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Dirty Little Secret


Who needs data to lighten the mood when the mood seems to lighten spontaneously every night? Stocks rallied early and today actually held onto their gains, finishing +3% on the day (the third best rally of the year) albeit on much lighter volume than on recent sessions.

It is highly unlikely that the market rallied so sharply because of good growth reports from China, Japan, and Australia, as Bloomberg suggested. It also seems unlikely to me that the failure of the ECB to cut interest rates today (Nouriel Roubini says that they ought to move rates to zero immediately to offset the austerity plans being implemented) is salutatory for dollar markets.

Initial Claims were a little weak, at 456k versus 450k expectations and with an upward revision to the prior week. No good rally reason there. Maybe some oscillators were oversold…

Whatever the reason, there is no doubting the result (although we may fairly doubt whether it will continue tomorrow, especially given the tepid volume). Bonds, too, were under pressure: the Street has a bunch of paper to distribute after the auctions this week, and they were distributing it into a falling market as the 10y Note futures fell 32.5/32nds and the 10y yield rose to 3.32%. Inflation swaps rose 2-4bps, which is actually pretty weak considering the 13bp rise in yields.

I continue to be negative on stocks. I am unimpressed by rallies on declining volume. And I am not nuts about bonds at a 3.32% yield, and TIPS are not cheap either. Commodities don’t pay dividends, and while I think everyone should have some money in a commodity index because the long-run sources of return are robust and have little to do with commodities (or other assets), you can’t put all your money in that basket. We’re all worried about what will happen to cash when inflation arrives, as I am confident it eventually will since it is the only way to escape this vortex. So what’s an investor to do?

Here’s a dirty little secret that inflation people do not like to mention very much. Treasury bills, or other short-term paper, are not horrible investments in inflationary times.

The reason for this counterintuitive result is that central banks’ reaction function is tied at least informally to inflation (if a central bank follows the Taylor Rule religiously, it is almost formally tied to inflation). When inflation goes up, so do short-term interest rates, albeit with a lag; when inflation goes down, short-term interest rates often follow. In the chart below, covering the period of the modern Federal Reserve (basically from Chairman William McChesney Martin onward), I’ve plotted the 3-month Treasury Bill rate and the year-on-year change in headline CPI. There is a very high correlation, and it is plainly not spurious: high inflation tends to cause interest rates to rise since investors insist on at least some real return; moreover, of course the Federal Reserve tends to reinforce that effect by raising the overnight rate and restricting liquidity to choke off inflation.

Historically...Tbills aren't so bad!

As an aside, for the 3-month Bill I used the monthly auction average (provided by a great little site called EconoMagic that I subscribe to) from 1951 until 2000, when the series was discontinued; thereafter I used the H.15 average TBill rate for the last business day of the month (Source: Federal Reserve).

So the message is that by sitting in cash you won’t do spectacularly well, but you probably won’t get killed, either. And you don’t have as much to worry about from inflation as you may think. Note of course that I distinguish cash-type investments from currency, which naturally is eroding away with every tick of the price level.

Now, it is fair to ask whether the current situation may make cash slightly less attractive, since there is a plausible argument for the FOMC to keep rates very low in an attempt (admitted or not) to push inflation just a bit higher. After all, the current 0.1% rate for TBills is below both the core and headline inflation rates. But even though I think this is likely to be the case, it isn’t a horrible opportunity cost. In most cases you may lose 1-2% in real value per year until the Fed normalizes interest rates; in the case where you would lose more, because inflation accelerates suddenly, you will still be better off than in other asset classes such as stocks (which get killed in rising inflation environments) or bonds. Losing 3-4% beats losing 40% any day.

If inflation explodes, you lose a lot of real value in Bills, stocks, and bonds…but if you’re worried about that case then just buy TIPS even though they are a little bit rich and be done with it. (By the way, at the moment a decent alternative to buying TBills, if you can get a decent price from your broker, is to buy the Jan 11s or Apr 11 TIPS).

So, although I am largely in cash right now, I’m not as worried as you would think I should be, since I have one eye on the inflation situation.

.

I will not publish a comment tomorrow (and thanks in advance to all of you who will write lovely notes or even poetry telling me how much you miss it!), but there is some economic data. Retail Sales (Consensus: +0.2%, +0.1% ex-auto) and the Michigan Sentiment number (Consensus: 74.5 from 73.6) will preoccupy us, a little, although as today’s action showed there is more going on behind the scenes than economic wiggles can explain. Next week we get inflation data! In the meantime, probably the most significant thing happening tomorrow is the kickoff of the World Cup. Expect liquidity off the Continent to begin to slacken around 10:00 ET, when South Africa plays Mexico. At 2pm France “battles” Uruguay, but by that time of the day the Europeans aren’t providing as much liquidity in our markets anyway.

U.S. battles England on Saturday. It would be a huge win (or even draw) for the Yanks, but I’m not holding my breath. We just want to get out of group.

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Categories: Uncategorized
  1. Tom C
    June 11, 2010 at 8:02 am

    isn’t the real, after tax return on t-bills negative? Some selective overseas sovereign debt might be better, no?

    • June 11, 2010 at 8:12 am

      It is, but at the moment I don’t mind losing a little to avoid losing a lot. The problem with buying overseas debt at the moment is that you get the FX volatility too. Don’t be lured by the higher yields on overseas short-term debt, either: remember that theoretically just compensates for expected FX movements anyway!

      But you’re on the right track, and it isn’t a bad solution…my point here was that staying very short-term isn’t necessarily as bad as you think. (If you’re talking about longer-term overseas sovereign debt, then I don’t really agree though).

  2. keyur
    June 11, 2010 at 2:38 pm

    contradictions –
    A. “We’re all worried about what will happen to cash when inflation arrives, as I am confident it eventually will since it is the only way to escape this vortex.”
    and
    B. “Treasury bills, or other short-term paper, are not horrible investments in inflationary times.”

    well, you dont escape this vortex so far as Taylor Rule is followed. debt dilutes when inflation rises and interest rates do not. and methinks THAT is already happening.

    • June 11, 2010 at 3:20 pm

      Absolutely…and I addressed that issue. You won’t get KILLED if that happens, because if inflation is 10% there is no way the Treasury will be able to sell TBills yielding 0! However, maybe they’ll only yield 7%, so you’ll have some real losses but they won’t be awful. At least, compared to what else you would have lost in other assets!

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