Archive for March, 2020

Why We Can Be Pretty Sure China is Lying About COVID-19

March 28, 2020 14 comments

This post has nothing to do with inflation (although to the extent that China’s problems are worse-than-advertised, the supply shock could be worse-than-expected and the resulting inflation impulse larger-than-expected). However, as a longtime participant in the financial markets – which, over the last decade or two has increasingly meant an observer of China and Chinese data – I have been absolutely flabbergasted at the evident willingness of press, government officials, and healthcare experts to accept at face value the reports China has released about the development of COVID-19. At worst, some observers will allow that these numbers might not be “verifiable,” but this is generally expressed as sort of a minor issue. Now, I realize that there are potentially partisan reasons to slant interpretations one way or t’other, but I don’t think this is a case of ‘ a little bit of wiggle room’ in the figures.

Just for fun, I decided to take what China has said about its experience with COVID-19 and use what we know about the development of the virus in the US to project what the true cases probably are. Obviously, as with any model, there are wide error bars…but it’s simply implausible that China is experiencing anything like what they claim to be experiencing. Here’s the math of it.

We know from the US and the rest of the world that the virus cases grow around 33% per day until they downshift “at some point.” See for example this outstanding chart from the Financial Times from last week.

That point of shifting is somewhat speculative and probably depends on a lot of things. But for our model we’ll assume that the virus grows in China at 33% per day and downshifts to a 2% growth rate (which is roughly what South Korea’s growth rate in new cases is now, so we are being very generous) at the point China claimed that the growth rate of new cases was starting to decline, roughly around February 11.

We also can infer from US numbers that the death rate is around 5%, with deaths taking about 5 days and recoveries about 17 days. So, we look backwards about 5 days to see the number of open cases, and realize about 5% of those will die. Similarly, we look backwards about 17 days and realize that about 95% of those cases eventually recover (recoveries take longer because they tend to be cases that were caught earlier, plus a ‘recovery’ is not defined until we get two negative tests while a death is pretty clear). There are a number of combinations of period lookbacks/mortality that work, but that’s about the best case. We can’t get a model that is consistent with the number of deaths we have in the US with a longer resolution time unless the fatality rate is much higher; if the fatality rate is lower than 5% it implies that cases resolve even faster than 5 days after detection which seems unlikely. Globally, the ratio of deaths to (deaths + recoveries) is about 16% (see here under “closed cases” for a source of that data), so 5% is quite conservative. Similarly, we can’t have the low number of recoveries we have unless recoveries take a lot longer than deaths to resolve, or the recovery rate is a lot lower (death rate is a lot higher) than 5%.

And that 5% is with the US having some advance warning, and outstanding medicine. I don’t have any reason to believe it would be lower in China. So those are the parameters I’m going to use. 33% growth rate of infections downshifting to 2%, 5% mortality rate, with resolutions happening in 5 days for death and 17 days for recovery.

The first case in China dates from 12/16/19.

Growing at the aforementioned rates, from 1 case on 12/16/19, China ought to have been around 72 cases by end of December. They admitted to 27. Since at low numbers the growth rate has a lot to do with idiosyncratic details of the particular cases, we will re-set to 27 on 12/31, to be generous. But recognize that there is some reason to think China was low by a factor of 2-3, two weeks in.

Growing at the aforementioned rates, China ought to have been around 14,300 by January 22, when they told the WHO they had 547 cases. (From here on, all of the data comes from Bloomberg whose numbers differ slightly, but insignificantly, from the Johns Hopkins data). So they’re off by a factor of about 25 from what we would expect, based on the experienced growth rates of other countries.

Around February 11, China claims to have had 44,653 cases. By our growth rates, it should have been more like 4.3 million. China must have had spectacular medicine! (even if we grow the 547 number from Jan 22, they would have been at 125k by Feb 11). So it looks like by Feb 11 China was already off by a factor of between 3 and 100. The 3 requires us to believe that they were being completely honest on Jan 22 when they said 547.

So let’s assume the new cases downshift on Feb 11 to only 2% growth. Even starting from their 44,653, we would see 109k cases by now (March 27) if growth rates were only 2%. Literally the only way to get to China’s figures is to say that the transmission rate was never very high, despite the widespread travel around the Chinese New Year and the fact that as the origin of the pandemic is it reasonable to conclude that their recognition of the danger of this disease would take a little longer. And if all of those things are true, then the aggressively autocratic crackdown seems really over the top, given the vanishingly-small prevalence of the disease in a country of 1.4 billion people.

Going back to our original trends of 33%, downshifting to 2%, and with the death and recovery rates I am estimating: I think the actual number of cases in China is more like 10 million, with 465k dead and 7 million recovered. Honestly, it’s hard to explain why their traffic and power usage is recovering so slowly if only 0.006% of the country ever contracted the virus and an even tinier fraction died. The economy should have immediately sprung almost fully back when the quarantine was lifted. Most people in China wouldn’t even know anyone who had been infected…only 1 person in 17,000 ever got the disease. The numbers would just be too small to notice.

We don’t just have to believe China is inherently deceitful…we just need to believe that the country doesn’t have miraculous medical powers. And we need to believe in math. There are other reasons why the numbers could be technically accurate, and yet not illuminating. It might be the case that China simply isn’t testing people very aggressively, so that it is the case that only 81,340 people have tested positive, and only 3,292 of those have died. In that case their numbers would be accurate but not necessarily the whole truth since the country would also be having the small issue of seeing a bunch of other bodies piling up for “unknown” reasons. That inconvenient fact would eventually become hard to not notice, which is one reason why it might make sense to expel external journalists…

Categories: Uncategorized

The Big Bet of 10-year Breakevens at 0.94%

March 11, 2020 5 comments

It is rare for me to write two articles in one day, but one of them was the normal monthly CPI serial and this one is just really important!

I have been tweeting constantly, and telling all of our investors, and anyone else who will listen, that TIPS are being priced at levels that are, to use a technical term, kooky. With current median inflation around 2.9%, 10-year breakevens are being priced at 0.94%. That represents a real yield of about -0.23% for 10-year TIPS, and a nominal yield of about 0.71% for 10-year Treasuries. The difference in these two yields is 0.94%, and is approximately equal to the level of inflation at which you are indifferent to owning an inflation-linked bond and a nominal bond, if you are risk-neutral.

First, a reminder about how TIPS work. (This explanation will be somewhat simplified to abstract from interpolation methods, etc). TIPS, the U.S. Treasury’s version of inflation-linked bonds, are based on what is often called the Canadian model. A TIPS bond has a stated coupon rate, which does not change over the life of the bond and is paid semiannually. However, the principal amount on which the coupon is paid changes over time, so that the stated coupon rate is paid on a different principal amount each period. The bond’s final redemption amount is the greater of the original par amount or the inflation-adjusted principal amount.

Specifically, the principal amount changes each period based on the change in the Consumer Price All Urban Non-Seasonally Adjusted Index (CPURNSA), which is released monthly as part of the Bureau of Labor Statistics’ CPI report. The current principal value of a TIPS bond is equal to the original principal times the Index Ratio for the settlement date; the Index Ratio is the CPI index that applies to the coupon date divided by the CPI index that applied to the issue date.

To illustrate how TIPS work, consider the example of a bond in its final pay period. Suppose that when it was originally issued, the reference CPI for the bond’s dated date (that is, its Base CPI) was 158.43548. The reference CPI for its maturity date, it turns out, is 201.35500. The bond pays a stated 3.375% coupon. The two components to the final payment are as follows:

(1)          Coupon Payment = Rate * DayCount * Stated Par * Index Ratio

= 3.375% * ½ * $1000 * (201.35500/158.43548)

= $21.45

(2)          Principal Redemption = Stated Par * max [1, Index Ratio]

= $1000 * (201.35500/158.43548)

= $1,270.90

Notice that it is fairly easy to see how the construction of TIPS protects the real return of the asset. The Index Ratio of 201.35500/158.43548, or 1.27090, means that since this bond was issued, the total rise in the CPURNSA – that is, the aggregate rise in the price level – has been 27.09%. The coupon received has risen from 3.375% to an effective 4.2892%, a rise of 27.09%, and the bondholder has received a redemption of principal that is 27.09% higher than the original investment. In short, the investment produced a return stream that adjusted upwards (and downwards) with inflation, and then redeemed an amount of money that has the same purchasing power as the original investment. Clearly, this represents a real return very close to the original “real” coupon of 3.375%.

Now, there is an added bonus to the way TIPS are structured, and this is important to know at times when the market is starting to act like it is worried about deflation. No matter what happens to the price level, the bond will never pay back less than the original principal. So, in the example above the principal redemption was $1,270.90 for a bond issued at $1,000. But even if the price level was now 101.355, instead of 201.355, the bond would still pay $1,000 at maturity (plus coupon), even though prices have fallen since issuance. That’s why there is a “max[ ]” operator in the formula in (2) above.

So, back to our story.

If actual inflation comes in above the breakeven rate, then TIPS outperform nominals over the holding period. If actual inflation comes in below the breakeven rate, then TIPS underperform over the holding period. But, because of the floor, there is a limit to how much TIPS can underperform relative to nominals. However, there is no limit to how much TIPS can outperform nominals. This is illustrated below. For illustration, I’ve made the x-axis run from -4% compounded deflation over 10 years to 13% compounded inflation over 10 years. The IRR line for the nominal Treasury bond is obviously flat…it’s a fixed-rate bond. The IRR line for the TIPS bond looks like a call option struck near 0% inflation.

Note that, no matter how far I extend the x-axis to the left…no matter how much deflation we get…you will never beat TIPS by more than about 1% annualized. Never. On the other hand, if we get 3% inflation then you’ll lose by 2% per year. And it gets worse from there.

Because annualizing the effect makes this seem less dramatic, let’s look instead at the aggregate total return of TIPS and Treasuries. For simplicity, I’ve assumed that coupons are reinvested at the current yield to maturity of the 10-year note, which would obviously not be true at high levels of inflation but is in fact the simplifying assumption that the bond yield-to-maturity calculation makes.

So, if you own TIPS in a deflationary environment, you’ll underperform by about 10% over the next decade. Treasuries will return 7.3% nominal; TIPS will return -2.3% nominal. Unfortunate, but not disastrous. But if inflation is 8%, then your return on Treasuries will still be 7.3%, but TIPS will return 103%. Hmmm. Yay, your 10-year nominal Treasuries paid you back, plus 7.3% on top of that. But that $1073 is now worth…$497. Booo.

So the point here is that at these prices you should probably own TIPS even if you think we’re going to have deflation, unless you are really confident that you’re right. You are making a much bigger bet than you think you’re making.

Summary of My Post-CPI Tweets (March 2020)

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy. Or, sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments (updated site coming soon). 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.

  • CPI day, coronavirus edition! Meaning that no matter what this month’s number is, next month’s number will be more “infected” and lots more interesting.
  • The consensus today is for core CPI to be a ‘soft’ +0.2%, with y/y core coming in at 2.3%.
  • Last month’s CPI figure was above expectations, but following a couple of weak months. Economists’ forecasts suggest they think the strength, not the weakness, was the outlier. I’m not so sure.
  • In last month’s CPI, core goods were weak, especially Used Cars and Pharmaceuticals. Both of those effects look to have recently reversed…altho question in both cases is whether it will be captured in the Feb number. Black Book figures have turned higher.
  • Important to note is the easy comparison of today’s CPI print to Feb 2019, which was only +0.127% core. So even a slightly strong 0.2% m/m could cause an uptick to 2.4% rounded on the y/y core.
  • Going forward, I’m really interested in housing, which has been resilient – if 10-year inflation markets are “right” at 1.0%, then Housing will have to collapse. I don’t see that.
  • And I think we are all more aware now that our supply chain of pharmaceuticals, specifically APIs, runs through China; efforts to bring back some drug manufacturing to the US will put upward pressure there.
  • That’s probably not this month’s story, but the Big Story to watch I think.
  • That’s all for now. 5 minutes to go…good luck with the number.
  • Well, core was +0.2% and the y/y was 2.4%, so that implies a strong core. But core figures being really slow to post to Bloomberg. That’s why the unnatural pause from me..
  • Weirdly getting entire breakdown except for core index level. Not sure if it’s a Bloomberg or a BLS issue but we’ll proceed. In any event looks like it was above 0.2% on core, and rounded down.
  • …and as I type that it comes in at +0.22%. That puts y/y core at 2.37%. That’s not QUITE the high for the cycle, but pretty close.
  • here is y/y core. I don’t see deflation yet, do you?

  • Last 12…the Oct and Dec figures looking more like the outliers.

  • Context for that. Here is the median CPI (which doesn’t come out until later) vs the 10y CPI swap rate. Clearly, market participants expect something big and negative.

  • Candidates for big and negative? It would have to be housing. But Owners’ Equivalent Rent this month was +0.246%. That’s softer than last month and the y/y fell to 3.28% from 3.35%…but not exactly weak.
  • Primary rents were unchanged y/y at 3.76%. Lodging Away from Home – to be sure, we ought to soon see that drop on the COVID-19 effect, was +2.03% m/m, but that only puts y/y at +0.78% from -0.21%. Lodging AFH hasn’t been a driver of inflation prints.
  • Now, possibly interesting, except that this is now a really volatile number, was the +0.43% jump in Apparel. China effect? Prob not yet. But y/y rose to -0.91% from -2.24% as recently as Oct. But the new survey method has made this volatile.
  • On Medical care – Pharma was -0.43% m/m, but that kept the y/y at 1.85% (was 1.80%). Last month Pharma was negative too. I’ll come back to drugs in a moment but Doctors’ Services rose to +0.83% y/y from +0.70% and Hospital Svcs to 4.28% from 3.84%.
  • Hospital Services y/y.

  • Recall 1 reason I’ve been expecting rise in Med Care is b/c insurance costs in the CPI have been soaring. But b/c of the way BLS measures insurance, as a residual, my hypothesis was that this was just proxying for stuff they hadn’t caught yet. But insurance STILL soaring!

  • So if I am right about the proxying effect, the recent rise in medical care pieces still leaves more to go.
  • I haven’t mentioned used cars yet. M/M used cars were +0.39%, moving y/y to -1.33% from -1.97%. The dip seems to be over. Recent surveys in last few weeks especially have seen surge in used car buying. Might be b/c auto manufacturing is having supply chain issues, or not.

  • Core CPI ex-housing rose to 1.70% y/y. That’s the highest level since Feb 2013. Again, I refer you to 10-year inflation breakevens, DOWN this morning to 0.99%. Just not seeing anything that even suggests a turn lower. Housing solid, and ex-housing at the highs.
  • …that doesn’t mean inflation can’t fall, and headline inflation in the near term is going to drop HARD because of energy, but to sell 10-year inflation at 1% you have to believe in more than an energy effect. Oil can’t fall 30% every month.
  • Again to sort of make the point that last month…while stronger than expected…was actually dragged LOWER by core goods: y/y core services stayed at 3.1%; y/y core goods rose to 0.0% vs -0.3% last month (but +0.1% month before).
  • One element of core goods is pharma. In the news recently b/c China supplies something like 90% of our APIs that go into drugs. This index has become lots more VOLATILE in recent yrs. Does that have anythng to do w/ the China part of supply chain becoming more important?

  • So biggest declining core categories this month: car/truck rental, misc personal goods, jewelry and watches. All down more than 10% annualized. Gainers: Lodging AFH, Women’s/Girls’ Apparel, Dairy (??), Personal Care Products. (Dairy not core, but unusual).
  • As if i didn’t already have enough reasons to give up ice cream. Here’s Dairy inflation, y/y. Come on, man.

  • Here is a little stealth inflation for you, although I suspect this will turn around. Here is y/y airfares, up at 2.35% y/y.

  • Why is that stealth inflation? Because airfares usually have a decent relationship to jet fuel. Except recently, they’ve been reluctant to fall. This is thru Feb since this is Feb CPI. Last point in red.

  • But here is jet fuel futures. This isn’t in CPI because consumers don’t buy jet fuel. Notice it was already declining in January and February before falling off a cliff this month. We OUGHT to be seeing this in airfares. Not yet, but soon.

  • last subcomponent pic today. This is college tuition & fees, y/y. This is going to start heading up unless the stock market starts to recover. When endowments take a beating, they share the pain.

  • Median CPI this month looks like it ought to be up around 0.26%ish. If that’s right, y/y median will be steady at 2.88% y/y.
  • Let’s see, why don’t we do the four pieces charts and then wrap up. Didn’t realize I’d been yammering for an hour.
  • Piece 1 is food & energy. Guess what: this is about to roll over, and hard. But it isn’t core, so it moves around a ton. We look through this volatility. Note the y axis scale!

  • Piece 2 is core goods. Back to roughly flat. Close to our model, but I’m still amazed this hasn’t seen more of an upswing yet with trade frictions. But I am pretty sure it will with COVID-19, because that’s a major supply shock and this is where it will tend to hit.

  • Still, of more concern is core services less rent-of-shelter. Significant weight here to medical care services, which as I showed earlier (see hospital services chart) is in a steady rise. Pharma shows up in core goods. The rest of medical shows up here.

  • Last but not least, rent of shelter. Solid as a rock. By the way, 10-year breakevens are down another 8bps today, to 0.95%. This makes zero sense. 1y CPI swaps? Different story. But 10y is nonsense.

  • Wrapping up: another stronger-than-expected number. I said last month that core CPI will be above 2.5% by summer, and we are still on track for that. COVID-19 might eventually pull prices lower if it becomes more demand shock than supply shock. We’re nowhere close to that now.
  • Of course, that doesn’t change the Fed’s decision. They’ll ease, aggressively. And the Federal government will spend like crazy. Folks, welcome to MMT. This is exactly what the MMT prescription is: deficit spend, and print money to cover it. We’ll see how it works out.
  • That’s all for today. Thanks for tuning in.

Nothing really further to add to this string of tweets. None of this stops the Fed from easing aggressively, but it wouldn’t have changed their decision much anyway because the Fed pretty much ignores inflation. But it should affect investment decisions. Really incredible to me is the way inflation bonds are underperforming so dramatically when they were already cheap and inflation is still rising. You have to be massively bearish, looking for a global collapse of monumental proportions, to want to sell 10-year inflation below 1% when housing is above 3% and ex-housing is at 7-year highs, and when the government is implementing MMT (effectively) and businesses are going to be under tremendous pressure to shorten supply chains and produce in higher-cost areas that are geographically safer/closer. It’s really hard to understand the TIPS market at the moment. (Some people say that it is always hard to understand the TIPS market!)

Categories: CPI, TIPS, Tweet Summary

Why Bond Folks Are More Afraid of COVID-19

March 8, 2020 1 comment

On Friday I tweeted a picture from our daily chart pack, and mused that either credit is too negative or stocks are not negative enough.

I spent the weekend musing about why the bond guys seem to be so negative about the effects of the COVID-19 virus compared to the stock guys. Equity investors tend to tell me things like “well, the fundamentals are pretty sound” (ignoring the role that multiples play in stock market levels), which sometimes manifests in super-dumb things like Larry Kudlow’s admonition a few thousand points ago that people should buy the dip. (By the way, all those folks who bought the dip because Larry said so…will the government make them whole? Didn’t think so. Rule to remember: never take the advice of someone who has a vested interest in the outcome.)

Meanwhile, bond investors had put bond yields at all-time lows. This is especially amazing compared to the levels that yields reached in the Global Financial Crisis; back then, a housing bubble was in the process of imploding and, since shelter is a major part of core inflation it was a done deal that inflation was going to plunge, and far (Core CPI eventually got as low as 0.6%, although it didn’t get very low at all ex-housing). So low nominal yields made sense. But today, this does not seem to be in the offing. Core inflation is more likely to accelerate with the effects of the supply shock, unless the virus gets so bad that we really do have a major demand shock. And even then it should not fall very far. So the message from the bond market is super negative on growth, and stocks are only a little off their all-time highs (at least, until tonight. Right now S&P futures are -4%, although a lot of that has to do with the collapse of energy prices thanks to the disintegration of OPEC+). So again, I wonder, why?

After long thought I think it is because bond investors understand much more viscerally the power of compound interest. Compound interest is the concept that money grows not linearly, but exponentially over time. If I start with $400 and grow it at 12% per year, here is what it becomes.

So that little $400 ends up being a really big pile of money after 60 years! From little acorns do mighty oak trees grow, and all of that. But equity folks don’t love this chart because the first 20 years looks incredibly uninteresting, not at all like Tesla. Now, if we look at this in log scale, it looks much more boring but this next chart says the same thing: stuff is compounding at 12%. And that chart actually looks kinda similar to this chart, sourced here.

This is a plot of COVID-19 cases outside of China, and the left axis is log scale. What this chart says is that there is no sign that the rate of growth of cases of COVID-19 is slowing. In fact, its spread has been remarkably consistent since the beginning of February. Roughly, the number of cases in the US has been growing at around 12% per day. Which means that the chart looks a whole lot like the chart of $400 turning into $360,000 over 60 years, except that now it is 400 cases (Friday’s figure) turning into 360,000 cases over 60 days.

So when people say “the flu kills more people than this virus,” I know they’re equity folks. They see 400 cases and compare to 36,000 flu deaths and scoff. But that just tells me they don’t appreciate the power of compounding. Yes, COVID-19 hasn’t killed 36,000 Americans yet. But the flu kills that many per year despite the fact that (a) it isn’t generally communicable for very long outside of the period when the carrier has symptoms – which is why it’s okay to go back to school when you’re fever-free for 24 hours, (b) it has a pretty low fatality rate in the 1-2% range, and (c) almost everyone is inoculated against the flu. COVID-19 beats the flu on all three of those metrics.

That doesn’t mean that this bug will kill everyone, but it does mean that it is fairly likely to kill more than the flu unless something changes with the rate of exponential growth. By the end of May, the same growth rate would mean more than 6 million Americans have gotten the virus, which means a couple hundred thousand would die.

This is not a prediction, and I really hope that the rate of contagion slackens and the survival rate increases. I don’t know what would cause that to happen: I am not an epidemiologist. I’m just a bond guy, and I understand compounding. In investments, compounding is your friend. In disease, compounding is your enemy.

Categories: Analogy Tags: ,
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