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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
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