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Velocity and Rates and the Vicious Cycle Possibility

November 1, 2017 3 comments

There was a potentially important development in inflation recently, but one that was generally overlooked.

Perhaps it was mostly overlooked because it is way too early to say that a trend is developed that could cause an adverse inflation occurrence. But I think that the main reason it was overlooked is that monetary velocity is not very well understood. In particular, most people seem to think that money velocity – definitionally, the number of times a unit of money is transacted in a year, on average – is somehow tied to nervousness about the economy. So, when money velocity fell in the global financial crisis, many observers attributed that to savers stuffing dollar bills in the proverbial mattress.

There may be some role for investor/consumer uncertainty in the modeling of velocity, but at best it is a secondary or tertiary cause. The main cause of changes in velocity is simple: when the cost of holding money is high, we work hard to hold less of it, and when the cost of holding money is low, we don’t mind holding more of it. Friedman first noticed this, so it isn’t a new discovery. In monetarist speak, velocity is the “inverse of the demand for real cash balances,” and the demand for such balances depends of course on the relative cost of cash balances relative to other investments.

The chart below shows the power of this relationship. I’m using the 5-year constant maturity treasury rate, but there are obviously other investments that would get thrown into this relationship. But it’s easy to envision the effect here. When interest rates are at 6%, then money does not sit idle for very long or accumulate without limit in your bank account – you will invest those monies in, say, a 5-year CD or Treasury Note, rather than earn basically nothing in a checking account. But when interest rates are at 1%, the urge to do so isn’t as much.

What you can see in the chart is that interest rate moves tend to precede movements in money velocity, which is what we would expect from a causal relationship such as this. So the reason that money velocity plunged in the GFC wasn’t because people were scared; it was mostly because interest rates fell, taking away the incentive to invest longer-term.

Changes in money velocity, of course, tend to cause changes in inflation. MVºPQ, after all, and Q tends to be mostly exogenously determined by aggregate fiscal variables, industrial policy (what’s that?) and the like. Changes in M and changes in V tend to be reflected mainly in P over time.

Also, interest rates are affected by inflation, or more properly by the expectations of inflation. And expectations about inflation tend to follow inflation.

So, the history of the 1980s’ declining inflation can be read like this, without too much of a stretch: declining money growth under Volcker caused declining inflation initially. The decline in inflation tended to cause interest rates to decline. Declining interest rates tended to cause declines in money velocity. Declining money velocity tended to cause declines in inflation…and we were in a virtuous cycle that extended, and extended, and extended, until we were close to zero in interest rates and inflation, and money velocity was as low as it has ever been.

Now, you can see from this chart that interest rates bottomed in 2013, but really have not appreciably risen above the lows, and so money velocity hasn’t reversed its slide although since the beginning of last year the trajectory has been slowing (I suspect some nonlinearity/stickiness of this relationship near zero). But the GDP report from last Friday, combined with recent money growth and increase in the price deflator, implied that money velocity actually rose slightly.

It has nudged higher before, but not by very much. And this is why I am reluctant to make a huge deal about this being the start of something, except that this is the first time since 2008 that there has been a reasonable expectation that interest rates might continue to rise because the central bank wishes it so.

And so I don’t think it’s wrong to consider the “what if” of the next cycle. Normalization of interest rates implies normalization of velocity, and there’s just no way to get appreciably higher velocity without higher inflation. Higher inflation would probably produce higher interest rates, because however much your expectations about inflation are “anchored” they are likely to become unanchored if inflation of 3%-4% starts to print. Higher interest rates could lead to higher velocity, and we have a cocktail for the opposite of the 1980s virtuous interest rate cycle.

This speculation isn’t destiny, and a lot depends on whether interest rates start to move higher and by how much. But there is already starting to be some concern about inflation and the FRBNY’s “Underlying Inflation Gauge” has recently gone to new post-crisis highs (see Chart above, source Bloomberg), so I don’t think it is unreasonable to consider and prepare. Because the best case for the next inflation uptick is that it rises a bit and falls back. But there are elements in place that support a much worse case, and that is a feedback loop through interest rates and velocity. The chances of that outcome are considerably higher than zero.


Note: these articles are now first released on my private Twitter feed, which you can subscribe to for only $10 per month here. Subscribers also get my real-time tweet analysis on the monthly CPI report, which are not on my public feed, and I am working on adding a free chart package to the mix as well.

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Inflation-Linked Bonds: For the Wary, but the “Wise?”

Only a quick article at the moment. This is longer than a tweet-length answer, but didn’t need to be super long.

A friend sent me the link to the following article from the FT:

Will UK inflation-linked bonds be the choice of the wise?

I must confess I don’t know about the answer to that question, although it is true that UK linkers – especially long linkers – are perennially rich thanks to pension fund demand. Below is a chart (source: Enduring Investments) that shows our analytical rich/cheap series for 10-year UK linkers.

But the article also includes a common gripe about inflation-linked bonds that isn’t really fair, and should be addressed. The argument is that inflation-linked bonds don’t really protect against inflation, because changes in real yields are much more impactful to the return than are changes in inflation.

This is true. It is also true that changes in nominal yields are much more impactful to the return of nominal bonds than is the coupon rate or yield on the bond. If you buy a 10-year Treasury yielding, say, 3%, and hold it for two years, you will most likely get a return quite a bit different from 3% because changes in the yield-to-maturity over that period overwhelms the yield of the bond (especially now). You only get 3% if you hold to maturity. (Well, technically you get 3% if you hold for a period equal to the Macaulay duration, but that’s a discussion for another time.)

So it isn’t fair to criticize inflation-linked bonds for not being an inflation hedge over every time period. As with nominal bonds, they are a perfect inflation hedge if held to the proper horizon, and a less-than-perfect hedge over different time periods.

However, you shouldn’t be trying to hedge inflation over the next week or month. You should be trying to hedge inflation over the long term. Accordingly, the fact that returns vary due to changes in real yields is not a damning fact about linkers. Unless, of course, you’re a highly levered participant.

Categories: Bond Market, Quick One, Theory, TIPS, UK

Inflation Trading is Not for the Weak

June 27, 2017 1 comment

I was prepared today to write a column about horse racing and value investing…that will have to wait until tomorrow…when this article was sent to me by about a dozen people:

Deutsche Bank Said to Face Possible $60 Million Derivative Loss

The article was sent my way because the loss was tied to a trade that used US dollar inflation derivatives, and since that’s a market I basically started back in 2003 folks figured I might want to know. And I do.

The inflation derivatives market is not huge. The chart below shows rolling 12-month inflation derivative volumes (source: BGC Partners) through last September, which was the last time I went looking for the data for a presentation. Total interbank volumes are around $10-15bln per month; customer volumes are not included here but are not insignificant (any more).

Most inflation books, especially these Volcker Rule days, are run pretty close to the vest. Most of these volumes will be set against customer flows, or against bond breakevens, or against other positions on the inflation curve. Net risk positions for any derivative book, especially these days, are pretty small…which is why Deutsche is investigating whether risk limits were breached in this case. In principle this should be easy to figure out, since DB and every other bank has risk control specialists whose job it is to monitor these risks.

But inflation risks are complex. Our firm breaks fixed-income risks down into six basis risks that add up to the net risk of a bond. For a TIPS bond, there is just one risk; for a corporate bond there will be six. Our risk schematic starts from real rate risks and builds up – unlike in most risk systems, which start with nominal risks and try to force real bonds to fit. Inflation-linked derivatives also have commodity deltas implied, since they are tied to headline inflation and headline inflation is tied largely to energy prices. Geez, I could write a book on this – it would be a combination of “Inflation Risks and Products[1] and, in this case, “Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports.”

Suffice it to say that even really sharp investors don’t always quite get it when it comes to inflation. In early 2014, a prestigious investment management firm took a multi-billion-dollar bath on a “risk-parity” product that hadn’t truly understood how to figure out the risks of TIPS. How much more difficult, then, is it for risk control officers, many of whom have shiny new Ph.D.s and very little direct market experience? A fast-talking trader who knows something about the product can, if he is unscrupulous, persuade risk control that he is not really taking risks that he knows, or ought to know, he is taking.

In short, I am sympathetic with the risk control guys in this case. They were probably outgunned by a slick operator pushing the limits of his limits. It’s almost assuredly the case: the market, as large as it is, is too small in the Volcker Rule era to allow the accumulation of a prudent position of large enough size to cause this sort of loss – especially in the recent period of exceptionally low market volatility.

This, then, is an object lesson: if you’re running inflation risk, and you think it’s pretty much like running nominal rate risk – you’re wrong, and you should get help before your firm’s name is the one in the Bloomberg article.[2]

Tomorrow, we can talk about horse racing.

[1] In which I co-wrote a chapter, on commodities actually, with Bob Greer.

[2] To be fair, in this case the problem was the combination of ignorance and what appears to be malfeasance. If you’re careful with your control structures and only hire high-quality people of sterling reputation, you shouldn’t have a problem with the second part of this formula.

Categories: Bond Market, TIPS, Trading

The Yield Curve is Critical of Fed Credibility

I was planning to write an article today about the shape of the yield curve. Since the Global Financial Crisis, the Treasury curve has been very steep – in early 2010 the 2y/10y spread reached almost 300bps, which is not only unprecedented in absolute terms but especially in relative terms: a 300bp spread when 2-year yields are below 1% is much more significant than a 300bp spread when 2-year yields are at 10%.

2s10s

But what I had planned to write about was the phenomenon – well-known when I was a cub interest-rate strategist – that the yield curve steepens in rallies and flattens in selloffs. The chart below shows this tendency. The 5-year yield is on the left axis and inverted high-to-low. The 2y/10y spread is on the right axis. Note that there is substantial co-movement for the recession of the early 1990s, throughout the ensuing expansion (albeit with a general drift to lower yields), in the recession of the early 2000s, the ensuing expansion, and the lead-up to the GFC.

and5yyields

I was ready to point out that the steepening and flattening trends tend to be steady, and I was going to illustrate that they feed on themselves partly for this technical reason: that when the curve is steep, steepening trades (selling 10-year notes and buying duration-weighted 2-year notes, financing both in repo) tend to be positive carry and therefore easier to maintain, while on the other hand when the curve is flat the opposite tends to be true. So the actual causality of the relationship between steepening and rallies is more complex than it seems at first blush.

It would have made a very good article, but then I noticed that since 2010 or so the tendency has in fact reversed!

Specifically, from 1987-1995 the correlation of the level of the 5-year spread to the level of the 2s/10s spread was -0.78. From 1995-1999, the correlation flipped to +0.48 (but I didn’t bother to de-trend the data and I suspect that correlation stems more from the strong, 350bp decline in interest rates from 1995-1999). From 1999-2009, the correlation was -0.81. Since 2010, the correlation is +0.60: the curve has tended to flatten in rallies and steepen in selloffs. And, in the recent bond market selloff, the curve steepened as long rates rose further than short rates.

This is interesting. Clearly, carry dynamics cannot explain why the relationship is inverted. I think the answer, though, is this: since 2010, the overnight has been anchored. That isn’t different than in the past – from late 1992 to early 1994, the Fed funds target was anchored at 3%. But the difference is that back then, traders acted as if the Fed might eventually move the overnight rate in a meaningful way. Since 2010, investors and traders have attributed no credibility to the Fed, with virtually no chance of a substantial move over a short period of time. Accordingly, while short interest rates historically have tended to be the tail wagging the dog, while longer-term interest rates move around less as investors assume the Fed will remain ahead of the curve and keep longer-term inflation and interest rates in a reasonable range…in the current case, short term rates don’t move while longer-term rates reflect the market belief that rates will eventually reach an equilibrium but over a much longer period than 2 years as the Federal Reserve is dragged kicking and screaming.

I happen to agree, but it isn’t a great sign. I suppose it was destined, in a way – “open mouth” operations can only work in the long run if the Fed is credible, and the Fed can only be credible in the long run if it delivers on its promises. But it hasn’t. This is probably because the Fed’s forecast have been worse than abysmal, meaning its promises were based on bad forecasts. In such a case, changing one’s mind when the data changes is the right thing to do. But even more important, if your forecasts are frequently wrong, is to shut up and stop trying to move markets where you want them with “open mouth” operations. I have said it for 20 years: the worst thing Greenspan ever did was to make “transparency” a goal of the Fed. They’re just not good enough at what they do to make their activities transparent…at least, if they want to maintain credibility.

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Administrative Note: On Monday I will be conducting the third and final in a series of webinars on inflation and inflation investing. This series will be done on the Shindig platform, sponsored by Enduring Investments, in cooperation with Investing.com. This webinar is on “Inflation-Aware Investing.” You can sign up directly with Shindig here, or find the webinar link at Investing.com.

Not So Fast on the Trump Bull Market

December 1, 2016 6 comments

**NOTE – please see the announcement at the end of this article, regarding a series of free webinars that begins next Monday.**


Whatever else the election of Donald Trump to be President of the United States has meant, it has meant a lot of excitement in precincts that worry about inflation. This is usually attributed, among the chattering classes, to the faster growth expected if Mr. Trump’s expressed preference for tax cuts and spending increases obtains. However, since growth doesn’t cause inflation that isn’t the part of a Trump Presidency that concerns me with respect to a continuing rise in inflation.

In our latest Quarterly Inflation Outlook, I wrote a short piece on the significance of the de-globalization movement for inflation. That is an area where, if the President-Elect delivers on his promises, a lot of damage could be done in the growth/inflation tradeoff. I have written before about how a big part of the reason for the generous growth/inflation tradeoff of the 1990s was the rapid globalization of many industries following the end of the Cold War. Deutsche Bank recently produced a research piece (I don’t recall whether it had anything to do with inflation, weirdly) that contained the following chart (Source: as cited).

freetradeagreementsperyearThis chart is the “smoking gun” that supports this version of events, in terms of why the inflation dynamic shifted in the early 1990s. Free trade helped to restrain prices in certain goods (apparel is a great example – prices are essentially unchanged over the last 25 years), by allowing the possibility of significant cost savings on production.

The flip side of a cost savings on production, though, is a loss of domestic manufacturing jobs; it is this loss that Mr. Trump took productive advantage of. If Mr. Trump moves to increase tariffs and other barriers to trade, and to reverse some of the globalization trend that has driven lower prices for the last quarter-century, it is potentially very negative news for inflation. While there was some evidence that the globalization dividend was beginning to get ‘tapped out’ as all of the low-hanging fruit had been harvested – and such a development would cause inflation to be higher than otherwise it would have been – I had not expected the possibility of a reversal of the globalization dividend except as a possible and minor side-effect of tensions with Russia over the Ukraine, or the effect the Syrian refugee problem could have on open borders. The election of Mr. Trump, however, creates the very real possibility that the reversal of this dividend might be a direct consequence of conscious policy choices.

I don’t think that’s the main reason that people are worried about inflation, though. Today, one contributor is the news that OPEC actually agreed to cut production, in January, and that some non-OPEC producers agreed to an additional cut. U.S. shale oil producers are clicking their heels in delight, because oil prices were already high enough that production was increasing again and they are more than happy to take more market share back. Oil prices are up about 15% since the announcement.

But that’s near-term, and I don’t expect the oil rally has legs much beyond current levels. Breakevens have been rallying, though, for weeks. Some of it isn’t related to Trump at all but to other initiatives. One correspondent of mine, who owns an office-cleaning business, sent me this note today:

“Think of you often lately as I’m on the front line out here of the “instant” 25% increase in min wage.  Voters decided to move min wage out here from 8.05 to $10 jan 1.  Anyone close to 10/hr is looking for a big raise.  You want to talk about fast dollars, hand a janitor a 25% pay bump and watch the money move.  Big inflation numbers pending from the southwest.  I’m passing some through but market is understandably reacting slower than the legislation.”

Those increases will definitely increase measured inflation further, though by a lot less than it increases my friend’s costs. Again, it’s an arrow pointing the wrong way for inflation. And, really, there aren’t many pointing the right way. M2 growth continues to accelerate; it is now at 7.8% y/y. That is too fast for price stability, especially as rates rise.

All of these arrows add up to substantial moves in inflation breakevens. 10-year breaks are up 55bps since September and 30bps since the election. Ten-year inflation expectations as measured more accurately by inflation swaps are now at 2.33%. Almost all of that rise has been in expectations for core inflation. The oft-watched 5y5y forward inflation (which takes us away from that part of the curve which is most impacted by energy movements) is above 2.5% again and, while still below the “normal” 2.75%-3.25% range, is at 2-year highs (see Chart, source Bloomberg).

5y5y

So what is an investor to do – other than to study, which there is an excellent opportunity to do for the next three Mondays with a series of educational webinars I am conducting (see details below)? There are a few good answers. At 0.46%, 10-year TIPS still represent a poor real return but a guaranteed positive 1/2% real return beats what is available from many risky assets right now. Commodities remain cheap, although less so. You can invest in a company that specializes in inflation, if you are an accredited investor: Enduring Investments is raising a small amount of money for the management company in a 506(c) offering and is still taking subscriptions. Unfortunately, it is difficult to own inflation expectations directly – and in any event, the easy money there has been made.

What you don’t want to do if you are worried about inflation is own stocks as a “hedge.” Multiples move inversely with inflation.

Unlike prior equity market rallies, I understand this one. It is plausible to me that a very business-friendly President, who cuts corporate and personal taxes and reduces regulatory burdens, might be good for corporate earnings and even for the economic growth rate (although the bad things coming on trade will blunt some of that). But before getting too ebullient about the potential for higher corporate earnings, consider this: if Trump is business-friendly, then surely the opposite must be said about President Obama who did essentially the reverse. But what happened to equities? They tripled over his eight years (perhaps they “only” doubled, depending on when you measure from). That’s because lower interest rates and the Fed’s removal of safe securities in search of a stimulus from the “portfolio balance channel” caused equity multiples to expand drastically. So, valuations went from low, to extremely high. Multiples matter a lot, and right now even if you think corporate earnings over the next four years might be stronger than over the last four you still have to confront the fact that multiples are more likely to move in reverse. In short: if stocks could triple under Obama, there is no reason on earth they can’t halve under a “business-friendly” President. That’s not a prediction. (But here is one: equities four years from now will be no more than 20% higher than they are now, and might well be lower.)

Also, remember Ronald Reagan? He who created the great bull market of the 1980s? Well, stocks rallied in the November he was elected, too. The S&P closed November 1980 at 140.52. Over the next 20 months, the index lost 24%. It wasn’t until almost 1983 before Reagan had a bull market on his hands.


An administrative announcement about upcoming (free!) webinars:

On consecutive Mondays spanning December 5, December 12, and December 19 at 11:00ET, I will be doing a series of one-hour educational seminars on inflation. The first is “How Inflation Works;” the second is “Inflation and Asset Classes;” and the third is “Inflation-aware Investing.” These webinars will also have live Q&A. After each session, a recording will be available on Investing.com.

Each of these webinars is financially sponsored by Enduring Investments.

Who Keeps Selling These Free Options?

November 22, 2016 Leave a comment

It seems that recently I’ve developed a bit of a theme in pointing out situations where the market was pricing one particular outcome so completely that it paid to take the other side even if you didn’t think that was going to be the winning side. The three that spring to mind are: Brexit, Trump, and inflation breakevens.

Why do these opportunities exist? I think partly it is that investors like to be on the “winning side” more than they like ending up with more money than they started. I know that sounds crazy, but we observe it all the time: it is really hard (especially if you are a fund manager that gets paid quarterly) to take losses over and over and over, even if one win in ten tries is all you need to double your money. It’s the “wildcatter” mindset of drilling a bunch of dry holes but making it back on the gusher. It’s how venture capital works. There are all kinds of examples of this behavioral phenomenon. I am sure someone has done the experiment to prove that people prefer many small gains and one large loss to many small losses and one large gain. If they haven’t, they should.

I mention this because we have another one.

December Fed Funds futures settled today at 99.475. Now, Fed funds futures settle to the daily weighted average Fed funds effective for the month (specifically, they settle to 100 minus the average annualized rate). Let’s do the math. The Fed meeting is on December 14th. Let’s assume the Fed tightens from the current 0.25%-0.50% range to 0.50%-0.75%. The overnight Fed funds effective has been trading a teensy bit tight, at 0.41% this month, but otherwise has been pretty close to rock solid right in the middle except for each month-end (see chart, source Bloomberg) so let’s assume it trades in the middle of the 0.50%-0.75% range for the balance of the month, except for December 30th (Friday) and 31st (Saturday), where we expect the rate to slip about 16bps like it did in 2015.

fedl01

So here’s the math for fair value.

14 days at 0.41%  (December 1st -14th)

15 days at 0.625% (December 15th-29th)

2 days at 0.465% (December 30th-31st)

This averages to 0.518%, which means the fair value of the contract if the Fed tightens is 99.482. If the Fed does not tighten, then the fair value is about 99.60. So if you buy the contract at 99.475, you’re risking…well, nothing, because you’d expect it to settle higher even if the Fed tightens. And your upside is 12.5bps. This is why Bloomberg says the market probability of a 25bp hike in rates is now 100% (see chart, source Bloomberg).

fedprob

There is in fact some risk, because theoretically the Fed could tighten 50bps or 100bps. Or 1000bps. Actually, those are all probably about equally likely. And it is possible the “turn” could trade tight, rather than loose. If the turn traded at 1%, the fair value if the Fed tightened would be 99.448. So it isn’t a riskless trade.

But we come back to the same story – it doesn’t matter if you think the Fed is almost certainly going to tighten on December 14th. Unless you think there’s a chance they go 50bps or that overnight funds start trading significantly higher before the meeting, you’re supposed to be long December Fed funds futures at 99.475.

The title of this post is a question, because remember – for everyone who is buying this option at zero (or negative) there’s someone selling it too. This isn’t happening on zero volume: 7207 contracts changed hands today. That seems weird to me, until I remember that it has been happening a lot lately. Someone is losing a lot of money. What is this, Brewster’s Millions?

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An administrative announcement about upcoming (free!) webinars:

On consecutive Mondays spanning December 5, December 12, and December 19 at 11:00ET, I will be doing a series of one-hour educational seminars on inflation. The first is “How Inflation Works;” the second is “Inflation and Asset Classes;” and the third is “Inflation-aware Investing.” These webinars will also have live Q&A. After each session, a recording will be available on Investing.com.

Each of these webinars is financially sponsored by Enduring Investments.

Why Are Inflation Expectations Rising?

November 2, 2016 5 comments

A persistent phenomenon of the last couple of months has been the rise in inflation expectations, in particular market-based measures. The chart below (source: Bloomberg) shows that 10-year inflation swap quotes are now above 2% for the first time in over a year and up about 25-30bps since the end of summer.

usswit10

The same chart shows that inflation expectations remain far below the levels of 2014, 2013, and…well, actually the levels since 2004, with the exception of the crisis. This is obviously not a surprise per se, since I’ve been beating the drum for months, nay quarters, that breakevens are too low and TIPS too cheap relative to nominals. But why is this happening now? I can think of five solid reasons that market-based measures of inflation expectations are rising, and likely will continue to rise for some time.

  • Inflation itself is rising. What is really amazing to me – and I’ve written about it before! – is that 10-year inflation expectations can be so low when actual levels of inflation are considerably above 2%. While headline inflation oscillates all the time, thanks to volatile energy (and to a lesser extent, food) markets, the middle of the inflation distribution has been moving steadily higher. Median inflation (see chart, source Bloomberg) is over 2.5%. Core inflation is 2.2%. “Sticky” inflation is 2.6%.

medcpia

Moreover, as has been exhaustively documented here and elsewhere, these slow-moving measures of persistent inflationary pressures have been rising for more than two years, and have been over the current 2% level of 10-year inflation swaps since 2011. At the same time inflation expectations have been declining. So why are inflation expectations rising? One answer is that investors are now recognizing the likelihood that the inflation dynamic has changed and inflation is not going to abruptly decelerate any time soon.

  • It is also worth pointing out, as I did last December in this article, that the inflation markets overreact to energy price movements. Some of this recovery in inflation quotes is just unwinding the overreaction to the energy swoon, now that oil quotes are rising again. To be sure, I don’t think oil prices are going to continue to rise, but all they have to do is to level off and inflation swap quotes (and TIPS breakevens) will continue to recover.
  • Inflation tail risk is coming back. This is a little technical, but bear with me. If your best-guess is that inflation over the next 10 years will average 2%, and the distribution of your expectations around that number is normal, then the fair value for the inflation swap is also 2%. But, if the length of the tail of “outliers” is longer to the high side than to the low side, then fair value will be above 2% even though you think 2% is the “most likely” figure. As it turns out, inflation outcomes are not at all normal, and in fact demonstrate long tails to the upside. The chart below is of the distribution of overlapping 1-year inflation rates going back 100 years. You can see the mode of the distribution is between 2%-4%…but there is a significant upper tail as well. The lower tail is constrained – deflation never goes to -12%; if you get deflation it’s a narrow thing. But the upper tail can go very high.

longtailsWhen inflation quotes were very low, it may have partly been because investors saw no chance of an inflationary accident. But it is hard to look at what has been happening to inflation over the last couple of years, and the extraordinary monetary policy actions of the last decade, and not conclude that there is a possibility – even a small possibility – of a long upside tail. As with options valuation, even an improbable event can have an important impact on the price, if the significance of the event is large. And any nonzero probability of double-digit inflation should raise the equilibrium price of inflation quotes.

  • The prices that are changing the most right now are highly salient. Inflation expectations are inordinately influenced, as noted above, by the price of energy. This is not only true in the inflation markets, but in forming the expectations of individual consumers. Gasoline, while it is a relatively small part of the consumption basket, has high salience because it is a purchase that is made frequently, and as a purchase unto itself (rather than just one more item in the basket at the supermarket), and its price is in big numbers on every corner. But it is not just gasoline that is moving at the moment. Also having high salience, although it moves much less frequently for most consumers: medical care. No consumer can fail to notice the screams of his fellow consumers when the insurance letter shows up in the mail explaining how the increase in insurance premiums will be 20%, 40%, or more. While I do not believe that an “expectations anchoring” phenomenon is important to inflation dynamics, there are many who do. And those people must be very nervous because the movement of several very salient consumption items is exactly the sort of thing that might unanchor those expectations.
  • Inflation markets were too low anyway. When 10-year inflation swaps dipped below 1.50% earlier this year, it was ridiculous. With actual inflation over 2% and rising, someone going short inflation markets at 1.50% had to assess a reasonable probability of an extended period of core-price disinflation taking hold after the first couple of years of inflation over 2%. By our proprietary measure, TIPS this year have persistently been 80-100bps too cheap (see chart, source Enduring Investments). This is a massive amount. The only times TIPS have been cheaper, relative to nominal bonds, were in the early days when institutions were not yet investing in TIPS, and in the teeth of the global financial crisis when one defaulting dealer was forced to blow out of a massive inventory of them. We have never seen TIPS as cheap as this in an environment of at least acceptable liquidity.

tipscheap

So, why did breakevens rally? Among the other reasons, they rallied because they were ridiculously too low. They’re still ridiculously too low, but not quite as ridiculously too low.

What happens next? Well, I look at that list and I see no reason that TIPS shouldn’t continue to outperform nominal bonds for a while since none of those factors looks to be exhauster. That doesn’t mean TIPS will rally – indeed, real yields are ridiculously low and I don’t love TIPS on their own. But, relative to nominal Treasuries (which impound the same real rate expectation), it’s not even a close call.

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