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Gold and TIPS – Related or Not?

September 27, 2017 4 comments

Because I spend so much time digging into inflation data and learning about how inflation works (and how securities and markets work, in different inflation regimes), I am always delighted when I come across something new, especially something simple and new that I could have previously stumbled on, but didn’t.

Recently, a friend sent me a link to an article by Scott Grannis (aka Calafia Beach Pundit). I occasionally read Scott’s stuff, and find it to be good quality. I’m not writing this article to either criticize or support most of his column, but rather to point to one particular chart he ran that amazed me. Specifically, he showed the 5-year TIPS yield against the nominal price of gold. Here is his chart:

He also showed the price of gold versus TIPS on a longer-term basis. I’ve replicated that here, although I’ve deflated gold by the CPI since the longer the time frame, the less the nominal price of gold will resemble its real price. It’s still basically the same picture:

This is an amazing chart, even allowing for the divergence in the 2000s (which some people would call prima facie evidence that the Fed eased too much back then). And it just tickles me because I’ve never noticed the correlation at all, and yet it’s really quite good. But here’s the really amazing part: there is no immediately obvious reason these two series should be related at all.

One of them is a price index. In Scott’s version, which isn’t adjusted for inflation, it should march upward to the right forever as long as the general price level continues to rise. Obviously, real yields will not march ever lower forever. When we adjust for the general level of prices, the real price of gold should, like real yields, oscillate (since the long-term real return to gold is approximately zero) so we have removed the tendency for nominal prices (unlike yields) to have a natural drift. But even in real terms, apples-to-apples, it’s an astonishing chart. What this chart seems to say is that when expected growth is poor, gold is worth more and when expected growth is strong, gold is less valuable. But that seems a bit crazy to me.

Okay, one possible interpretation is this: when expected returns from other asset classes such as stocks and bonds and inflation-linked bonds are low, then the expected return from gold should also be low, which means its price should be high. That makes sense, although it is hard to find many gold investors who think as I do that the expected forward-looking real return to gold right now is negative. Heck, I wrote about that last month (see “The Gold Price is Not ‘Too Low’”). It makes some sense, though. But the implication is that as inflation rises, and yields – both real and nominal – rise, then gold prices should fall. I think you’d discover it difficult to find an investor in gold who would think the gold price should fall if inflation picks up!

Where you would think to see more of a relationship is in inflation expectations versus gold. When inflation expectations are high, you’d think you would see gold prices high and vice-versa. But that chart has really nothing suggestive at all, possibly since inflation expectations have really been fairly grounded for the last twenty years. Gold prices, however, have not!

So going back to the original Grannis chart, I am still very suspicious. Fortunately, some time ago we developed a very long history of real interest rates, using a more advanced approach than had previously been applied (you can see the long-term series in this article). That series is derived, rather than observed as the TIPS series is, but it’s probably pretty close to where TIPS yields might have traded had they existed during that period. And when we look at real gold prices versus 5y TIPS yields…

…we get a pretty disappointing chart. What I see is that in the 1970s and early 1980s, high gold prices were associated with high real yields; in the 2000s and 2010s, a high gold price was associated with low real yields.

So, this is a bit of a bummer in one sense but a relief in another sense. That initial chart suggested some very weird dynamics happening between real yields, inflation expectations, and the price of a real commodity. I think this latter chart indicates that the relationship we saw was not some fundamental previously-undiscovered truth – sadly, I guess – but rather something more prosaic: an illustration of how the relative values of all assets tend to move more or less together. TIPS are expensive. Bonds are expensive. Stocks are expensive. Gold is expensive. Unfortunately, I don’t think that tells us a lot that we didn’t already know (although I have strong opinions about the relative ordering of the richness/cheapness of those asset classes).

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Categories: Commodities, Gold, TIPS

The Gold Price is Not ‘Too Low’

August 1, 2017 2 comments

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Before I start today’s article, let me say that I don’t like to write about gold. The people who are perennially gold bulls are crazy in a way that is unlike the people who are perennial equity bulls (Abby Joseph Cohen) or perennial bond bulls (Hoisington). They will cut you.

That being said, they are also pretty amusing.

To listen to a gold bull, you would think that no matter where gold is priced, it is a safe haven. Despite the copious evidence of history that says gold can go up and down, certain of the gold bulls believe that when “the Big One” hits, gold will be the most prized asset in the world. Of course, there are calmer gold bulls also but they are similarly dismissive of any notion that gold can be expensive.

The argument that gold is valuable simply because it is acceptable as money, and money that is not under control of a central bank, is vacuous. Lots of commodities are not under the control of a central bank. Moreover, like any other asset in the world gold can be expensive when it costs too much of other stuff to acquire it, and it can be cheap when it costs lots less to acquire.

I saw somewhere recently a chart that said “gold may be forming a major bottom,” which I thought was interesting because of some quantitative analysis that we do regularly (indeed, daily) on commodities. Here is one of the charts, approximately, that the analyst used to make this argument:

I guess, for context, I should back up a little bit and show that chart from a longer-term perspective. From this angle, it doesn’t look quite like a “major bottom,” but maybe that’s just me.

So which is it? Is gold cheap, or expensive? Erb and Harvey a few years ago noticed that the starting real price of gold (that is, gold deflated by the price index) turned out to be strikingly predictive of the future real return of holding (physical) gold. This should not be terribly shocking – although it is hard to persuade equity investors today that the price at which they buy stocks may affect their future returns – but it was a pretty amazing chart that they showed. Here is a current version of the chart (source: Enduring Investments LLC):

The vertical line represents the current price of gold (all historical gold prices are adjusted by the CPI relative to today’s CPI and the future 10-year real return calculated to derive this curve). It suggests that the future real return for gold over the next decade should be around -7% per annum. Now, that doesn’t mean the price of gold will fall – the real return could be this bad if gold prices have already adjusted for an inflationary future that now unfolds but leaves the gold price unaffected (since it is already impounded in current prices). Or, some of each.

Actually, that return is somewhat better than if you attempt to fit a curve to the data because the data to the left of the line is steeper than the data to the right of the line. Fitting a curve, you’d see more like -9% per annum. Ouch!

In case you don’t like scatterplots, here is the same data in a rolling-10-year form. In both cases, with this chart and the prior chart, be careful: the data is fit to the entire history, so there is nothing held ‘out of sample.’ In other words, “of course the curve fits, because we took pains to fit it.”

But that’s not necessarily a damning statement. The reason we tried to fit this curve in the first place is because it makes a priori sense that the starting price of an asset is related to its subsequent return. Whether the precise functional form of the relationship will hold in the future is uncertain – in fact, it almost certainly will not hold exactly. But I’m comfortable, looking at this data, in making the more modest statement that the price of gold is more likely to be too high to offer promising future returns than it is too low and likely to provide robust real returns in the future.

Hard to Sugar-Coat Nonsense Like This

July 20, 2017 3 comments

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One of the things that fascinates me about markets – and one of the reasons I think “Irrational Exuberance”, now in its third edition, is one of the best books on markets that there is – is how ‘storytelling’ takes the place of rational analysis so easily. Moreover, almost as fascinating is how easily those stories are received uncritically. Consider this blurb on Bloomberg from Wednesday (name of the consultant removed so as not to embarrass him):

Sugar: Talk in market is that climate change has pushed back arrival of winter in Brazil and extended the high-risk period for frost beyond July, [name removed], risk management consultant for [company name removed] in Miami, says by telephone.

Sugar futures have recently been bouncing after a long decline. From February through June, October Sugar dropped from 20.40 cents/lb to 12.74¢; since the end of June, that contract has rallied back to 14.50¢ (as of Wednesday), a 14% rally after a 38% decline. There are all sorts of reasons this is happening, or may be happening. So let’s think about ‘climate change’ as an explanation.

There are several layers here but it boils down to this: the consultant is saying (attributing it to “talk in the market,” but even relaying this gem seems like gross negligence) that the rally in the last few weeks is due to a change in the timing of the arrival of winter…a change which, even if you believe the craziest global warming scaremongers, could not possibly have been large enough over the last decade to be measurable against the backdrop of other natural oscillations. Put another way, in late June “the market” thought the price of sugar ought to be about 12.74¢/lb. Then, “the market” suddenly realized that global warming is increasing the risk to the sugar crop. Despite the fact that this change – if it is happening at all – is occurring over a time frame of decades and centuries, and isn’t exactly suffering from a lack of media coverage, the sugar traders just heard the news this month.

Obviously, that’s ridiculous. What is fascinating is that, as I said, in this story there are at least 4 credulous parties: the consultant, the author of the blurb, the editor of the story, and at least part of the readership. Surely, it is a sign of the absolute death of critical thinking that only habitual skeptics are likely to notice and object to such nonsense?

Behavioral economists attribute these stories to the need to make sense of seemingly-random occurrences in our universe. In ancient times, primitive peoples told stories about how one god stole the sun every night and hid it away until the morning, to explain what “night” is. Attributing the daily light/dark cycle to a deity doesn’t really help explain the phenomenon in any way that is likely to be useful, but it is comforting. Similarly, traders who are short sugar (as the chart below, source Floating Path, shows based on June 27th data) may be comforted to believe that it is global warming, and not unusually short positioning, that is causing the rally in sugar.

As all parents know, too much sugar (or at least, being short it) isn’t good for your sleep. But perhaps a nice story will help…

 

Tariffs are Good for Inflation

The news of the day today – at least, from the standpoint of someone interested in inflation and inflation markets – was President Trump’s announcement of a new tariff on Canadian lumber. The new tariff, which is a response to Canada’s “alleged” subsidization of sales of lumber to the US (“alleged,” even though it is common knowledge that this occurs and has occurred for many years), ran from 3% to 24% on specific companies where the US had information on the precise subsidy they were receiving, and 20% on other Canadian lumber companies.

In related news, lumber is an important input to homebuilding. Several home price indicators were out today: the FHA House Price Index for new purchases was up 6.43% y/y, the highest level in a while (see chart, source Bloomberg).

The Case-Shiller home price index, which is a better index than the FHA index, showed the same thing (see chart, source Bloomberg). The first bump in home price growth, in 2012 and 2013, was due to a rebound to the sharp drop in home prices during the credit crisis. But this latest turn higher cannot be due to the same factor, since home prices have nearly regained all the ground that they lost in 2007-2012.

Those price increases are in the prices of existing homes, of course, but I wanted to illustrate that, even without new increases in materials costs, housing costs were continuing to rise faster than incomes and faster than prices generally. But now, the price of new homes will also rise due to this tariff (unless the market is slack and so builders have to absorb the cost increase, which seems unlikely to happen). Thus, any ebbing in core inflation that we may have been expecting as home price inflation leveled off may be delayed somewhat longer.

But the tariff hike is symptomatic of a policy that provokes deeper concern among market participants. As I’ve pointed out previously, de-globalization (aka protectionism) is a significant threat to inflation not just in the United States, but around the world. While I am not worried that most of Trump’s proposals would result in a “reflationary trade” due to strong growth – I am not convinced we have solved the demographic and productivity challenges that keep growth from being strong by prior standards, and anyway growth doesn’t cause inflation – I am very concerned that arresting globalization will. This isn’t all Trump’s fault; he is also a symptom of a sense among workers around the world that globalization may have gone too far, and with no one around who can eloquently extol the virtues of free trade, tensions were likely to rise no matter who occupied the White House. But he is certainly accelerating the process.

Not only do inflation markets understand this, it is right now one of the most-significant things affecting levels in inflation markets. Consider the chart below, which compares 10-year breakeven inflation (the difference between 10-year Treasuries and 10-year TIPS) to the frequency of “Border Adjustment Tax” as a search term in news stories on Google.

The market clearly anticipated the Trumpflation issue, but as the concern about BAT declined so did breakevens. Until today, when 10-year breakevens jumped 5-6bps on the Canadian tariff story.

At roughly 2%, breakevens appear to be discounting an expectation that the Fed will fail to achieve its price inflation target of 2% on PCE (which would be about 2.25% on CPI), and also excluding the value of any “tail outcomes” from protectionist battles. When growth flags, I expect breakevens will as well – and they are of course not as cheap as they were last year (by some 60-70bps). But from a purely clinical perspective, it is still hard to see how TIPS can be perceived as terribly rich here, at least relative to nominal Treasury bonds.

Irrational Lugubriousness on Inflation

Today the 1-year CPI swap rate closed at 1.77%, the highest rate since 2014 (see chart, source Bloomberg).

1ycpiswap

The CPI swap (which, as an aside, is a better indicator of expected inflation than are breakevens, for technical reasons discussed here for people who truly have insomnia) indicates that headline inflation is expected to be about 1.77% over the next year. That’s nearly double the current headline inflation rate, but well below the Fed’s target of roughly 2.3% on a CPI basis. But at least on appearances, investors seem to be adjusting to the reality that inflation is headed higher.

Unfortunately, appearances can be deceiving. And in this case, they are. The headline inflation rate is of course the combination of core inflation plus food inflation and energy inflation; as a practical matter most of the volatility in the headline rate comes from the volatility endemic in energy markets. I’ve observed before that this leads to unreasonable volatility in long-term inflation expectations, but in short-term inflation expectations it makes perfect sense that they ought to be significantly driven by expectations for energy prices. The market recognizes that energy is the source of inflation volatility over the near-term, which is why the volatility curve for inflation options looks strikingly like the volatility curve for crude oil options and not at all like the volatility curve for LIBOR (see chart, source Enduring Investments).

volcompar

The shape of the energy futures curves themselves also tell us what amount of energy price change we should include in our estimate of future headline inflation (or, alternatively, what energy price change we can hedge out to arrive at the market’s implied bet on core inflation). I am illustrating this next point with the crude oil futures curve because it doesn’t have the wild oscillations that the gasoline futures curve has, but in practice we use the gasoline futures since that is closer to the actual consumption item that drives the core-headline difference. Here is the contract chart for crude oil (Source: Bloomberg):

crudeccrv

So, coarsely, the futures curve implies that crude oil is expected to rise about $4, or about 9%, over the next year. This will add a little bit to core inflation to give us a higher headline rate than the core inflation rate. Obviously, that might not happen, but the point is that it is (coarsely) arbitrageable so we can use this argument to back into what the market’s perception of forward core inflation is.

And the upshot is that even though 1-year CPI swaps are at the highest level since 2014, the implied core inflation rate has been steadily falling. Put another way, the rise in short inflation swaps has been less than the rally in energy would suggest it should have been. The chart below shows both of these series (source: Enduring Investments).

ImpliedCore

So – while breakevens and inflation swaps have been rallying, in fact this rally is actually weaker than it should have been, given what has been happening in energy markets. Investors, in short, are still irrationally lugubrious about the outlook for price pressures in the US over the next few years. Remember, core CPI right now is 2.2%. How likely is it to decelerate 1.5% or more over the next twelve months?

(**Administrative Note: Get your copy of my new book What’s Wrong with Money: The Biggest Bubble of All! Here is the Amazon link.)

Categories: Commodities, CPI, Good One, Theory

Interesting Intraday Oil Futures Flows

April 27, 2016 2 comments

Here is an interesting chart that might suggest flows into oil markets.

Or perhaps it suggests something else. But I put together the chart below (data sourced from Bloomberg) because it seemed to me as if recently crude oil – and other energy markets, but I am focusing on Crude – has been having a nice little spike in the middle of the morning. Often, these have seemed inexplicable to me; other times (like yesterday) there was ostensibly news but it was not immediately obvious that the news was oil-supportive.

intradayoil

This chart shows a composite trading day for June NYMEX Crude Oil futures for the last 20 days. You can see that it appears I am not imagining it: on average, Crude has been rallying about 30 cents per day, beginning about 9:00ET.

I thought this might be flattered by the DOE weekly release, which is at 10:30ET on Wednesdays. So I removed those days and the relationship is still clear (although it makes the rise from 3am to 9am look relatively more important).

I don’t know exactly what this means, but it has “felt” to the old trader in me that the market was tending to gap in that time frame and this seems to confirm the visceral sense. It doesn’t necessarily mean my other gut feeling, that this might represent systematic daily allocations – perhaps to energy or broad commodity ETFs? Or OTC products? Or both? – is correct, however.

Categories: Commodities, Quick One

The Pendulum of Inflation Complacency

April 26, 2016 1 comment

I am sure that in my career I have seen weirder reactions, but when the Durable Goods number came out and plainly was significantly weaker-than-expected and energy rallied I must admit it was hard to think of one.

Presumably the reaction was an indirect one: weaker growth means the Fed is less likely to tighten, which means a lower dollar and hence, higher global demand for oil. But that seems a wild overthink. If there is a recession in the offing, and if we care about demand in oil markets (and I think we should), then weak economic growth from one of the world’s largest economies probably ought to be reflected in lower oil prices.

There is part of me that wants to say “maybe investors have finally realized that any given month of Durable Goods Orders is almost meaningless because the volatility of the number makes it hard to reject any particular null hypothesis.” I haven’t done this recently, but many years ago I discovered that a forecast driven by the mechanical rule of -0.5 times last month’s Durables change had a better forecasting record than Street economists. Flip the sign, divide by two. However, I don’t really think the market suddenly got wise.

I also don’t think it’s that a bunch of people got the API report, which came out at 4:30pm to subscribers only, early. That report supposedly showed a large draw in crude inventories when a build was expected – but I’m not into conspiracy theories. That would be too obvious, anyway.

The perspective of analysts on Bloomberg was that the oil market will “rebalance” this year, a point which isn’t very far from the point I made last week in my article “Don’t Forget Oil Demand Elasticity!” But rebalancing doesn’t mean that prices should go higher. They have, after all, already gone quite a bit off the lows. By our proprietary measure, the real price of oil is at a level which implies a 10-year expected real return of about 1% per annum. In other words, it’s within about 10% of fair value quantitatively; given the immense supply overhang that doesn’t seem to promise lots of upside from these levels.

It isn’t just energy. The Bloomberg Commodity Index is 15% off its January lows (see chart, source Bloomberg). Precious metals, industrial metals, softs, grains, and meats are all above their lows of the last 1-2 quarters.

bcom

Unfortunately, much of this is simply a function of the dollar’s retracement. The chart below (source: Bloomberg) shows the Bloomberg Commodity Index (left axis, inverted) against the broad trade-weighted dollar. Heck, arguably commodities are still lagging.

dollarcommod

But the winds of change do seem to be about. Last week, the Treasury auctioned 5y TIPS; though this isn’t an event in and of itself, the fact that the auction was strongly bid is certainly unusual. The 5y TIPS are a difficult sell. People who are concerned about inflation are typically looking to protect against the long-term. But TIPS also represent real interest rate risk, and if you think inflation is going to be rising near-term then you probably don’t want to own lots of interest rate risk. Sure, you’ll prefer inflation-linked real rates to nominal rates (see my timely comment from January, “No Strategic Reason to Own Nominal Bonds Now”: since then, 10y real yields have fallen 40bps while 10y nominal yields have fallen 7bps), but if you really think inflation is about to rear its ugly head then you don’t want any real or nominal duration but only inflation duration.

And inflation duration has lately been doing really well. The chart below (source: Bloomberg) shows the marked rebound in the 10-year breakeven inflation rate since February 9th.

10ybreaks

I think there’s some evidence that the pendulum of complacency on inflation has begun finally to swing back the other way. Core inflation is rising in Europe, the UK, Japan, and the US, and it was inevitable that someone would notice. Ironically, it took energy’s rally to make people notice (and energy, of course, isn’t in core inflation). But what do I care?

If in fact the pendulum of complacency and concern has finally reversed, then both stocks and bonds are in for a rough ride. Bonds may be marginally protected by a dovish Fed, but that only works as long as the inscrutable Fed stays dovish…or inscrutable.

(**Administrative Note: Get your copy of my new book What’s Wrong with Money: The Biggest Bubble of All! Here is the Amazon link.)

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