Two relatively quick items that I want to address today; they have been in my ‘to do’ box for a while.
One of the most interesting features of the fixed-income landscape today, and one that will likely serve in the future as an exam question on finance quizzes, is the increasingly widespread proliferation of negative nominal interest rates among government bond markets…and occasionally even for high-quality corporate paper.
In finance theory, this can’t happen. Because currency earns a 0% nominal interest rate, theory says that no rational person would ever accept a negative nominal interest rate. If I have $50 today, and put it in the bank, I will have $49 tomorrow. So why not just keep the $50 in my wallet? (Obviously this leads to high cash balances, which means low monetary velocity, by the way). And this is true in the absence of “other costs.”
So why are so many interest rates negative? Are individuals irrational? No: at least not so irrational that they prefer less money to more money. However, what is true at an individual level does not necessarily scale to the institutional level. An institution, such as a money fund or corporation, does not have the freedom to hold its assets in physical currency. Microsoft has $90 billion in cash and equivalents. If this were in $100 bills, it would weigh about one thousand tons. That’s a pretty big vault. And vaults cost money. Guards cost money. And, if Microsoft had this money in the vault, it would be harder to spend. It is much easier to wire $5 million than it is to send an armored car.
In the presence of those costs, Microsoft and other institutions will accept a negative interest rate. It will invest its money at a negative rate rather than build a vault.
Now, an important (if obvious) point is that cash balances are so high, and interest rates so low, because global central banks are making sure we have plenty of cash. Too much cash chasing too few investment opportunities causes rates to be low.
Walmart and Minimum Wage Increases
It has been a few weeks now, but when Walmart in February announced it was going to increase the minimum wages it plans to pay its employees (preceded by Starbucks, Aetna, and the Gap and followed by TJX and Target), I received a number of queries about what the hike was going to do to inflation. Is this the beginning of the much-feared “cost-push inflation”?
The answer is no. Wages, as I have said many times, follow inflation rather than lead it. Think about it: wouldn’t it be really weird for companies to raise wages and then raise prices, to the extent that they have control – at least with respect to timing – over both? No, whatever price increase is going to be caused by the increase in the wages Walmart expects to pay is already in the price. Walmart is not surprised by their own move to raise wages. Nor is anyone surprised by the general increase in the minimum wage, which happened in 2009.
So, while I continue to believe that inflation is rising, and will continue to rise…I don’t believe that the increase in prices is going to be any faster due to these wage increases. It does, however, increase my confidence that inflation is rising, since obviously these retailers are confident enough in the pricing environment to be able to increase wages (which are sticky – it is harder to lower them than to raise them).
Below you can find a recap and extension of my post-CPI tweets. You can 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.
- CPI -0.7%, core +0.2%. Ignore headline. Annual revisions as well.
- Core +0.18% to two decimals. Strong report compared to expectations.
- Core rise also off upwardly-revised prior mo. Changing seasonal adj doesn’t affect y/y but makes the near-term contour less negative.
- y/y core 1.64%, barely staying at 1.6% on a rounded basis.
- Core for last 4 months now 0.18, 0.08, 0.10, 0.18. The core flirting with zero never made a lot of sense.
- Primary rents 3.40% from 3.38% y/y, Owners’ Equiv to 2.64% from 2.61%. Small moves, right direction.
- Overall Housing CPI fell to 2.27% from 2.52%, as a result of huge drop in Household Energy from 2.53% to -0.06%. Focus on the core part!
- RT @boes_: As always you have to be following @inflation_guy on CPI day >>Thanks!
- A bit surprising is that Apparel y/y rose to -1.41% from -1.99%. I thought dollar strength would keep crushing Apparel.
- Also New & Used Motor Vehicles -0.78% from -0.89%. Also expected weakness there from US$ strength. Interesting.
- Airline fares, recently a big source of weakness, now -2.98% y/y from -4.71% y/y.
- 10y BEI up 4bps at the moment. And big extension tomorrow. Ouch, would hate to have bet wrong this morning.
- Medical Care 2.64% y/y from 2.96%.
- College tuition and fees 3.64% from 3.43%. Child care and nursery school 3.05% from 2.24%. They get you both ends.
- Core CPI ex-[shelter] rose to 0.72% from 0.69%. Still near an 11-year low.
- Overall, core services +2.5% (was +2.4%), core goods -0.8% (was -0.8%). The downward pressure on core is all from goods side.
- …and goods inflation tends to be mean-reverting. It hasn’t reverted yet, and with a strong dollar it will take longer, but it will.
- That’s why you can make book on core inflation rising.
- At 2.64% y/y, OER is still tracking well below our model. It will continue to be a source of upward pressure this year.
- Thank you for all the follows and re-tweets!
- Summary: CPI & the assoc. revisions eases the appearance that core was getting wobbly. Median has been strong. Core will get there.
- Our “inflation angst” index rose above 1.5% for the 1st time since 2011. The index measures how much higher inflation FEELS than it IS.
- That’s surprising, and it’s partly driven by increasing volatility in the inflation subcomponents. Volatility feels like inflation.
- RT @czwalsh: @inflation_guy @boes_ using surveys? >>no. Surveys do a poor job on inflation. See why here: http://www.palgrave-journals.com/be/journal/v47/n1/abs/be201135a.html …
- 10y BEI now up 5.25bps. 1y infl swaps +28bps. Hated days like this when I made these markets. Not as bad from this side.
- Incidentally, none of this changes the Fed outlook. Median was already at target, so the Fed’s focus on core is just a way to ignore it.
- Once core rises enough, they will find some other reason to not worry about inflation. Fed isn’t moving rates far any time soon.
- Median CPI +0.2%. Actually slightly less, keeping the y/y at 2.2%.
What a busy and interesting CPI day. For some months, the inflation figures have been confounding as core inflation (as always, we ignore headline inflation when we are looking at trends) has consistently stayed far away from better measures of the central tendency of inflation. The chart below (source: Bloomberg), some version of which I have run quite a bit in the past, illustrates the difference between median CPI (on top), core CPI (in the middle), and core PCE (the Fed’s favorite, on the bottom).
I often say that median is a “better measure of central tendency,” but I haven’t ever illustrated graphically why that’s the case. The following chart (source: Enduring Investments) isn’t exactly correct, but I have removed all of the food and beverages group and the main places that energy appears (motor fuel, household energy). We are left with about 70% of the index, about a third of which sports year-on-year changes of between 2.5% and 3.0%. Do you see the long tail to the left? That is the cause of the difference between core and median. About 12% of CPI, or about one-sixth of core, is deflating. And, since core is an average, that brings the average down a lot. Do you want to guide monetary policy on the basis of that 12%, or rather by the middle of the distribution? That’s not a trick question, unless you are a member of the FOMC.
Now, let’s talk about the dollar a bit, since in my tweets I mentioned apparel and autos. Ordinarily, the connection between the dollar and inflation is very weak, and very lagged. Only for terribly large movements in the dollar would you expect to see much movement in core inflation. This is partly because the US is still a relatively closed economy compared to many other smaller economies. The recent meme that the dollar’s modest rally to this point would impress core deflation on us is just so much nonsense.
However, there are components that are sensitive to the dollar. Apparel is chief among them, mainly because very little of the apparel that we consume is actually produced in the US. It’s a very clean category in that sense. Also, we import a lot of autos from both Europe and Asia, and they compete heavily with domestic auto manufacturers. As a consequence, the connection between these categories and the dollar is much better. The chart below shows a (strange) index of New Cars + Apparel, compared to the 2-year change in the broad trade-weighted dollar, lagged by 1 year – which essentially means that the dollar change is ‘centered’ on the change in New Cars + Apparel in such a way that it is really a 6-month lag between the dollar and these items.
It’s not a day-trading model, but it helps explain why these categories are seeing weakness and probably will see weakness for a while longer. And guess what: those categories account for around 7% of the “tail” in that chart above. Ergo, core will likely stay below median for a while, although I think both will resume upward movement soon.
One of the reasons I believe the upward movement will continue soon is that housing continues to be pulled higher. The chart below (source: Enduring Investments using Bloomberg data) shows a coarse way of relating various housing price indicators to the owners’ rent component of CPI.
We have a more-elegant model, but this makes the point sufficiently: OER is still below where it ought to be given the movement in housing prices. And shelter is a big part of the core CPI. If shelter prices keep accelerating, it is very hard for core (and median) inflation to decline very much.
One final chart (source Enduring Investments), relating to my comment that our inflation angst index has just popped higher.
This index is driven mainly by two things: the volatility of the various price changes we experience, and the dispersion of the price changes we experience. The distribution-of-price-changes chart above shows the large dispersion, which actually increased this month. Cognitively, we tend to overlook “good” price changes (declines, or smaller advances) and recall more easily the “bad”, “painful” price changes. Also, we tend to encode rapid up-and-down changes in prices as inflation, even if prices aren’t actually going anywhere much. I reference my original paper on the subject above, which explains the use of the lambda. What is interesting is the possibility that the extremely low levels of inflation concern that we have seen over the last couple of years may be changing. If it does, then wage pressures will tend to follow price pressures more quickly than they might otherwise.
Thanks for all the reads and follows today. I welcome all feedback!
Sometimes being a value investor, amid overvalued (and ever more so) markets, feels a bit like being a Stark in Westeros. The analogy will be lost on you if you do not follow Game of Thrones, but the Starks hold the largest of the sub-kingdoms in Westeros. This kingdom also happens to be the coldest, and the sober Starks are always reminding people that “Winter is coming.”
I should observe that winter in Westeros is a much more serious affair than it is around here; it comes at odd intervals but can last for years. So being prepared for winter is really important. However, getting people to prepare for winter during the long “summer” is very difficult.
Sound familiar? The thing to keep in mind is that the Starks are always right, eventually, and they’re the ones who come through the winter in the best shape. Such is the case with value investors. (Some people might prefer calling value investors who are bearish on stocks right now “Chicken Littles” but I prefer being compared to Ned Stark, thanks. Although both of them have been known to lose their heads on occasion.)
Fortunately, it does not appear that winter is coming to the U.S. very soon. Friday’s Employment report was strong, despite the beginnings of downsizing in the oil and gas extraction businesses. The chart below shows the Baker Hughes oil and gas rig count, which is falling at a rate every bit as fast as it did in the credit crisis.
Yet, the U.S. economy as a whole generated 267,000 new jobs last month, which was above expectations. It is unlikely that this pace will continue, since the extraction (and related industry) jobs will be a drag. But in 2008, this happened when every other industry was being squeezed, and in the current case other industries are being squeezed by the strong dollar, but only mildly so. I think this will actually serve to increase the labor force participation rate, which has been in a downtrend for a long time – because laid-off oil workers will still be in the labor force looking for work, while other jobs will be getting filled by (sometimes) discouraged workers coming off the sidelines. So we may well see the Unemployment Rate rise even as jobs growth remains reasonable, even if less robust than the most recent figures.
Winter, though, is still coming.
In the near-term, winter is coming to Europe. Unusually, it is moving from the south to the north because Greece appears to be finally heading for the denouement that has been utterly unavoidable from the beginning. I wrote this in June 2012 (and I wasn’t the only one saying such things – the only real question has been how long it would take before the Greeks decided they’d had enough of sacrifice to hold together the Eurozone for the elites):
Greece will still leave the Euro. Government or no government, austerity or no austerity – the fiscal math simply doesn’t make sense unless Europe wants to pay for Greece forever. In principle, the Greeks can dig themselves out of trouble if they work harder, retire later, pay more taxes, and receive fewer government services. I do believe that people can change, and a society can change, under pressure of crisis. Remember Rosie the Riveter? But the question is whether they can change, whether they will change, do they even want to change, if the benefit of the change flows not to Greece’s people but to the behemoth European institutions that have lent money to Greece?
If a person declares bankruptcy, and the judge declares that he must pay all of his wages for the next thirty years, after deducting enough for food and shelter, to the creditors…do you think that person is going to go looking for a 60-hour workweek?
Am I sure that Greece is going to leave the Euro in a week, or a month, or a year? Not at all. The institutional self-preservation meme is very strong and I am always amazed at how long it takes obvious imperatives to actually happen. But I am quite confident that Greece will eventually leave the Euro, and it does seem as if parties on all sides of the negotiating table are coming to that conclusion as well.
One question that authorities have had to come to peace with first was whether Grexit is really Armageddon. I have argued that default and an exit from the Euro is not bad for Greece, at least when compared to a multi-year depression.
And it’s probably not even horrible for Europe, or the world at large, at least compared to the credit crisis, despite all protestations that this would be “Lehman squared.” Again, this is old news and as I lay out the reasoning here there is no reason to repeat myself.
But it won’t be a positive thing. And it is likely to bring on “winter,” economically. Helpfully, the world’s central banks not only remain in easing mode but are increasing the dovishness of their stance, with the ECB foremost among the central banks that are priming the pumps again. M2 money growth in the Eurozone was up to 4.5% y/y in December (latest data available), with the highest quarter-over-quarter growth rate (8.3%, annualized) in money since the end of 2008! Meanwhile the Fed, while it is no longer adding to reserves, is still watching the money supply grow at 6% y/y with no good way to stop it. For all the talk about the FOMC hiking rates by mid-year, I think the probable rise in the Unemployment Rate discussed above, plus the weak inflation readings (with the notable exception of Median CPI), plus the fact that all other central banks are easing and likely to continue doing so, plus the probability of turbulence in Europe, makes it very unlikely that this Committee, with a very dovish makeup, will be tightening any time soon.
The likely onset of some winter will not help hold down inflation, however. Upward pressures remain, and the fact that the ECB is now running the pumps makes higher prices more likely. Yes, we care about money supply growth in Europe: the chart below shows the M2 growth of the US and Europe combined, against core CPI in the US. The fit is actually better than with US CPI alone.
Now, some markets are priced for winter and some are not. We think that real interest rates in Europe are far too low compared to real rates in the US, and stock prices in the US are too high compared to stock prices in Europe. The first chart below shows the spread of 10-year real rates in the US minus Europe (showing US yields are high compared to European yields); the second chart shows the ratio of the S&P 500 to the Eurostoxx 50.
You can see in the latter chart that the out-performance of the S&P has proceeded since 2009, while the under-performance of US inflation-linked bonds has only happened since 2012, so these are not simply two ways of looking at the same trade. In both cases, these deviations are quite extreme. But the European economy and the US economy are not completely independent of one another; weak European growth affects US corporate entities and vice-versa, and as I suggest above the growth of European money supply tends to affect US inflation as well. We think that (institutional) investors should buy TIPS and sell European linkers, and also buy European stocks against US stocks. By doing both of these things, the exposure to currency flows or general trends in global equity market pricing is lessened. (Institutional investors interested in how we would weight such a trade should contact us.)
 As another example, take the shrinking of Wall Street. It was obvious after 2008 that it had to happen; only recently, however, as banks and dealers have been forced to become more and more like utilities have we started to see layoffs while stocks are rising, which is very unusual. But Wall Street defended the bloated structures of the past for more than six years!
Below is a summary and extension of my post-CPI tweets. You can follow me @inflation_guy:
- Core CPI unchanged – which is amazing. I can’t wait to see the breakdown on this one.
- Core 0.003%, taken out one more decimal. I thought y/y had a chance of rising to 1.8%; instead it fell to 1.61%.
- Last Dec, core was 0.10%, so part of this may be faulty seasonal adjustment. It is December, after all.
- Core services +2.4%, down from 2.5%. Core goods down to -0.8%, worst since mid-2007.
- Medical Care Commodities +4.8%! Biggest increase since 1993. Oh ACA, we hardly knew ye.
- Housing weakened, which isn’t insignificant. Primary rents 3.38% from 3.48%; OER 2.61% from 2.71%.
- We still think housing is headed higher but that was part of the surprise. Apparel too, -2.0% y/y from -0.3% previous.
- The apparel move is likely related to dollar strength. Most apparel isn’t made here.
- Accelerating major groups: Food/Bev, Med Care, Rec (28.2%). Decel: Housing, Apparel, Transp, Educ/Comm, Other (71.8%)
- Decline in apparel prices may be a story. In recent yrs Apparel had been rising after many years of dis/deflation. Weakness in Asia…
- Apparel y/y decline was largest since 2003.
- Core ex-housing down to 0.69%. Much lower than crisis lows. That’s where to look if you’re worried about deflation, not the headline.
- Very interesting core goods. Our three-item proxy is Apparel (-2%), New cars (-0.1%), and Medical Care commodities (+4.8%). Figure THAT out.
- This CPI is hard to dismiss. Hsng dip is most concerning (think it’s temporary tho), but broadening of decel categories worrisome.
- Core ex-housing looking really soft. Now, some of that is probably energy sneaking thru…not a prob normally but for BIG moves – maybe.
- That being said, market is pricing in 1% core for next yr, 1.25% for 2 years, 1.37% for 3 years…so infl market has overshot. A lot.
- number of categories at least 1 std dev above deflation went from 43% to 20% in one month.
- Now here’s something to not be worried about yet: our “relative inflation angst” index reached its highest level since 2011. Still low.
This was a wild report, full of interesting items. Let’s start with Apparel. In recent years, I have watched Apparel closely because one of my theses was that the domestic benefit from exporting production to cheap-labor countries was ending. Apparel is a nice clean category that went from normal inflation dynamics when most apparel was produced domestically (prior to 1993), to disinflation/deflation over the years where virtually all production was moved offshore, to normal inflation again once the cost savings on labor had been fully realized and so no longer a source of disinflation (at which time, costs ought to begin to track wage inflation in the exporting country, adjusted for currency moves).
While it seems that the recent decline should challenge that thesis (and that was my knee-jerk reaction), I think that perhaps it isn’t quite as clear-cut as I thought. In the past I had ignored the effect of foreign exchange movements, since (a) it didn’t matter when we were mostly domestic production and (b) over the last few years currencies have been broadly stable. I think the latest decline in apparel is almost surely related to the dollar’s strength, which unfortunately means that it isn’t as pure a test of my thesis as I had hoped. In any event, apparel is one place (one of few, in the US) where dollar strength manifests clearly in core goods prices, so this is a dollar effect.
The next chart is the chart of Medical Care Commodities (mainly pharmaceuticals). Remember when we had that quaint notion that the Affordable Care Act (Obamacare) was going to permanently reduce inflation in medical care? (Actually, we didn’t all have that quaint notion – in particular, I did not – but it was certainly a view pushed very hard by the Administration). It turns out that the decline in medical care inflation was mostly due to the effects of the sequester on Medicare payments, and now prices seem to be catching up. This is an ugly chart.
Ex-medical care commodities, however, it doesn’t appear that disinflation in core commodities will be in for much of a respite unless the dollar rally is arrested.
And now for one of the scariest charts: core inflation ex-shelter is as low as it has been since the early 2000s, when the uptick in housing costs (like now) hid a close scrape with deflation. I think the causes of that deflationary scrape were similar to those of today, if in fact we are going to head that way: too much private debt. Although the higher level of public debt makes the answer more indeterminate, high private debt imparts a disinflationary tendency. The “deleveraging” was supposed to get rid of the disinflationary tendency by moving private debt onto the public balance sheet. It really didn’t happen, except for auto companies and some large financial institutions like Fannie Mae.
The important difference between now and then is that in the early 2000s we had higher rates, higher velocity (which is correlated to rates) and no excess reserves. Today, all the Fed would need to do to arrest this tendency would be to lower the interest on excess reserves to a significant penalty rate and those excess reserves would quickly enter the money supply. Interestingly, a movement the other way – to raise interest rates – will likely also cause inflation to rise as it will raise money velocity. So I am not particularly concerned we will get into deflation even ex-housing. There are lots of ways out of that pickle. I am much more worried about overreaction. Once again, the Fed might have stumbled into the right policy: doing nothing. If you can’t be good…be lucky.
One final remark on our “inflation angst” index (not shown here): the rise in the index, which manifests itself in a perception that inflation is actually higher than reported, is driven by the increasing volatility of index components (such as airfares, gasoline, and apparel) and the increased dispersion of index components (such as apparel and medical care commodities). These both have the impact of making inflation feel higher than it actually is. It is nothing to worry about at these levels of inflation, because “higher than it actually is” still feels low. But if inflation volatility continues to pick up as the level picks up (as it eventually will), then it will feel much worse for consumers than it actually is. That’s not a 2015 story, however.
Keep in mind that the market has already discounted really bad core inflation for a long time. We are very unlikely to get such a bad outcome, unless housing collapses – which it might, since prices are getting back into bubble territory, but I don’t think it’s very likely. As a consequence, even such a bearish inflation report as this one has been followed by a rally in inflation swaps and breakevens. I think this is a wonderful time to be buying inflation. It’s hard to do in the retail market, although the Proshares UINF ETF is a reasonably clean way to be long 10-year breakevens. It is $28.80, and I expect it to be at $36 within 6-9 months. [Disclosure: Neither I nor any entity or fund owned or controlled by me owns this ETF or has any current plans to buy or sell it.] [Additional Disclosure: That would be difficult it seems. While Bloomberg says it has NAV it also seems to have been liquidated. Pity if true. But RINF, a 30-year breakeven, still exists. From $30.57, I would expect $37 over a similar period.]
There are many funny stories out about disinflation these days. The meme has gotten amazing momentum, even more than it usually does at this time of year (see my post last month, “Seasonal Allergies“). One of the most amusing has been the idea that the decision by the Bank of Japan to greatly increase its quantitative easing would be disinflationary in the U.S., because the yen would decline so sharply against the dollar, and dollar strength is generally assumed to be disinflationary.
The misunderstanding of the dollar effect is amazing, considering how easy it is to disprove. Sure, I understand the alarm at the dollar’s recent robust strength. Of course, such a large and rapid move must be disinflationary, right? Because who could forget the inflationary spiral of 2002-2008 in this country, when the value of the dollar fell 25%?
For the record, when the dollar hit its high in February 2002, core inflation was at 2.6%. It declined to 1.1% in 2003, before rebounding to 2.9% in 2006 and was at 2.3% in April 2008, when the dollar reached its pre-crisis low. That is, the dollar’s protracted and large decline caused essentially no meaningful change in core inflation. Indeed, without the housing bubble, core inflation would have declined markedly over this period.
Now, headline inflation rose during that period, because energy prices rose. This may or may not be the result of the dollar, or the causality may run at least partly the other way (because the dollar was cheaper, and oil is priced in dollars, oil got comparatively cheaper in foreign currencies, leading to greater demand). But what is very clear is that the underlying rate of inflation was not impacted by the dollar.
The bifurcation of inflation into core inflation and energy inflation (or food and energy inflation, if you like, but most of the volatility comes from energy inflation) is a critical point for both investors and policymakers. Much ink has recently been spilled about how the Saudi decision to lower the price of oil to better compete with U.S. shale supply, and the burgeoning shale supply itself, is disinflationary. But it isn’t, and it is important to understand why. Inflation is a rate of change measure, and more to the point a change in prices is not inflation per se unless it is persistent. Policymakers don’t focus on core inflation because they don’t care about food or energy or think that we don’t buy them; they focus on core inflation because it is more persistent than food or energy inflation.
So if gasoline prices aren’t merely in their usual seasonal dip, but actually continue lower for another year, it will result in headline inflation that is lower than core inflation over that period. But once it reaches a new equilibrium level, that downward pressure on headline inflation will abate, and it will re-converge with core.
Oil prices, in fact, are almost always a growth story rather than an inflation story, and some of the big monetary policy crack-ups of the past have occurred when the Fed addressed oil price spikes (plunges) with tighter (looser) monetary policy. In fact, if any policy response is warranted it would probably be the opposite of this, since higher oil prices cause slower broad economic growth and lower oil prices cause faster broad economic growth. (However, long time readers will know that I don’t believe monetary policy can affect growth significantly anyway.)
Back, briefly, to the BOJ balance sheet expansion story. This was a very significant event for global inflation, assuming as always that the body follows through with their stated intention. Money printing anywhere causes the equilibrium level of nominal prices globally to rise. To the extent that this inflation is to be felt idiosyncratically only in Japan, then the decline of the currency will offset the effect of this global increase in prices so that ex-Japan prices are steady while prices in Japan rise…which is the BOJ’s stated intent. Movements in foreign exchange are best understood as allocating global inflation between trading partners. However, for money-printing in Japan to lead to disinflation ex-Japan, the movement in the currency would have to over-react to the money printing. If markets are perfectly efficient, in other words, the movement in currency should cause the BOJ’s idiosyncratic actions to be felt only within Japan. There are arbitrage opportunities otherwise (although it is very slow and risky arbitrage – better thought of as arbitrage in an economic sense than in a trading sense).
Of course, if the BOJ money-printing is not idiosyncratic – if other central banks are also printing – then prices should rise around the world and currencies shouldn’t move. This is why the Fed was able to get away with increasing M2 significantly without cratering the dollar: everyone was doing it. What is interesting is that the global price level has not yet fully reflected the rise in the global money supply, because of the decline in global money velocity (which is due in turn to the decline in global interest rates). This is the story that is currently being written, and will be the big story of the next few years.
The inflation market offers such wonderful opportunities for profit since so few people understand the dynamics of inflation, much less of the inflation market.
One of the things which continually fascinates me is how the inflation trade has become sort of a “risk on” kind of trade, in that when the market is pricing in better growth expectations, reflected in rising equity prices, inflation expectations move with the same rhythm. The chart below (source: Bloomberg) shows the 10-year inflation breakeven rate versus the S&P 500 index. Note how closely they ebb and flow together, at least until the latest swoon in inflation expectations.
Your knee-jerk reaction might be that this is a spurious correlation caused by the fact that (a) bond yields tend to rise when growth expectations rise and (b) when bond yields rise, the components of bond yields – including both real rates and expected inflation – tend to rise. But look at the chart below (source: Bloomberg), covering the same period but this time charting stocks versus real yields.
If anything, real yields ought to be more correlated to movements in equities than inflation expectations, since presumably real economic growth is directly related to the real growth rates embedded in equity prices. But to my eyes at least, the correlation between real interest rates and equity prices, for which there is a plausible causal explanation, doesn’t look nearly as good as the relationship between stocks and inflation expectations.
It doesn’t make any sense that long-term inflation expectations should be so closely related to equity prices. I know I have mentioned before – in fact, regular readers are probably sick of me pointing it out – that there is no causal relationship between growth and inflation. Really, it is worse than that: one really needs to torture the data to find any connection at all, causal or not. The chart below (source: Bloomberg) shows quarterly real GDP in yellow against core inflation in white.
I’ve pointed out before that the big recession in ’08-09 saw almost no deceleration in core inflation (and none at all if you remove housing from core inflation), but it’s hard to find a connection anywhere. The next chart (source: Bloomberg) makes the point a different way, simply plotting core inflation (y-axis) against real GDP (x-axis) quarterly back to 1980.
In case anyone out there is protesting that there should be a lagged relationship between growth and inflation, I am happy to report that I was able to get an r-squared as higher as 0.257 with a lag of 12 quarters. Unfortunately, the lag goes the wrong way: high inflation precedes high growth, not vice-versa. And I don’t know anyone who proffers a reasonable explanation of a causality running in that direction. Lags the other way fail to produce any r-squared over 0.1.
So, how to explain the fact that since the end of August we have seen 10-year real rates rise 29 basis points while 10-year breakevens were falling 12bps (producing a net rise in nominal rates of only 17bps)? The explanation is simple: the market is wrong to treat breakevens as a “risk on/risk off” sort of trade. Breakevens have cheapened far too much. I don’t know if that means that TIPS yields have risen too much, or nominal yields have risen too little (I rather expect the former), but the difference is too narrow. The short end of the US curve (1 year inflation swaps are at 1.44%) implies either that core inflation will decline markedly from its already-depressed level well below median inflation, or that energy prices will decline sharply and much further than implied by gasoline futures.
I think that one of the reasons US inflation has been under pressure is that it is currently at a very large spread versus European inflation, and earlier this month it was at the highest level in at least a decade (see chart, source Enduring Investments).
This may look like an appealing short, perhaps, but based on our internal analysis and some historical relationships we track we actually believe the spread is too low by about 50bps. And think about it this way: if Europe really is in the process of inheriting Japan’s lost decade, then 10-year expectations for the US ought to be much, much higher than in Europe. I don’t really think Europe will end up there, because the ECB seems to be trying to do the right thing, but it is not unreasonable to think that there should be a hefty premium to US inflation over Europe.
 Of course, the correlation of levels won’t be very good because stocks have an upward bias over time while inflation expectations do not. To run the correlation, you’d have to de-trend stocks but I’m trying to make a visceral point here rather than a quantitative one.
Here is a summary of my post-CPI tweets. You can follow me @inflation_guy or (if you’re already following me on Twitter or seeing this elsewhere) subscribe to direct email of my free articles here.
- Complete shocker of a CPI figure. Core at +0.01%, barely needed any rounding to get to 0.0. Y/y falls to 1.73%. Awful.
- Zero chance the Fed does anything today, anyway. The doves just need to point to one number and they win.
- Stocks ought to LOVE this.
- Core services dropped to 2.5% y/y from 2.6% and core goods to -0.4% from -0.3%.
- Accelerating major groups: Food/bev. That’s all. 14.9% of basket. Everything else decelerating.
- I just don’t see, anecdotally, a sudden change in the pricing dynamics in the economy. That’s why this is shocking to me.
- Primary rents to 3.18% from 3.28%. Owners’ Equiv to 2.68% from 2.72%. Both in contravention of every indicator of market tightness.
- Apparel goes to 0.0% from +0.3% y/y. That’s where you can see a dollar effect, since apparel is mostly manufactured outside US.
- Airline fares -2.7% versus -0.2% y/y last month and +4.7% three months ago. It’s only 0.74% of the basket but big moves like that add up.
- Medical care: 2.09% versus 2.61% y/y. Now THAT is where the surprise comes in. Plunge in ‘hospital and related services.’ to 3.8% vs 5.5%.
- …we (and everyone else!) expect medical care to bounce back from the sequester-inspired break last year. I still think it will.
- core inflation ex-housing at 0.91% y/y, lowest since August 2004. Yes, one decade.
- core inflation ex-housing is now closer to deflation than during the deflation scare. In late 2010 it got to 1.08% y/y.
- Needless to say our inflation-angst indicator remains at really really low levels.
- Interestingly, the proportion of CPI subindices w y/y changes more than 2 std dev >0 (measuring broad deflation risk) still high at 38%.
- To sum up. Awful CPI nbr. Housing dip is temporary & will continue to keep core from declining much. Suspect a lot of this is one-off.
- …but I thought the same thing last month.
- Neil Diamond said some days are diamonds, some days are stones. If you run an inflation-focused investment mgr, this is a stone day.
- Interestingly, Median CPI was unchanged at 2.2% this month. I’d thought it fell too much last month so this makes sense.
I am still breathing heavily after this truly shocking number. This sort of inflation figure, outside of a crisis or post-crisis recovery, is essentially unprecedented. Lower prints happened once in 2010, once in 2008, three times in 2003, and once in 1999. But otherwise, basically not since the 1960s.
The really amazing figure is the core-ex-Housing number of 0.91% y/y. A chart of that (source: Enduring Investments) is below.
There are interesting similarities between the current situation and late 2003, which is the last time that ex-housing inflation flirted with deflation. Between late 2000 and June 2003, money velocity fell 11%, in concert with generally weakening money growth. Velocity fell primarily because of a sharp decline in interest rates from 6% on the 5y note to around 2.25%. The circumstances are similar now: 5y interest rates declined from around 5% to 0.5% from 2006 through mid-2013, accompanied by a 24% decline in money velocity. And voilá, we have weakness in core inflation ex-housing.
The important differences now, though, are twofold. The first is that the absolute levels of money velocity, and of interest rates, are much lower and very unlikely to fall much further – indeed, money velocity is lower than it “should” be for this level of interest rates. And the second is that there is an enormous supply of inert reserves in the system which will be difficult to remove once inflation begins to rise again. The Fed began to increase interest rates in 2004, which helped increase money velocity (and hence, inflation) while it also caused M2 growth to decline to below 4% y/y. Core inflation rose to 3%, but the Fed was basically in control. Today, however, the Fed has no direct control over the money supply because any reserves they remove will be drawn from the “excess” reserves held by banks. This will make it difficult to increase overnight rates except by fiat (and increasing them by setting a floor rate will merely cause money velocity to rise while having no effect on the money supply). So the ‘potential inflation energy’ is much higher than it was in 2003. As an aside, in 2004 I was quite vocal in my opinions that inflation was not about to run away on the upside, which is another key difference!
If you are a tactical inflation trader, today’s CPI figure should make you despise inflation-linked bonds for a few weeks. But they have already taken quite a drubbing this month, with 10-year breakevens falling from 2.27% to 2.08% as I type. It’s okay to watch them fall, tactically, especially if nominal bonds generally rally. But strategically, not much has changed about the inflationary backdrop. I don’t expect airline fares to continue to drop. I don’t expect Medical Care inflation, which has a strong upward bias due to base effects, to plunge further but to return to the 3%-4% range over the next 6-12 months. And Housing inflation slowed slightly this month but remains on course to continue to rise. So, if you are considering your inflation allocations, this is a good time to increase them while markets are dismissive of any possibility of higher prices.
Without a doubt, today’s number – especially following another weak CPI print last month – is a head-scratcher. But there aren’t a lot of downside inflation risks at the moment. Our forecast had been for core (or median) inflation to reach 2.6%-3.0% in 2014. I would say that core CPI isn’t going to get to that level this year with 4 prints left, and even median CPI (which is a better measure right now of the central tendency of inflation, thanks to the aforementioned base effects in medical care, and remained at 2.2% this month) is going to have a harder time reaching that target. I’d lower and narrow the target range for 2014 median inflation to 2.5%-2.8% based on today’s data.