments such as stocks and bonds You have a unionized workforce that operates under collectively-bargained fixed-price contracts with a certain term
You have fixed-price contracts with suppliers that have shorter terms than your fixed-price contracts with customers.
You have significant “nominal” balance sheet assets, like cash or long-term receivables
You have large liability reserves, e.g. for product liability

So obviously there is some differentiation between companies in terms of which do better or worse with inflation, but what about the market in general? This is pretty messy to disentangle, and the following chart hints at why. It shows the Russell 1000 profit margin, in blue, versus core CPI, in red.

Focus on just the period since the crisis, and it appears that profit margins tighten when core inflation increases and vice-versa. But there are two recessions in this data where profits fell, and then core inflation fell afterwards, along with one expansion where margins rose along with inflation. But the causality here is hard to ferret out. How would lower margins lead to lower inflation? How would higher margins lead to higher inflation? What is really happening is that the recessions are causing both the decline in margins and the central bank response to lower interest rates in response to the recession is causing the decline in inflation. Moreover, the general level of inflation has been so low that it is hard to extract signal from the noise. A slightly longer series on profit margins for the S&P 500 companies, since it incorporates a higher-inflation period in the early 1990s, is somewhat more suggestive in that the general rise in margins (blue trend) seems to be coincident with the general decline in inflation (red line), but this is a long way from conclusive.

Bloomberg doesn’t have margin information for equity indices going back any further, but we can calculate a similar series from the NIPA accounts. The chart below shows corporate after-tax profits as a percentage of GDP, which is something like aggregate corporate profit margins.

And this chart shows…well, it doesn’t seem to show much of anything that would permit us to make a strong statement about profit margins. Over time, companies adapt to inflation regime at hand. The high inflation of the 1970s was very damaging for some companies and extremely bad for multiples, but businesses in aggregate managed to keep making money. There does seem to be a pretty clear trend since the mid-1980s towards higher profit margins and lower inflation, but these could both be the result of deregulation, followed by globalization trends. To drive the overall point home, here is a scatterplot showing the same data.

So the verdict is that inflation might be bad for profits as it transitions from lower inflation to higher inflation (we have one such episode, in 1965-1970, and arguably the opposite in 1990-1995), but that after the transition businesses successfully adapt to the new regime.

That’s good news if you’re bullish on stocks in this rising-inflation environment. You only get tattooed once by rising inflation, and that’s via the equity multiple. Inflation will still create winners and losers – not always easy to spot in advance – but business will find a way.

You Haven’t Missed It

April 26, 2018 2 comments

A question I always enjoy hearing in the context of markets is, “Have I missed it?” That simple question betrays everything about the questioner’s assumptions and about the balance of fear and greed. It is a question which, normally, can be answered “no” almost without any thought to the situation, if the questioner is a ‘normal’ investor (that is, not a natural contrarian, of which there are few).

That is because if you are asking the question, it means you are far more concerned with missing the bus than you are concerned about the bus missing you.

It usually means you are chasing returns and are not terribly concerned about the risks; that, in turn – keeping in mind our assumption that you are not naturally contrary to the market’s animal spirits, so we can reasonably aggregate your impulses – means that the market move or correction is probably underappreciated and you are likely to have more “chances” before the greed/fear balance is restored.

Lately I have heard this question arise in two contexts. The first was related to the stock market “correction,” and on at least two separate occasions (you can probably find them on the chart) I have heard folks alarmed that they missed getting in on the correction. It’s possible, but if you’re worried about it…probably not. The volume on the bounces has diminished as the market moves away from the low points, which suggests that people concerned about missing the “bottom” are getting in but rather quickly are assuming they’ve “missed it.” I’d expect to see more volume, and another wave of concern, if stocks exceed the recent consolidation highs; otherwise, I expect we will chop around until earnings season is over and then, without a further bullish catalyst, the market will proceed to give people another opportunity to “buy the dip.”

The other time I have heard the angst over missing the market is in the context of inflation. In this, normal investors fall into two categories. They’re either watching 10-year inflation breakevens now 100bps off the 2016 lows and 50bps off the 2017 lows and at 4-year highs (see chart, source Bloomberg) and thinking ‘the market is no longer cheap’, or they just noticed the well-telegraphed rise in core inflation from 1.7% to 2.1% over the last several months and figuring that the rise in inflation is mostly over, now that the figure is around the Fed’s target and back at the top of the 9-year range.

Here again, the rule is “you didn’t miss it.” Yes, you may have missed buying TIPS 100bps cheap to fair (which they were, and we pointed it out in our 2015Q3 Quarterly Inflation Outlook to clients), but breakevens at 2.17% with median inflation at 2.48% and rising (see chart, source Bloomberg), and still 25bps below where breakevens averaged in the 5 years leading up to the Global Financial Crisis, says you aren’t buying expensive levels. Vis a vis commodities: I’ve written about this recently but the expectations for future real returns are still quite good. More to the point, inflation is one of those circumstances where the bus really can hit you, and concern should be less about whether you’ve missed the gain and more about whether you need the protection (people don’t usually lament that they missed buying fire insurance cheaper, if they need fire insurance!).

(In one way, these two ‘did I miss it’ moments are also opposites. People are afraid of missing the pullback in stocks because ‘the economy still looks pretty strong,’ but they’re afraid they missed the inflation rally because ‘the economy is going to slow soon and the Fed is tightening and will keep inflation under control.’ Ironically, those are both wrong.)

My market view is this:

  • For some time, TIPS have been very cheap to nominal bonds, but rich on an absolute Negative real yields do not a bargain make, even if they look better than other alternatives when lots of asset classes are even more expensive. But as real yields now approach 1% (70bps in 5y TIPS, 80bps in 10y TIPS), and with TIPS still about 35bps cheap to nominal bonds, they are beginning to be palatable to hold on their own right. And that’s without my macro view, which is that over the next decade, one way or the other, inflation protection will become an investment theme that people tout as a ‘new focus’ even though it’s really just an old focus that everyone has forgotten. But the days of <1% inflation are over, and we aren’t going to see very much <2% either. We may not see 4% often, or for long, but at 3% inflation is something that people need to take into account in optimizing a portfolio. I think we’re at that inflection point, but if not then we will be in a year or two. And TIPS are a key, and liquid, component of smart real assets portfolios.
  • Stocks have been outrageously expensive with very poor forward return expectations for a long time. However, these value issues have been overwhelmed by strong momentum (that, honestly, I never gave enough credit to) and the currently in-vogue view that momentum is somehow better than value. But perennially strong momentum is no longer a foregone conclusion. Momentum has stalled in the stock market – the S&P has broken the 50-day, 100-day, and (a couple of times, though only briefly so far) 200-day moving averages. The 50-day has now crossed below the 100-day. And the longer that the market chops sideways the weaker the momentum talisman becomes. Eventually, the value anchor will take over. There may be more chop to come but as I said above, I think another leg down is likely to come after earnings season.

And so, in neither case have you “missed it.”

Being Closer to the ‘Oh Darn’ Inflation Strike

April 19, 2018 5 comments

The time period between spikes of inflation angst seems to be shortening. I am not sure yet about the amplitude of those spikes of angst, but the concern seems to be quickening.

This is not without reason as it seems that concerning headlines are occurring with more frequency. This week the Bloomberg Commodity Index again challenged the 2016 and 2017 highs before backing off today (see chart, source Bloomberg).

Somewhat more alarming than that, to people who watch commodities, is how the commodity indices are rallying. The culprits are energy as well as industrial metals, and each has an interesting story to tell. Energy has been rallying partly because of global tensions, but also partly because US shale oil production appears to be running into some bottlenecks on production (wages, shortages of frack sand) as well as delivery (capacity constraints on pipelines), and part of what has kept a lid on energy prices over the last couple of years was the understanding that shale oil production was improving rapidly and becoming lots more efficient due to improved technology. If shale is limited, the ‘lid’ on prices is not as binding as we had thought. On industrial metals, some of the upward pressure has been due to fallout from US sanctions on Rusal, a major supplier of aluminum and alumina. Since those sanctions were announced, aluminum prices have risen around 25%, and alumina (a raw input to aluminum production) about 50%, with knock-on effects in other industrial metals.

Both of these items bear on the market’s recent fears about new pressures on inflation – capacity constraints (especially rising wages for long-haul truckers) and potential fracturing of the global trade détente.

And 10-year breakevens are at new 4-year highs, although it is worth remembering that this is nowhere near the 10-year highs (see chart, source Bloomberg).

Shorter inflation swaps look less alarming, and not at new four-year highs. However, even here the news is not really soothing. The reason that shorter inflation swaps are lower than they have been in the past is because the energy curves are in backwardation – meaning that the market is pricing in lower energy process in the future. In turn, this means that implied core inflation – once we strip out these energy effects – are, in fact, at 4-year highs (see chart, source Enduring Investments).

So there is legitimate cause to be concerned about upside risks to inflation, and that’s one reason the market is a bit jumpier in this regard. But there is also additional premium, volatility, and angst associated with the level of inflation itself. While as I have pointed out before much of the rise in core inflation to date due to optics arising from base effects, that doesn’t change the fact that the ‘oh, rats’ strike is closer now. That is to say that when core inflation is running at 1.5%, stuff can go wrong without hurting you if your pain threshold is at 3%. But when core inflation is at 2.5% (as it will be this summer), not as much “bad stuff” needs to happen to cause financial pain. In other words, both the ‘delta’ and the ‘gamma’ of the exposure is higher now – just as if one were short a call option struck at (say) 3% inflation. Because, implicitly, many investors are.

If inflation is low, then even if it is volatile in a range it can be consistent with high market valuations for stocks and bonds. But when inflation starts to creep above 3%, those markets tend to suffer in non-linear fashion.

And this, I believe, is why the market’s nervousness about inflation (and market volatility resulting from that nervousness) is unlikely to soon abate.

Why the M2 Slowdown Doesn’t Blunt My Inflation Concern

April 12, 2018 1 comment

We are now all good and focused on the fact that inflation is headed higher. As I’ve pointed out before, part of this is an illusion of motion caused by base effects: not just cell phones, but various other effects that caused measured inflation in the US to appear lower than the underlying trend because large moves in small components moved the average lower even while almost half of the consumption basket continues to inflate by around 3% (see chart, source BLS, Enduring Investments calculations).

But part of it is real – better central-tendency measures such as Median CPI are near post-crisis highs and will almost certainly reach new highs in the next few months. And as I have also pointed out recently, inflation is moving higher around the world. This should not be surprising – if central banks can create unlimited amounts of money and push securities prices arbitrarily higher without any adverse consequence, why would we ever want them to do anything else? But just as the surplus of sand relative to diamonds makes the former relatively less valuable, adding to the float of money should make money less valuable. There is a consequence to this alchemy, although we won’t know the exact toll until the system has gone back to its original state.

(I think this last point is underappreciated. You can’t measure an engine’s efficiency by just looking at the positive stroke. It’s what happens over a full cycle that tells you how efficient the engine is.)

I expect inflation to continue to rise. But because I want to be fair to those who disagree, let me address a potential fly in the inflationary ointment: the deceleration in the money supply over the last year or so (see chart, source Federal Reserve).

Part of my thesis for some time has been that when the Fed decided to raise interest rates without restricting reserves, they played a very dangerous game. That’s because raising interest rates causes money velocity to rise, which enhances inflation. Historically, when the Fed began tightening they restrained reserves, which caused interest rates to rise; the latter effect caused inflation to rise as velocity adjusted but over time the restraint of reserves would cause money supply growth (and then inflation) to fall, and the latter effect predominated in the medium-term. Ergo, decreasing the growth rate of reserves tended to cause inflation to decline – not because interest rates went up, which actually worked against the policy, but because the slow rate of growth of money eventually compounded into a larger effect.

And so my concern was that if the Fed moved rates higher but didn’t do it by restraining the growth rate of reserves, inflation might just get the bad half of the traditional policy result. The reason the Fed is targeting interest rates, rather than reserves, is that they have no power over reserves right now (or, at best, only a very coarse power). The Fed can only drain the inert excess reserves, which don’t affect money supply growth directly. The central bank is not operating on the margin and so has lost control of the margin.

But sometimes they get lucky, and they may just be getting lucky. Commercial bank credit growth (see chart, source Federal Reserve) has been declining for a while, pointing to the reason that money supply growth is slowing. It isn’t the supply of credit, which is unconstrained by reserves and (at least for now) unconstrained by balance sheet strength. It’s the demand for credit, evidently.

Now that I’ve properly laid out that M2 is slowing, and that declining M2 growth is typically associated with declining inflation (and I haven’t even yet pointed out that Japanese and EU M2 growth are both also at the lowest levels since 2014), let me say that this could be good news for inflation if it is sustained. But the problem is that since the slowing of M2 is not the result of a conscious policy, it’s hard to predict that money growth will stay slow.

The reason it needs to be sustained is that we care about percentage changes in the stock of money plus the percentage change in money velocity. For years, the latter term has been a negative number as money velocity declined with interest rates. But M2 velocity rose in the fourth quarter, and my back-of-the-envelope calculation suggests it probably rose in Q1 as well and will rise again in Q2 (we won’t know Q1’s velocity until the advance GDP figures are reported later this month). If interest rates normalize, then it implies a movement higher in velocity to ‘normal’ levels represents a rise of about 12-14% from here (see chart, source Bloomberg.[1])

If money velocity kicks in 12-14% over some period to the “MVºPQ” relationship, then you need to have a lot of growth, or a pretty sustained decline in money growth, to offset it. The following table is taken from the calculator on our website and you can play with your own assumptions. Here I have assumed the economy grows at 2.5% per year for the next four years (no mean feat at the end of a long expansion).

The way to read this chart is to say “what if velocity over the next four years returns to X. Then what money growth is associated with what level of inflation?” So, if you go down the “1.63” column, indicating that at the end of four years velocity has returned to the lower end of its long-term historical range, and read across the M2 growth rate row labeled “4%”, you come to “4.8%,” which means that if velocity rises to 1.63 over the next four years, and growth is reasonably strong, and money growth remains as slow as 4%, inflation will average 4.8% per year over those four years.

So, even if money growth stays at 4% for four years, it’s pretty easy to get inflation unless money velocity also stays low. And how likely is 4% money growth for four years? The chart below shows 4-year compounded M2 growth rates back thirty or so years. Four percent hasn’t happened in a very long time.

Okay, so what if velocity doesn’t bounce? If we enter another bad recession, then it’s conceivable that interest rates could go back down and keep M2 velocity near this level. This implies flooding a lot more liquidity into the economy, but let’s suppose that money growth is still only 4% because of tepid credit demand growth and velocity stays low because interest rates don’t return to normal. Then what happens? Well, in this scenario presumably we’re no longer looking at 2.5% annual growth. Here’s rolling-four-year GDP going back a ways (source: BEA).

Well, let’s say that it isn’t as bad as the Great Recession, and that real growth only slows a bit in fact. If we get GDP growth of 1.5% over four years, velocity stays at 1.43, and M2 grows only at 4%, then:

…you are still looking at 2.5% inflation in that case.

I’m going through these motions because it’s useful to understand how remarkable the period we’ve recently been through actually is in terms of the growth/inflation tradeoff, and how unlikely to be repeated. The only reason we have been able to have reasonable growth with low inflation in the context of money growth where it has been is because of the inexorable decline in money velocity which is very unlikely to be repeated. If velocity just stops going down, you might not have high inflation numbers but you’re unlikely to get very low inflation outcomes. And if velocity rises even a little bit, it’s very hard to come up with happy outcomes that don’t involve higher inflation.

I admit that I am somewhat surprised that money growth has slowed the way it has. It may be just a coin flip, or maybe credit demand is displaying some ‘money illusion’ and responding to higher nominal rates even though real rates have not changed much. But even then…in the last tightening cycle, the Fed hiked rates from 1% to 5.25% over two years in 2004-2006, and money growth still averaged 5% over the four years ended in 2006. While I’m surprised at the slowdown in money growth, it needs to stay very slow for quite a while in order to make a difference at this point. It’s not the way I’d choose to bet.


[1] N.b. Bloomberg’s calculation for M2 velocity does not quite match the calculation of the St. Louis Fed, which is presumably the correct one. They’re ‘close enough,’ however, for this purpose, and this most recent print is almost exactly the same.

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