Float On


It is Golden Week in Asia, and the May Day holiday in Europe. In other words, it has been a slow couple of days in the markets.

The world still keeps producing news, though, whether or not anyone feels like trading it. Late last week, Japan extended its asset-purchase program by one-third in amount (¥40 trln from ¥30 trln) and one-half in maturity (from 3 years to 2 years). Last night, the Reserve Bank of Australia surprised markets by cutting interest rates 50bps to 3.75%, against general expectations for 25bps. The RBA had made its initial rate cut in December, so now they’re officially closer to the 2009 bottom in the cash rate target (3.00%) than to the 2011 highs (4.75%). Join the crowd, Australia!

The Chicago Purchasing Managers’ Report released on Monday was weak, in fact the weakest since 2009. Fortunately, the market didn’t worry too much about that, since today the equivalent national index (the ISM) rose to its highest level since last summer although well off the highs of last spring. Remember that these are relative-change indices, so that a higher print means growth accelerated a little bit from one month to the next. With an election coming up, and the federal government in effective control of the automotive industry, don’t expect a sharp slowdown in manufacturing any time soon! More interesting will be the non-Manufacturing ISM, released on Thursday, but it will be in any event overshadowed by tomorrow’s ADP report (Consensus: 170k vs 209k last) and Friday’s Employment Report (Consensus: 161k vs 120k).

Richmond Fed President Lacker said that the Fed may have to raise interest rates in mid-2013, even if the Unemployment Rate is above 7% and even though it has previously promised to keep rates on hold until mid-2014.[1] Now, Lacker has been a hawkish dissenter for some time, so this isn’t a particularly shocking revelation. It was interesting though that according to Bloomberg he said “It is ‘really tricky’ for the Fed to find ‘that time when interest rates need to rise to prevent inflation pressures from emerging, before you see them emerge, before you see inflation move up steadily.’” I am not sure what constitutes “inflation moving up steadily” if 16 out of 17 months of acceleration in year-on-year core inflation doesn’t qualify!

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Interest rates are near or at all-time lows, with long-term rates considerably below expected inflation (1.94% on 10-year Treasuries; 2.61% on 10-year inflation swaps). So what is a country to do, if it needs to borrow trillions of dollars for the next couple of decades?

Apparently, the answer is ‘issue floating rate debt!’

As Tim Geithner looks to sew up the “worst Treasury Secretary ever” award,[2] apparently the U.S. Treasury is considering issuing floating-rate debt. Why? The Treasury needs to raise enormous amounts of money, but would like to raise it on the part of the curve where rates are effectively zero. However, it already issues so many TBills that the risk of a failure in that market isn’t zero, if there grew any concern about the size of the government’s debt. So it wants to issue longer. That part seems smart: reduce ‘rollover’ risk by issuing long but having rates pegged to short-term rates. I don’t have any issue with the desire to issue longer-dated debt; in fact, I’d advise the Treasury to issue perpetual notes or, as Robert Shiller has suggested, notes linked to GDP that are effectively equity in the United States.

But if you’ve decided to replace uncertain bill rollovers with longer-dated notes, that doesn’t resolve the question of whether to issue fixed-rate or floating-rate notes. That’s a wholly different question. Consider this analogy: you’ve bought a house, and you need to choose whether to take out a one-year balloon mortgage at a great, low rate or a 30-year mortgage. Clearly, the one-year balloon mortgage represents way too much rollover risk, because if you’re unable to roll it over you’ll default on the mortgage. But does that mean you should take out an adjustable-rate mortgage? Well, no – that’s a false choice. You can take out a 30-year ARM, or a 30-year fixed-rate mortgage. Your choice between those two depends on several factors, but they are equally acceptable alternatives along the maturity dimension.

What the Treasury is really trying to do is to raise money at low rates, so as to keep the current interest bill low and help the deficit numbers. (And who cares, really, if rates go up during the next Administration, which anyway is unlikely to be Obama’s and if it is then there will be plenty of time to fix this?) But that puts the government in exactly the same position as the homebuyer who in 2006 took out a 3y/1y ARM relying on the low teaser rate to qualify for more home than he could otherwise afford. We have more government than we can afford, to be sure! I suppose Geithner assumes/hopes that no one will foreclose on the U.S. government.

Incidentally, you may perhaps be thinking “well, a floating-rate note will be inflation-protected, because short rates are correlated with inflation.” This is true (at least, when the Fed isn’t lashing itself to the mast), and there are some money managers who in fact sell products based on the idea that floating-rate notes are an inflation-protected asset class. To be sure, floating-rate notes are more inflation-protected than fixed-rate notes, but unless the maturity is extremely long, the investor still has ample inflation exposure. This is because while the coupons are roughly inflation-protected (because they go up and down with a high correlation to inflation), the principal is not.

If you invest $100 in a 5-year floating rate note, in five years you will get back $100. Along the way you will have received floating coupons that provide inflation protection – but only if the part of the coupon that represents inflation protection of the principal is re-invested in more notes of the same type. In other words, you had better have more than $100 of principal at the end of the deal, or you’ve lost real principal. And on a 5-year note, at these yields, something like 96% of the value of the bond is the present value of the return of principal. Even for a 10-year note, 82% of the value of the note reflects the value of principal, and on a 30-year note 40% of the note’s value still derives from the principal payback. So, in a nutshell, unless you’re carefully reinvesting your coupons in the same security, your real return is not assured with a floating rate note. I would steer clear of any such Treasury issues unless they trade extremely cheap. If you want floating-rate inflation protection in a bond form, a superior investment (although still one I’d avoid at these real yields) is to buy TIPS so that your principal is also explicitly protected against inflation.

And speaking of protecting against inflation, I’d appreciate your help with a one-question poll. We are trying to determine how protected investors feel they are, today, with respect to inflation (whether naturally or because of steps they have taken). The poll appears below. Now, there’s likely to be quite a bit of bias in the results considering that if you’re reading this you surely already have more awareness of the inflation threat than the average investor, so feel free to point others to the poll via the “Share This” link at the bottom of the poll. Thanks in advance.


[1] There is ongoing discussion about whether the Fed saying “at least” mid-2014 constitutes a promise, but I stick with my original analysis: either it was meant to be a promise, in which case the institution’s credibility should be damaged if they don’t hold to it, or it was meant to be a forecast in which case it was pointless since there’s no reason the Fed’s forecast ought to have any impact on rates – especially since they are demonstrably worse at forecasting than private-sector economists. Or, what is most likely, it was originally meant to be a promise because the Fed wanted to force rates lower, but now they want it to be considered just a forecast because they think they may no longer want rates that low for that long and they don’t want to lose credibility.

[2] Stop! Stop! We’ll concede the point! Please take a vacation until January!

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  1. JS
    May 23, 2012 at 6:59 am

    This is a very long post, and like a Hussman post, will take some time to digest. (Longer than the 5 minutes allottted for your average links “round-up.”) What I wanted to mention was your stance on commodities vs. equities. Commodoties seem on the verge of an incredible breakdown, technically. What is your opinion on the suddenly-seeming and astonishgly strong deflationary feel that is coming out of markets, worldwide? Is this the result of diminshing (QE3 aka Twist, + the latest EU/US Swaps +LTRO, which aggregated were massive) returns? From a TA perspective, gold and commodities look like there is a complete vacuum that may be filled by rapidly dropping prices. So much, possibly, for inflation. (The next inference of course after that means the global recovery is over, for now.) I have had a great deal of respect for your past articles, and maybe this one went over my head, but as a portfolio manager do you have any deflationary hedges? More than happy to have your opinion.

    • May 23, 2012 at 7:23 am

      I appreciate your note!

      My company specializes in constructing hedges for any sort of inflation environment. At the present time, it’s difficult to construct deflationary hedges because deflation is essentially ‘priced in,’ or largely so, with long-term interest rates near zero. The best ‘hedge’ would be a nominal bond, but that has far more downside than upside (actually, a real bond like the current TIPS give you ALMOST as much deflation protection, because your par value is protected, but also inflation protection) at these levels. A more-sophisticated hedge would be to buy negative-strike (or zero-strike) inflation floors, but these are expensive. We can synthetically create a “deflation floor” more-cheaply than the market supplies it, with some other advantages. (The options solutions are really institutional solutions, as they require a minimum amount of capital to be able to trade the necessary instruments.

      But I am not particularly worried about deflation. In the global credit crisis of 2008-2009, inflation barely slowed – core inflation ex-housing went from 1.9% in 2007 to 1.6% in 2008 before rebounding to 2.9% in 2009. Every inflation indicator we follow bottomed in 2009 or 2010, for Japan, the UK, Europe, and the US, and the rise in the global money supply is accelerating, not slowing, as the ECB loses its Bundesbank DNA. (We discuss all of these trends in our Quarterly Inflation Outlook, available to customers). Accordingly, I believe the commodity move is pure investor error of mistaking nominal prices for real prices. Remember that supply and demand curves cross at a REAL price, not a nominal price…but it seems most investors have forgotten this nuance in the years of essentially zero inflation.

      By the way, none of this discussion would alter our view of commodities over equities in the event of deflation. Equities do just as poorly in deflation as they do in inflation, and unlike commodities they start from an overvalued position. If we experience deflation, it will also compress margins rather than tending to support them as a small inflation would. So if the world’s central banks truly screwed up and money supply began to decline (or velocity PLUNGED so that they couldn’t catch up), stocks would probably lose 30-50% of their value over a period of a couple of years. So inflation or deflation wouldn’t in any event change my RANKING of commodities and stocks.

      Thanks for writing, and especially for the comparison to Hussman!

  1. January 29, 2014 at 9:26 pm

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