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Re-Blog: Limits on the 500-pound Gorilla

February 22, 2018 1 comment

With interest rates flirting with 3% on the 10-year Treasury note, and the potential (and eventuality) that they will go significantly higher, I thought it might be timely to review a blog post from February 10, 2013 called “Limits on the 500-pound Gorilla.” (It’s worth reading that original post for some of the comments attached thereto.)


Well, here’s an interesting little tidbit. (But first, a note from our sponsors: some channels didn’t pick up my article from  last Wednesday, “Fun With The CPI,” so follow that link if you’d like to read it.)

The Fed adds permanent reserves by buying securities, as we all know by now. The Open Market Desk buys securities and credits the Fed account of the selling institution. Conversely, when the Fed subtracts reserves permanently, it sells securities and debits the account of the buying institution.

As of February 6th, the Fed owned $1.782 trillion in face value of Treasury and agency mortgage-backed securities. At the closing prices from Friday, those securities are worth $2.069 trillion, plus accrued interest which I didn’t bother to calculate.

So let’s revisit for a second the question of how the Fed would unwind the quantitative easing and actually tighten policy. In order to do that, the Fed would first need to vaporize the $1.58 trillion that exists in excess reserves, before they could actually affect the required reserves which is where the rubber meets the road for monetary policy (at least, in the absence of the “portfolio balance channel”).

We have reviewed some of the options before: sell the securities held in the System Open Market Account (SOMA); conduct massive and long-dated repo operations; sell bills or pay interest on deposits at the Fed (or raise IOER). Some people have suggested that the Fed could just “let the securities in the SOMA roll off”: i.e., let the bonds mature and don’t reinvest the proceeds. I was curious how long, after Operation Twist, such a passive approach would take.

The current value of Excess Reserves is $1.58 trillion. If Excess Reserves did not move for any other reason, it would take until November of 2039 before we saw that many bonds mature. To be fair, with coupon payments and such it would take less time, but we’re still looking at a couple of decades. So that’s not an option, at least by itself.

Then I noticed something interesting. Some economists have suggested that when the economy begins to improve, the Desk could simply start selling securities into the market, since with a stronger economy the Treasury would presumably be running a smaller deficit (now, that’s blind faith if ever there was such a thing) and auctioning fewer securities, so the Fed could take up the slack without impacting the market very much. Leaving aside the question that it isn’t clear that market rates would be in the range they are now if the Fed actually stopped buying (after all, that’s the whole point of the portfolio balance channel – that investors won’t pay the high price the Fed has set so they buy riskier securities), I’m not sure it’s even possible that the Fed could drain the excess reserves even if they sold every single bond on their balance sheet. Here’s why.

The SOMA portfolio has a DV01 of approximately $1.56billion, based on the reported holdings and Bloomberg’s calculated modified duration. For those unfamiliar with bond math, this means that every 1/100th of 1% rise in interest rates causes the value of the Fed’s holdings to decline $1.56bln.

The current market value of the portfolio, as I said, is $2.07 trillion, while Excess Reserves are $1.58 trillion. But the problem is that the ‘market value’ of the portfolio assumes the portfolio is liquidated at mid-market prices. Ask the London Whale how well that works when you are a big player. Ask Long Term Capital.

But forget about the market impact. Suppose interest rates were to rise 300bps, so that the 10-year was around 5% and, with expected inflation remaining (again, let’s go with the blind faith argument) around 2.5%, real interest rates were up to around 2.5%. That would be a fairly neutral valuation for an economy with decent prospects and contained inflation, growing at its sustainable natural growth rate.

The SOMA portfolio, valued 300bps higher in yield, would be worth $2.07T – $1.56B * 300 = 1.60T. In other words, if the Fed sold every single bond in its portfolio, 300bps higher, it would just barely be able to drain all of the excess reserves. Yes, I did ignore the question of convexity, but since the MBS tend to have negative convexity that balances the positive convexity of the Treasuries, I suspect that isn’t a huge effect over this small a move.

So the Fed, in this circumstance, would have used all of its gunpowder just getting back to the point where traditional tools would begin to work again. This is an entirely natural outcome, by the way! If a behemoth market participant lurches into the market to buy securities, and then lurches to sell them, and repeats that pattern over and over, it loses value because it is consuming liquidity in both directions. It is going to be buying high (and again, that’s the Fed’s goal here: to pay more than anyone else wants to pay) and selling low. So in this case, if rates rise 300bps, the Fed will be unwinding its entire portfolio and have no securities left to sell to actually drain the liquidity that matters.

This is obviously a thought experiment – I can’t imagine the Fed could unwind that sort of portfolio with only a 300bp market impact. But it just highlights, for me, the fact that the ‘end game’ for the FOMC almost must involve raising the interest paid on excess reserves – the other tools aren’t only impractical in size, but may be de facto impotent (because, remember, the first thing that needs to happen is that Excess Reserves are drained, before policy has traction again through the traditional channels).

I am sure someone else has pointed out this little mathematics dilemma before, but I don’t think it had previously occurred to me. I guess I’d always stopped at the mechanics/feasibility of selling $2 trillion in securities, and never asked whether that would actually do the job. I don’t think it would! It is not actually true that a 500-lb gorilla sits “anywhere he wants,” as the old joke goes – he can’t sit anywhere that won’t hold a 500-lb gorilla.

Now, the Committee doesn’t really seem to believe in traditional monetary policy any more, so it may be that they figure the reverse of the “portfolio balance channel” effect will be good enough: raise the returns to the ‘less risky’ part of the market enough to pull capital out of the risky parts of the market. But I find it hard to convince myself that, as much as they clearly intended to push housing and equity market prices higher, they’d be willing to do the opposite. And I do believe that other stakeholders (e.g., Congress) would be less accommodating in that direction. Which brings me back again to the conclusion I keep coming to: does the Fed theoretically have the tools to reverse QE? Yes, although they have one fewer than I thought yesterday. But is it plausible that the Fed will have the will to use those tools, to the degree they’d need to be used, to reverse QE? I really don’t believe they’d be willing to crash the housing and stock markets, just to cool down inflation.

We do live in interesting times. And they will remain interesting for a long, long time.

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Summary of My Post-CPI Tweets (Feb 2018)

February 14, 2018 1 comment

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guyPV and get this in real time, by going to PremoSocial. Or, sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments or Enduring Intellectual Properties. Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • Link to my appearance on TD Ameritrade Network [on Monday]:
  • It looks like I will be able to do most of my CPI tweet storm after all. I will be on Bloomberg live at 8:30ET with @adsteel and @DavidWestin, but I will be on the phone and will post my tweets immediately thereafter.
  • Going in, we’re facing roughly a 0.21-0.22% consensus on core CPI. I think to get an adverse reaction from equities you need to keep y/y from declining to 1.7%, which means you need core CPI to be near the year-ago comp, which means something that rounds to 0.3%.
  • Anything that rounds DOWN to 0.3% will be ugly. Again I’m talking core here.
  • It’s important to remember that this is the hardest remaining comp we have in CPI for a long time. In fact, Jan 2017 m/m was higher than any other core print of 2017. The next 6 months are only 1.1% annualized.
  • This is why we can talk about the ‘bad optics’. Core CPI will appear to be rapidly accelerating over the next half-year unless we get some weird one-offs like we did last year.
  • This month I will be especially focused on Used Cars and Trucks, which is subject to a change in BLS procedure this month. Big difference of opinion out there about whether it’s an add or subtract.
  • I believe it will be an add, because the price level is what BLS surveys and this has been very far below what private surveys have shown. Catching up to do unless the BLS just ignores that prices are higher than they thought.

  • But a tremendous amount of noise around any element of the data so it could be anywhere of course!
  • Have to go now and prep for Bloomberg call. Will be back several minutes after CPI for recap. Thanks for subscribing, everyone.
  • oh my…0.349% on core…1.846% y/y…and this was supposed to be the hard comp.
  • Supposedly the seasonals were going to dampen this figure. Whoops.
  • Remember this is a January number but…it’s hard to ignore. Accelerating major categories: Food/Bev, Apparel, Medical Care, Other.
  • Housing decelerated but that was mostly Lodging Away from Home, -2% for the month. AirBnB making a comeback?!? Primary Rents accelerated to 3.73% from 3.68% y/y and OER to 3.20 from 3.17%. This is on our model.
  • Here’s last 12 m/m core CPIs. Notice a trend?

  • CPI-used cars and trucks…was 0.32% m/m. Sorry, people who thought that it would be down. y/y though it’s still a drag at -0.61%. But last month that was -0.99%.
  • In Medical Care, Pharma decelerated to 2.39% vs 2.77%. But Doctor’s Services -1.51% vs -1.77% y/y last; Hospital Services 6.04% vs 5.09%.
  • That matters more than you think, because more care is being funneled through hospitals every day.
  • CPI for medical care…bottoming?

  • CPI pharma

  • Now, whilst Used cars and trucks accelerated, New Vehicles decelerated to -1.24% vs -0.53% y/y last month. And New Vehicles have almost twice the weight of used vehicles. So cars, actually, were a net drag. Just not the place that pointy-head economists said it would be.
  • I wouldn’t get too overenthused about apparel. Yes, it had a big jump. And with a weaker dollar and some protectionism I’d expect to see this going up. Just…lot of wood to chop.

  • Sorry I am jumping around a bit. Back to hospital services. Near longer-term high pace, but really need to see it break higher. This is an important part of core services.

  • Here’s CPI-Used Cars vs the Manheim survey. Rate-of-change. Looks like it’s catching up. But…

  • Here (again) is the index level (normalized) of CPI vs Manheim. This month’s move doesn’t do much. EVEN IF THE HARVEY JUMP IN MANHEIM GOES AWAY, BLS is still way below where it should be. This is a source of positive variance going forward.

  • Here is the distribution of price changes. As expected the weight in the left tail is starting to decline, which will cause core to converge with median eventually (or anyway, get close).

  • OER accelerated slightly, but as I mentioned this is what our model expects. Not to anthropomorphize a model. The real question is which of our submodels – which agree at this level but diverge – ends up being ‘correct’.

  • So here’s the ‘four pieces’ look. What it shows, frighteningly, is that nothing unusual is happening. As a reminder to people seeing this 1st time…this breakdown of CPI has four roughly-equal pieces.

  • Food and Energy

  • Now the core pieces. Core Goods. With dollar weakness this will eventually go mildly positive. But this happens with a lag and hasn’t happened yet. Maybe Apparel is first shot?

  • Core Services less Rent of Shelter. If Medical Care is bottoming, this is an upside risk. I doubt there’s much downside risk at this point.

  • And Rent of Shelter. It’s decelerated, but home prices are still rising and I don’t think this is going to drop out of the sky. Net result: hard to see where disinflation would come from.

  • This is where I usually conclude by forecasting Median CPI. But median category looks like a subcomponent of OER, which the Cleveland Fed separately computes a seasonal adj for. However, looks to me like Median won’t be anywhere close to core. Probably around 0.2%.
  • Looking forward, remember: the EASY core comps are ahead. Feb 2017 was +0.17%, March -0.07, April +0.09%, May +0.08%. June and July 0.14%. Not until Aug do we have another 0.2% comp. This means core CPI is going to be rising from the current 1.85%.
  • …and that in turn is going to scare investors, and the Fed (which usually follows the bond market) might overreact for all their brave talk currently. Today’s data certainly created a WTF moment at Constitution and 20th St. NW
  • That’s a wrap for now people. It was a fun one. Thanks for tuning in! Thanks for signing up!

The big takeaway from this month was that this was supposed to be the difficult comp for year/year CPI. With all of the sturm und drang about inflation over the last couple of weeks, this was set up to be a whipsaw when the January data turned out to show a decline in year/year core CPI. Going into the data, I would have preferred the long side of equities (for a trade) because it seemed like the talk around this CPI was overdone.

But instead we got the highest m/m core CPI in 12 years, and it was very close to printing 0.4% with rounding. That would have been heart-stopping.

The stock market seems at this hour to have fallen in love with the idea that this was all due to “weird jump in Apparel.” But Apparel is only 3% of CPI and 4% or so of Core. So a 1.5% miss in Apparel would only add 0.06% to core CPI. And core CPI missed by more than twice that. Moreover, the jump in Apparel is just reversing some curious recent weakness in the series, so arguably it’s an unwind of a one-off, not a new one-off. Year/year, Apparel is still deflating at -0.62%/year even with this month’s jump. That’s steeper deflation, actually, than the four-year average! With the dollar weakening, I would expect Apparel to be adding, not subtracting, from inflation over the balance of this year. But, with such a small weight…who cares?

I agree that one should not exaggerate the importance of any one month’s data, for any data series (including Average Hourly Earnings, which seems very likely to reverse some next month). But the next six months are going to see core inflation continue to rise, optically. If we get “only” 0.2% prints for each of the next six months, then July core CPI will be around 2.5% y/y. At that point, people will be extrapolating crazy numbers. But for now, we still have all of the ugly optics to look forward to.

This is a bad figure. There are no two ways about it.

Historical Context Regarding Market Cycles

February 5, 2018 4 comments

I really enjoy listening to financial media outlets on days like this. Six days removed from all-time highs, the equity guys – especially the strategists, who make their money on the way up – talk about “capitulation,” and how “nothing has changed,” and how people need to “invest for the long-term.” If equities have entered a bear market, they will say this all the way down.

It helps to have seen a few cycles. Consider the early-2000s bear market. In 2000, the Nasdaq crested in March. After a stomach-churning setback, it rallied back into August (the S&P actually had its highest monthly close for that cycle in August). The market then dropped again, bounced, dropped again, bounced, and so on. Every bounce on the way down, the stock market shills shrieked ‘capitulation’ and called it a buying opportunity. Eventually it was, of course. But if there is a bear market, there will be plenty of time to buy later. This was also true in ’09, which was much more of a ‘spike’ bottom but let’s face it, you had months and months to get in…except that no one wanted to get in at the time.

If it is not a bear market, then sure – it’s a buying opportunity. But what I know from watching this drama play out several times is that you cannot tell at the time whether it’s a buying opportunity, or a dead-cat bounce. It does not help at all to say “but the economy is okay.” Recalling that the Nasdaq’s peak was in March 2000: the Fed was still hiking rates in May of that year, and didn’t cut rates until 2001.  In late July 2000, GDP printed 5.2% following 4.8% in Q1. In October 2000, GDP for Q3 was reported to still be at 2.2%. Waiting for the economy to tell you that all was not well was very costly. By the time the Fed was alarmed enough to ease, in a surprise move on January 3, 2001, the S&P was down 16%. But fortunately, that ended it as stocks jumped 5% on the Fed’s move. Buy the dip!

By mid-2002, stocks were down about 50% from the high. Buying the dip was in that case precisely wrong.

Then there is the bear market of a decade ago. The October 2007 market high happened when the economy was still strong, although there were clearly underlying stresses in mortgages and mortgage banking and the Fed was already easing. Yet, on January 10, 2008, Fed Chairman Bernanke said “the Federal Reserve is not currently forecasting a recession.” On January 18, he said the economy “has a strong labor force, excellent productivity and technology, and a deep and liquid financial market that is in the process of repairing itself.” In June 2008, he said “The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.” Stocks were already down 19%. It got somewhat worse…and it didn’t take long.

So the thing to remember is this: equities do not wait for earnings to suffer, or for forecasts of earnings to suffer, or for everyone to figure out that growth is flagging, or for someone to ring a bell. By the time we know why stocks are going down, it is too late. This is why using some discipline is important – crossing the 200-day moving average, or value metrics, or whatever. Or, decide you’ll hold through the -50% moves and ignore all the volatility. Good luck…but then why are you reading market commentary?

I don’t know that stocks are going to enter a bear market. I don’t know if they’ll go down tomorrow or next week or next month. I have a pretty strong opinion about expected real returns over the next 10 years. And for that opinion to be realized, there will have to be a bear market (or two) in there somewhere. So it will not surprise me at any time if a bear market begins, especially from lofty valuation levels. But my point in this article is just to provide some historical context. And my general advice, which is not specific to any particular person reading this, is that if anyone tells you that price moves like this are ‘capitulation’ to be followed by ‘v-shaped recoveries,’ then don’t just walk away but run away. They haven’t any idea, and that advice might make you a few percent or lose you 50%.

To be sure, don’t panic and abandon whatever plan you had, simply because other people are nervous. As Frank Herbert wrote, “fear is the mind-killer. Fear is the little-death that brings total obliteration.” This is why having a plan is so important! And I also think that plans should focus on the long term, and on your personal goals, and matching your long-term investments to those goals. Rebalancing and compounding are powerful tools, as is a value ethic of buying securities that have a margin of safety.

And, of course, diversification. Bonds today did what they’re supposed to do when ‘risky assets’ take a tumble: they rallied. As I noted on Friday: “I am not saying that interest rates are going directly from 3% to 6%. Indeed, the rates/equity ecosystem is inherently self-dampening to some degree (at least, until we reach a level where we’ve exceeded the range of the spring’s elasticity!) in that if equity prices were to head very much lower, interest rates would respond under a belief that central bankers would moderate their tightening paths in the face of weak equities.” The problem with nominal bonds at this point, though, is that they’re too expensive. At these yields, there is a limit to the diversification they can provide, especially if what is going to drive the bear market in stocks is rising inflation. Bonds will diversify against the sharp selloff, but not against the inflation spiral. (I’ve said it before and I will say it again. If you haven’t read Ben Inker’s piece in the latest GMO quarterly, arguing why inflation is a bigger risk for portfolios right now than recession, do so. “What happened to inflation? And What happens if it comes back?”)

Which brings us to commodities. If the factor driving an equity bear market turns out to be inflation, then commodities should remain uncoupled from equities. For the last few days, commodity indices have declined along with equities – not nearly as much, of course, but the same sign. But if the problem is a fear of inflation then commodities should be taking the baton from stocks.

So there you go. If the problem is rising interest rates, then that is a slow-moving problem that’s self-limiting because central banks will bring rates back down if stocks decline too far. If the problem is rising inflation, then commodities + inflation bonds should beat equities+nominal bonds. Given that commodities and inflation bonds are both relatively cheaper than their counterparts, I’d rather bet that way and have some protection in both circumstances.

The Era of Bizarro Bill Gross is Beginning

February 2, 2018 2 comments

Note: my articles are now released about 8 hours earlier on the blog site and on my private Twitter feed @inflation_guyPV, which you can sign up for here, than they are released on my ‘regular’ Twitter feed.


It’s hard to believe that 10-year yields in the US have doubled in the last 18 months. It’s the last 50bps, taking us from 2.35% to 2.84% since December, that has received the most attention but 10yr Treasury rates have literally spanned the width of the nearly 40-year-old channel over that 18 months (see chart, source Bloomberg).

Such a long-term chart needs to be done in log scale, of course, because a 200bp move is more significant when rates are at 2% than when they are at 10%. I have been following this channel for literally my entire working career (more than a quarter-century now), and only once has it seriously threatened the top of that channel. Actually, that was in 2006-07, which helped precipitate the last bear market in stocks. Before that, the last serious test was at the end of 1999, which helped precipitate that bear market.

You get the idea.

The crazy technicians will note that a break above about 3.03%, in addition to penetrating this channel, would also validate a double bottom from the last five years or so. Conveniently, both patterns would project 10-year rates to, um, about 6%. But don’t worry, that would take years.

Let’s suppose it takes 10 years. And let’s suppose that velocity does what it does and follows interest rates higher. The regression below (source: Bloomberg) shows my favorite: velocity as a function of 5y Treasury rates. Rates around 5% or 6% would give you an eyeball M2 velocity of 2.1.

So, let’s go to the calculator on our website, and see what happens if money velocity goes to 2.1 over the next decade, but real growth averages a sparkling 3%.

Looking down the “2.1” column for velocity, we can see that if we want to get roughly 2% inflation – approximately what the market is assuming – then we need to have money growth of only 1% per annum for a decade. That is, the money supply needs to basically stop growing now. The only problem with that is that there are trillions in excess reserves in the banking system in the US, and trillions upon trillions more on the balance sheets of other central banks, and not only does the Fed not plan to remove all of those reserves but rather to maintain a permanently larger balance sheet, but other central banks are still pumping reserves in. So, you can see the problem. If money growth is only 3%, then you’re looking at average inflation over the next decade of 3.9% per annum. By the way, average money growth in the US since the early 1980s has been 5.9% (see chart, source Bloomberg). Moreover, it has been below 3% only during the recessions of the early 1990s and the global financial crisis, and never for more than a couple of years at a time.

The bottom line is that rising interest rates and more importantly rising money velocity create a very unfortunate backdrop for inflation, and this is what creates the trending nature of inflation and the concomitant ‘long tails’: higher rates create higher velocity, which creates higher inflation, which cause higher rates. Etc. The converse has been true for nearly 40 years – a happy 40 years for monetary policymakers. Yes, I know, there are a lot of “ifs” above. But notice what I am not saying. I am not saying that interest rates are going directly from 3% to 6%. Indeed, the rates/equity ecosystem is inherently self-dampening to some degree (at least, until we reach a level where we’ve exceeded the range of the spring’s elasticity!) in that if equity prices were to head very much lower, interest rates would respond under a belief that central bankers would moderate their tightening paths in the face of weak equities. And if interest rates were to head much higher, we would get such a response in equities that would provoke soothing tones from central bankers. So tactically, I wouldn’t expect yields to go a lot higher from here in a straight shot.

I am also not saying that money velocity is going to gap higher, and I am not saying that inflation is about to spring to 4% (in fact, just the other day I said that it will likely be mainly the optics on inflation that are bad this year because some one-off events are rolling out of the data). Just as with interest rates, this cycle will take a long time to unwind even if, as I suspect, we have finally started that unwind. We’re going to have good months and bad months in the bond market. But the general direction will be to yields that are somewhat higher in each subsequent selloff. And some Bizarro Bill Gross will be the new Bond King by riding yields higher rather than riding them lower.

I am also told that mortgage convexity risk, which in the past has taken rallies and selloffs in fixed-income and made them more extreme, is less of a problem than it used to be, since the Fed holds most mortgages and servicing rights have been sold from entities that would hedge extensions to those who “just want yield” (unclear how this latter group responds to the same yield, at longer maturities). On the other hand, the Volcker Rule has gutted a lot of the liquidity provision function on Wall Street, so if you have a million to sell you’re okay; if you have a yard (a billion) then best of luck.

I will note that real yields are still lower (10year TIPS yields 0.70%) than they reached at the highs in 2016, which were lower than they got to in 2015, which were lower than they hit in 2013. The increase in interest rates is not coming from a surge in belief about rising real growth. The increase is coming from a surge in concern about the backdrop for inflation. For nominal interest rates to go much higher, real yields will have to start contributing more to the selloff. So I think we are probably closer to the end of the bond selloff, than to the beginning…at least, this leg of it.

Forward Inflation is Nothing to be Alarmed About (Yet)

February 1, 2018 2 comments

Note: my articles are now released about 8 hours earlier on the blog site and on my private Twitter feed @inflation_guyPV, which you can sign up for here, than they are released on my ‘regular’ Twitter feed.


It’s time to get a little wonky on inflation.

Recently, I saw a chart that illustrated that 5y, 5y forward inflation – “what the Fed watches” – had recently risen to multi-year highs. While a true statement, that chart obscures a couple of important facts that are either useful, or interesting, or both. Although probably just interesting.

First, the fact that 5y, 5y forward inflation (for the non-bond people out there, this is the rate that is implied from the market for 5-year inflation expectations starting 5 years from now) has recently gone to new highs is interesting, but 5y5y breakevens are still at only 2.20% or so. Historically, the Fed has been comfortable with forward inflation (from breakevens) around 2.50%-2.75% even though its own target is 2% on core PCE (which works out to be something like 2.25%-2.35% on core CPI). That’s because yield curves are typically upward-sloping; in particular, inflation risk ought to trade with a forward premium because the inflation process exhibits momentum and so inflation has long tails. Ergo, long-dated inflation protection is much more valuable than shorter-dated inflation protection, not just because there is more uncertainty about the future but because the value of that option increases with time-to-maturity just like any option…but actually moreso since inflation is not naturally mean-reverting, unlike most financial products on which options are struck.

[As an aside, the fact that longer-term inflation protection is much more valuable than shorter-term inflation protection is one of the reasons it is so curious that the Treasury keeps wanting to add to the supply of 5-year TIPS, as it just announced it intends to do, even though the 5-year auction is usually the worst TIPS auction because not many people really care about 5 year inflation. On the other hand, 10-year TIPS auctions usually do pretty well and 30-year TIPS auctions often stop through the screens, because that’s very valuable protection and there isn’t enough of it.]

A second interesting point about 5y5y inflation is that it is only at recent highs if you measure it with breakevens. If you measure it with inflation swaps, forward inflation is still 10bps or so short of the 2016 highs (see chart, source Bloomberg and Enduring Investments calculations).

This chart also illustrates something else that is really important: actual 5y5y forward inflation expectations are up around 2.40%, not down at 2.20%. Inflation swaps are a much better way to measure inflation expectations because they do not suffer from some of the big problems that bond-based breakevens have. For example:

  1. The inflation swaps market is always trading a clean 5-year maturity swap and a clean 10-year maturity swap. By contrast, the ’10-year note’ is a 10-year note for only one day, but remains the on-the-run 10-year note until a new one is auctioned.
  2. The 5-year breakeven consists of a “5-year” TIPS bond and a “5-year” Treasury, even though these may have different maturities. They are always close, but not exact, and the duration of the TIPS bond changes at a different rate as time passes than the duration of the Treasury. In other words, the matching bonds for the breakeven don’t match very well.
  3. A minor quantitative point is that the “breakeven” is typically taken as the difference between the nominal Treasury yield and the real TIPS yield, but since the Fisher equation says (1+n) = (1+r)(1+i), the breakeven (i in this notation) should actually be (1+n)/(1+r)-1. At low yields this is a small error, but the error changes with the level of yields.
  4. A more important quantitative point is that the nominal bond’s yield not only has real rates and expected inflation, but also a risk premium which is unobservable. So, in the construction above, I ignored the fact that the Fisher equation is actually (1+n)=(1+r)(1+i)(1+p), with the breakeven therefore representing both the i and the p. Inflation swaps, on the other hand, represent pure inflation.
  5. But then why is the inflation swap always higher than the breakeven? This is the biggest point of all: the breakeven is created by buying a TIPS bond and shorting a nominal Treasury security. Shorting the Treasury security involves borrowing the bond and lending money in the financing markets; because nominal Treasuries are coveted collateral – especially the on-the-run security used for the breakeven – they very often trade at “special” rates in the financing markets. As a result, nominal Treasury yields are ‘too low’ by the value of this financing advantage, which means in turn that the breakeven is too low. If TIPS also traded “special” at similar rates, then this would be less important as it would average out. However, TIPS almost never trade special and in particular, they don’t trade as deep specials. Consequently, breakevens calculated as the spread between a TIPS bond and nominal bond understate actual inflation expectations.[1]

This is all a very windy way to say this: ignore 5y5y forward breakevens and focus on 5y5y forward inflation swaps. Historically the Fed is comfortable with that up around 2.75%-3.25%, although that’s probably partly because they are iffy on bond math. In any case, there is nothing the slightest bit alarming about the current level of forward inflation expectations; indeed, central bankers had much more cause to be alarmed when forward inflation expectations were down around 1.50% – implying that investors had no confidence that the Fed could get within 50bps of its own stated target when given half a decade to do it – than where they are now.

But check with me again in 50bps!


[1] This is widely known, although I think I get the credit for being the first person to point it out in 2006, only two years after the inflation swaps market in the US got started. I figured it out because I was a market maker in swaps and when I was paying inflation in the swap, and receiving a fixed rate higher than the breakeven, and hedged with the breakeven, I was breaking even. The answer was in the financing. I formalized my argument in this paper although my original article was credited and cited in this much more widely read article by Fleckenstein, Longstaff, and Lustig. But the bottom line is that as the Dothraki say, ‘it is known.’

Summary of My Post-CPI Tweets (Jan 2018 – Dec figure)

January 12, 2018 Leave a comment

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guyPV and get this in real time, by going to PremoSocial. Or, sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments or Enduring Intellectual Properties. Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • 22 minutes until CPI. Not sure I am looking forward to this one. The little birds are all whispering that this is supposed to be high, and that concerns me.
  • Not the economists: consensus forecast is for a reasonably high 0.24% on m/m core. But we drop off 0.22% from last December so the y/y won’t move much from 1.7% if that’s the print we get.
  • Yes – there are lots of reasons this COULD be higher. Chief among them is the divergence between surveys of used car prices and the BLS cars index. Cars are 6.4% of CPI, so it matters. But PPI showed weakness in vehicles for another month. (I usually ignore PPI, though).
  • ..it’s December, which means it’s crazy-seasonal-adjustment month. December is the only month of the year where you can confidently reject the hypothesis that there’s no seasonal (on headline CPI), as prices tend to fall. But there’s also a lot of volatility.
  • Rents have come back to model, and home prices continue to rise, so decent chance that housing starts to contribute again here soon.
  • What I fear is that some of the forecasts for a “surprise” higher are coming from the fact that the inflation markets have been rallying, so people are afraid “someone knows something.” Economists don’t ignore markets. But in this case I think it’s just year-end reassessment.
  • …let’s face it, inflation bonds are cheap. About 50bps cheap at the 10-year point by my model. Commodities are cheap. And everything else is expensive. I don’t have to believe inflation is coming to swap out of stocks into commodities.
  • Of note – inflation swaps have been rising in every major market recently. So there definitely is an undercurrent of inflation concern.
  • Don’t fade the whispers! +0.3% on core. Actually 0.277%. But enough to put y/y up to 1.77%, rolling it to 1.8% rounded.
  • Wow, 2 yr Tsy above 2% for the first time since September 2008!
  • Last 12 CPIs. Try hard not to see an uptrend here. It’s an illusion caused by the low mid-year figures. But that said, this is highest in a while.

  • Let’s see…Housing up slightly, Transportation up, no change in medical care (talking major subgroups here)…will be interesting to see where the wiggle is.
  • Core services 2.6% vs 2.5% and core goods -0.7% vs -0.9% y/y. That’s the least goods deflation since last July. But it’s still deflation.
  • Pulling in the micro data now. The BLS series is so rich. But while the sheet is calculating this is a good time to remind everyone that these figures are for DECEMBER so try hard not to get too excited. The breakdown will be more important to tell us if this is ‘real.’
  • If you haven’t read Ben Inker’s piece in the latest GMO quarterly, arguing why inflation is a bigger risk for portfolios right now than recession, do so. Very good piece. “What happened to inflation? And What happens if it comes back?” https://www.gmo.com/docs/default-source/research-and-commentary/strategies/gmo-quarterly-letters/what-happened-to-inflation-.pdf?sfvrsn=5
  • One more item of context before we dive deeper: Median CPI is at 2.3%. So we should be expecting something right around 0.2% per month if there’s no trend. The uptick from 1.7% to 1.8% is just catching up, mostly.
  • OK on the breakdown. New and Used cars, 8% of core CPI, rose to -0.33% from -1.05%. As expected, and that’s a big part of the surprise.
  • I say “surprise,” but it really oughtn’t be a surprise. Remember that Hurricane Harvey had a similar effect to Cash for Clunkers in terms of the number of cars removed from the road. The private car prices indices were showing this. BLS has a lot of catching up yet.

  • Just lost power. Anyway. Wasn’t just used cars. Used cars went from -2.1% to -0.99% but new went from -1.08% to -0.53%
  • Owners Equivalent Rent went to 3.175% from 3.124%, and primary rents from 3.675% to 3.689%. So housing back on track.
  • Medical Care broadly went to 1.78% from 1.68%. Pharma went 1.87% to 2.37%. Other components pretty stable (in medical). Medicinal drugs (pharma) is about one fifth of medical care subindex.
  • Wireless telephone services again steady. The jump will be fun when the plunge washes out. Right now it’s -10.19% y/y vs -10.24%.
  • Wish I could post my chart of distributions of price changes. Left tail starting to move rightward a bit. Hopefully get power back soon. This is all on backup power to my pc. [Editors’ Note – I added it later, see below]
  • Well, looks like power isn’t coming back on quickly. I will have to come back later with the median CPI estimate etc. Got most of the details out though.
  • Bottom line is that the components we expected to start converging, did. Housing behaved. Medical care behaved. And so we moved towards the real middle of the distribution, around 2.3% or so presently.
  • This shouldn’t be taken as an acceleration in inflation. This is just one (flawed) number converging with the better ones. Core inflation is going to head higher, but this isn’t convincing evidence that it is yet doing so.
  • Having said that, in a couple of months the y/y comps start to get better so the inflation story will have much better OPTICS. And it’s optics these days, more than fundamentals, that drive markets. So don’t jump off the commodities or tips bandwagon. That trend will continue.
  • Power’s back on! Of note is that Median CPI printed at 0.29%, the highest level since July 2008 (sound familiar? That was also true two months ago when it was 0.27%). So y/y up to 2.44% now.
  • Yeah, I know I said don’t think of this was an uptrend. And it’s not; it’s an unwind of one-offs. But still, that’s gotta look scary.

  • Better late than never. Here’s what I meant about the distribution moving right. Those two bars on the left were one bar before today. So you can see those components – largely cars and cell phones – are dragging down core relative to median.

  • The rally in breakevens shouldn’t be terribly surprising – this chart shows it’s just keeping pace (and not even) with the turn back higher in median CPI.

  • The market is NOT AT ALL ahead of itself in this sense.

This was certainly not the easiest time I have had with a CPI report, but that’s mostly because the power grid in this country is as brittle as glass. The story was actually not as much about screwy seasonal as I was concerned about. Actually, it was a fairly humdrum report in many ways, and that’s what is scary if you’re thinking we are in a “lowflation” period. The chart of Median CPI is interesting. Core inflation had risen mostly because car prices are starting to catch up with private measures of car prices – what remains in the gap between the red line and the blue line in the “Manheim” chart would add about 0.5% to core CPI – and housing stopped decelerating. But then Median CPI, which doesn’t care about the New and Used car prices since those are outliers, rose at the highest rate (m/m) in nearly a decade, and the Median-Core spread actually widened slightly this month. That means more core acceleration is ahead.

I mentioned that in a few months the year-ago comparisons will start getting easier. This month, we got 0.28% from core CPI versus 0.22% last year. But in Jan 2017, core CPI was +0.31%. That will be a hard comp to beat. But after that, Feb 2017 was +0.21%, March was -0.12%, April was +0.07%, May was +0.06%, June was +0.12%, and July was +0.11%. At the time, we mused “is the natural run rate for core really 0.5%/annum?” which was what those five months were averaging. That seemed very unlikely. Median CPI told us that wasn’t the case. Now, if core CPI merely averages a monthly 0.17% print from now until July, the y/y figure will be up at 2.20%. And if it’s 0.2% per month, in July we will be sitting at 2.42%.

I don’t think you want to fade those optics, even if you think we’re only going to get 0.15%. Perhaps the next month or two, because of the more-difficult comps, will take some wind out of the sails of the inflation bulls and offer better entry points. But the direction of travel looks fairly clear for the next six months or so. And that also means that the direction of travel for monetary policy is also likely set, to be at least as aggressive as the market is pricing. And, perhaps, the direction of travel for equity prices isn’t quite as clear as it currently seems.

And it bears repeating that this is going to be the case even if inflation is not actually in an uptrend, but just maintaining its current run rate around 0.2% per month (commensurate with median CPI at 2.4%/yr). If inflation is in fact turning higher – and there are some signs of that, though not as widespread as everyone seems to suddenly think – then it could be a lot uglier in 2018. As I said again above: don’t jump off the commodities or TIPS bandwagon yet. But…you might want to trim some of that nominal bond exposure!

Summary of My Post-CPI Tweets (Oct 2017)

October 13, 2017 Leave a comment

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guyPV or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments or Enduring Intellectual Properties. Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here or get it a little cheaper on our site here.

  • Friday the 13th and a heavy data day. What could go wrong?
  • 10y breakevens at local highs of 1.90% – but that’s the biggest spread over core CPI in several years.
  • …yet we still have 10y TIPS 50bps to fair at this level of interest rates.
  • Economist expectations are for 0.21% on core and 1.78% y/y. Interesting given how low it has been recently.
  • I don’t usually look at headline but the y/y number is forecast to jump to 2.3% from 1.9%. That will get some attention.
  • I think the market forecasts are about right for core, but there’s a wide range of upside risks. Autos are due to catch up, e.g.
  • But that’s why the forecasts make sense. 0.15% for trend plus 0.05% for expected value of risks.
  • …in turn, that means the point forecasts are not the most likely prints. They’re in between the most likely prints.
  • Core +0.13%, 1.69% y/y.
  • Breakdown will be interesting. Housing broad category went to 2.79% y/y from 2.91%. Medical Care fell to 1.56% from 1.81%.
  • Used cars/trucks went to -3.7% vs -3.8% y/y, so that rebound is still ahead of us. Surveys of car prices are up a lot, just not in BLS yet.
  • pulling in the breakdown now…core services 2.6% from 2.5%, but core goods deflation deepens to -1.0% from -0.9%.
  • Core goods deflation, however, ought soon to be rising again after the lagged effect of the dollar’s decline passes in.
  • In Housing, Primary Rents plunged to 3.78% from 3.88%. That’s huge. OER dropped to 3.18% from 3.27%. Also huge. There’s your story.
  • Core ex-housing rose to 0.58% vs 0.52% y/y, so there’s more going on here but the housing. Wow.
  • A few months ago we had y/y OER fall by more, but that was when OER was overextended.
  • Here is primary rents y/y. I guess this isn’t DRAMATIC – just quite contrary to my own expectations for a continuation of the rebound.

  • In Medical Care, Medicinal Drugs fell to 1.01% from 2.51%. Wow! But Professional Services and Hospital Services accelerated slightly.
  • Here’s CPI for pharma. Think we’ve discussed this before – likely compositional in nature, more generics thanks to worse insurance.

  • Professional services (doctors) bounced;not significant. Also somewhat compositional as old doctors quit rather than take ins. headaches.

  • College Tuition 2.08% vs 1.89%. Have I mentioned the new S&P Target Tuition Inflation Index recently? 🙂
  • Just b/c …who can get enough of wireless telecom services? Bounced, mostly base effect of course. Bottom line was that dip was a 1-off.

  • New cars also still deflating, BTW. -1.0% vs -0.68%. Obviously this will change with Houston buying loads of new cars.
  • Speaking of Houston: core CPI in Houston y/y ended June: 1.31%. For y/y ended Aug: 1.90%. But that’s actually before Harvey.
  • In Miami, 2.01% vs. 2.26% (June vs August). Have to wait a bit to get October numbers – they’ll come out in Dec.
  • Bottom line on the storms is that we haven’t seen the impact yet on CPI. Still to come.
  • My early estimate of Median CPI is 0.20%, bringing y/y up to 2.17% from 2.15%.
  • Housing and Medical Care still keeping pressure on core.

  • Interestingly, these other categories, including Food, and Energy too, all saw acceleration this month (except for other).

  • distribution of changes getting more spread out…

  • Percentage of basket over 3% hasn’t changed much, ergo median didn’t change much.

  • Does this change the Fed’s calculus? I don’t think so, especially with wages accelerating. Still waiting for one-offs to unwind.
  • The doves will argue that the unwind of a one-off is itself a one-off and we should therefore look thru and see 0.12-0.14 as the trend.
  • They’re unlikely to carry the day in Dec, even if the data don’t bounce higher. But if core stays weak the mkt will unwind the 3 in 2018.
  • 10y breakevens -3bps since the number. Market had seemed a little long but this is still too low for breakevens.
  • Four pieces. Piece 1: Food & Energy

  • Piece 2: core goods. Won’t go down forever with the dollar well off its highs.

  • Core services less ROS. A bounce. Sustainable? We’ll have to see.

  • Piece 4, Rent of Shelter. Seemingly ignoring continued rise in home prices. Back to model but weaker than I expected.

  • Last chart. here is the argument: do we cheer the weak consumer inflation or worry about higher wages?

  • Yes, wages follow inflation rather than lead…but the Fed doesn’t believe that.

Thanks to everyone who followed my new “premium” (but cheap) channel. I wrote on Wednesday about the reason for changing my Tweet storm; in a nutshell, it’s because research is starting to be priced a la carte at the major dealers and hopefully this means that quality but off-Street analysis might finally be competing on an even footing rather than competing with “free.” If you think there’s value in what I do, I’d appreciate a follow. If not…well, if the market tells me that what I’m producing isn’t worth anything, then I’ll stop producing it of course!

But in the meantime, here is the story of CPI this month. A continuing regression of rents and OER to model levels held core down to recent-trend levels. But there are many one-off and temporary effects that are due to be reversed, and relationships that suggest certain components are due to catch up to underlying realities. For example, here is the picture of Used Cars and Trucks CPI, compared to the Manheim Used Vehicle Value Index 4 months prior.

According to the relationship between these series over the last decade, CPI for Used Cars and Trucks should be growing about 5% faster than it is presently, and rise another 3-4% in the next few months. New and Used Motor Vehicles inflation is about 8% of core CPI, so this effect alone could add 0.7% to core CPI! Or, put another way, right now core CPI is about 0.4% lower than it would be if the CPI was measuring the actual price of vehicles the same way that Manheim does it. That’s a big number when the entire core CPI is only 1.7%.

The continued, and actually extended weakness in core goods is also due to reverse. I don’t mean that core goods inflation will go from -1% to +3% but only to 0.5%. But that 150bp acceleration, in one-quarter of the core CPI, would also raise core CPI by 40bps or so. To be sure, there is some double-counting since a third of core commodities is new and used vehicles, but that merely reinforces the message.

So, too, are the effects in medical. Volatility in those series should persist, which means that since they are at a low ebb there’s a better bet that the next volatile swing is to higher prices.

All of which is to say that the hawks on the Federal Reserve Board actually have it right, in a sense. Prices are headed higher, and inflation is accelerating. It would be a truly shocking development if core inflation one year from now was unchanged from the current level. Indeed, I think there is a better chance that core inflation is above 2.7% than below 1.7%. On another level, the hawks aren’t quite right though. By hiking rates before draining excess reserves, the Fed risks kicking off the vicious cycle I have mentioned before: higher rates cause higher money velocity, which causes higher inflation, which causes higher rates etc. Without control of reserves at the margin, the Fed cannot control money supply growth and so the normal offset to rising monetary velocity in a tightening cycle, slowing money growth, comes down to chance. Either way, the Fed is very likely to tighten in December, but beyond that it probably matters more who ends up in the Chairman’s seat than anything economic data.

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