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First Ballots are in on Results of Fed Tightening

February 11, 2016 3 comments

It fascinates me how bear markets all feel alike in some ways. What I remember very clearly from the equity bear markets of 2000-2002 and 2007-2009 is that bulls wanted to bottom-tick the market at every imagined opportunity. Every “support level,” for the first half of each decline at least, saw bulls pile in as if the train were about to leave the station without them on it. Of course, the train was about to leave the station, but it was backing up.

Today, the S&P didn’t quite touch 1810 on the downside, basically matching the 1812 low from January. Bulls love double-bottoms. Of course, many of those turn out not to be double-bottoms after all, but the ones that are look very nice on the charts. So stocks rocketed off the lows, rising 25 S&P points in a matter of minutes after briefly being down 51. The rally was helped ostensibly by comments from the UAE oil minister, who claimed OPEC is ready to cooperate on a production cut. But that isn’t really why stocks rallied so dramatically; after all the news only pushed crude oil itself up about a buck. The real reason is that bulls are crazy maniacs.

They’re that way for a reason. If you are benchmarked against an equity index, it is very hard for an unlevered fund manager to beat that index in an up market. Once you subtract fees, and a drag from whatever cash holding you must have, you’re doing well to match the index since your limitation is (by definition of ‘unlevered’) 100% long.[1] Where a fund manager must beat his index is in a down market, by participating less than 100% in a selloff. But being an outperformer in a down market is less valuable since customer outflows are likely to outweigh the inflows if there is a serious bear market. Therefore, fund managers naturally fall into a pattern of scalping small selloffs for outperformance. But since they can’t really afford to miss being long in a bull market, there is a serious tendency to dive back in at any hint that the decline may be over.

So we get these entertaining, furious bear market rallies, which tend not to last very long. Of course, my entire premise is that this is an equity bear market, and I could be completely wrong on that. If I am, then ignore the prior paragraphs.

Where I am more confident that I am right is on the monetary policy side. Get this: since the Fed hiked rates, year-over-year M2 money growth has gone from 5.7% to…5.7%. Lest you think this anomaly (because tightening is supposed to involve a deceleration in money growth, right?!?), the 26-week growth rate in M2 has gone from 5.3% to 6.8%, and the 13-week growth rate from 2.9% to 7.3%. The annualized growth rate of M2 from mid-December to February 1st (the figure that was released today) is 11.2%. In other words, money supply growth is clearly not decelerating.

Now, in a traditional tightening, the Fed would restrict reserves and this would have the effect of reducing, or at least causing a deceleration in the growth rate of, M2 through the money multiplier. As a side effect, interest rates would rise but the point of tightening is to reduce the growth rate of money. Or, at least, it used to be.

With the Fed’s current operating framework, in which interest rates are moved around like magnets on a refrigerator to the desired level, there should be no meaningful effect on money supply growth. That’s not to say that money growth rates should accelerate (as they evidently have), merely that the growth rates should be stochastic with respect to authoritarian interest-rate manipulation. They may fall, or they may rise, but it should not be related to the Fed’s “tightening.” I’ve been saying this for a long, long time and the first evidence is in. The Fed’s rate hike has done nothing to reduce the growth rate of money, and therefore ought to do nothing to restrain inflation. Indeed, if higher interest rates follow from a series of Fed hikes – which they haven’t, but mainly because no one believes the Fed is going to hike again while their precious stocks are only 35% above fair value rather than 50% – then the expected effect would be for monetary velocity to rise and inflation to accelerate.

At this point, the Fed can thank the market that their moves haven’t accelerated the already-established trend towards higher inflation. But the clock is ticking. If the Fed does indeed hike rates next month, the bond market may start taking it seriously and start the rates-inflation spiral.

[1] Unless, of course, you’re adding alpha. But the universe of fund managers adds approximately zero alpha – slightly positive, and negative net of fees. Except whoever your manager is, of course. I’m sure he’s the best. Good job finding him!

Fed Nonsense and Error Bars

February 5, 2016 Leave a comment

Today’s news was the Employment number. I am not going to talk a lot about the number, since the January jobs number is one of those releases where the seasonal adjustments totally swamp the actual data, and so it has even wider-than-normal error bars. I will discuss error bars more in a moment, but first here is something I do want to point out about the Employment figure. Average Hourly Earnings are now clearly rising. The latest year-on-year number was 2.5%, well above consensus estimates, and last month’s release was revised to 2.7%. So now, the chart of wage growth looks like this.

ahe

Of course, I always point out that wages follow inflation, rather than leading it, but since so many people obsess about the wrong inflation metric this may not be readily apparent. But here is Average Hourly Earnings, y/y, versus Median CPI. I have shown this chart before.

aheandmedian

The salient point is that whether you are looking at core CPI or PCE or Median CPI, and whether you think wages lead prices or follow prices, this number significantly increases the odds that the Fed raises rates again. Yes, there are lots of reasons the Fed’s intended multi-year tightening campaign is unlikely to unfold, and I am one of those who think that they may already be regretting the first one. But a number like this will tend to convince the hawks among them otherwise.

Speaking of the Fed, last night I attended a speech by Cleveland Fed President Loretta Mester, sponsored by Market News International. Every time I hear a Fed speaker speak, afterwards I want to put my head into a vise to squeeze all of the nonsense out – and last night was no different. Now, Dr. Mester is a classically-trained, highly-accomplished economist with a Ph.D. from Princeton, but I don’t hold that against her. Indeed, credit where credit is due: unlike many such speakers I have heard in the past, Dr. Mester seemed to put more error bars around some of her answers and, in one of the best exchanges, she observed that we won’t really know whether the QE tool is worth keeping in the toolkit until after monetary conditions have returned to normal. That’s unusual; most Fed speakers have long been declaring victory. She is certainly a fan and an advocate of QE, but at least recognizes that the chapter on QE cannot yet be written (although I make what I think is a fair attempt at such a chapter in my book, due out in a month or so).

But the problem with the Federal Reserve boils down to two things. First, like any large institution there is massive groupthink going on. There is little true and significant diversity of opinion. For example there are, for all intents and purposes, no true monetarists left at the Fed who have any voice. Daniel Thornton at the St. Louis Fed was the last one who ever published pieces expressing the important role of money in monetary policy, and he retired a little while back. As another example, it is taken as a given that “transparency” is a good thing, despite the fact that many of the questions posed last night to Dr. Mester boiled down to problems that are actually due to too much transparency. I doubt seriously whether there has ever been a formal discussion, internally, of the connection between increased financial leverage and increased Fed transparency. Many of the problems with “too big to fail” institutions boil down to too much leverage, and a transparent Fed that carefully telegraphs its intentions will tend to increase investor confidence in outcomes and, hence, tend to increase leverage. But I cannot imagine that anyone at the Fed has ever seriously raised the question whether they should be giving less, rather than more, information to the market. It is significantly outside of chapter-and-verse.

The second problem is that the denizens of the Fed overestimate their knowledge and their ability  to know certain things that may simply not be knowable. Again, Dr. Mester was a mild exception to this – but very mild. When someone says “We think the overnight rate should normalize more slowly than implied by the Taylor Rule,” but then doesn’t follow that up with an explanation of why you think so, I grow wary. Because economics in the real world, practiced honestly, should produce a lot of “I don’t know” answers. It may be boring, but this is how the question-and-answer with Dr. Mester should have gone:

Q: What do you think inflation will do in 2016?

A: I don’t know. I can tell you my point estimate, but it has really wide error bars.

Q: What do you think short rates will do in 2016?

A: I don’t know. I can tell you my point estimate, but it has really wide error bars.

Q: What do you think the Unemployment Rate will do in 2016?

A: I don’t know. I can tell you my point estimate, but it has really wide error bars.

Q: What do you think the Unemployment Rate will do in 2017?

A: I don’t know. I can tell you my point estimate, but it has really, really wide error bars.

Q: What do you think the consensus is at the Fed about the optimal pace of raising rates?

A: I don’t know. Each person on the Committee has a point estimate, each of which has really wide error bars. Collectively, we have an average that has even wider error bars. We cannot therefore usefully characterize what the path of the short rate will look like. At all.

Indeed, this is part of the problem with transparency. If you are going to be transparent, there is going to be pressure to provide “answers.” But a forecast without an error bar is just a guess. The error bars are what cause a guess to become an estimate. So we get a “dot plot” with a bunch of guesses on it. The actual dot plot, from December, looks like this:

dotplot

But the dot plot should look more like this, where the error bars are all included.

betterdotplotObviously, we would take the latter chart as meaning…correctly…that the Fed really has very little idea of where the funds rate is going to be in a couple of years and cannot convincingly reject the hypothesis that rates will be basically unchanged from here. That’s simultaneously transparent, and very informational, and colossally unhelpful to fast-twitch traders.

And now I can release the vise on my head. Thank you for letting me get the nonsense out.

Back From the Moon

January 6, 2016 2 comments

Economics is too important to be left to economists, apparently.

When the FOMC minutes were released this afternoon, I saw the headline “Some FOMC Members Saw ‘Considerable’ Risk to Inflation Outlook” and my jaw dropped. Here, finally, was a sign that the Fed is not completely asleep at the wheel! Here, finally, was a glimmer of concern from policymakers themselves that the central bank may be behind the curve!

Alas…my jaw soon returned to its regular position when I realized that the risk to the inflation outlook which concerned the FOMC was the “considerable” risk that it might fall.

A quick review is in order. I know it is a new year and we are still shaking off the eggnog cobwebs. Inflation is caused (only) when money growth is faster than GDP growth. In the short run, that holds imprecisely because of the influence of money velocity, but we also have a pretty good idea of what causes money velocity to ebb and flow: to wit, interest rates (more precisely, investment opportunities, which can be simply modeled by interest rates but more accurately should include things such a P/E multiples, real estate cap rates, and so on). And in the long run, velocity does not continue to move permanently in one direction unless interest rates also continue to move in that direction.

It is worth pointing out, in this regard, that money growth continues to swell at a 6.2% domestically over the last 12 months, and nothing the Fed is currently contemplating is likely to slow that growth since there are ample excess reserves to support any lending that banks care to do. But it is also worth pointing out that inflation is currently at 7-year highs and rising, as the chart below (source: Bloomberg) shows.

medcpi

Core inflation is also rising in Japan (0.9%, ex-food and energy, up from -0.9% in Feb 2013), the Eurozone (0.9% ex-food and energy, up from 0.6% in January 2015), and recently even in the UK where core is up to 1.2% after bottoming at 0.8% six months ago. In short, everywhere we have seen an acceleration in money growth rates, we are now seeing inflation. The only question is “why has it taken so long,” and the answer to that is “because central banks held interest rates, and hence velocity, down.”

In other words, as we head towards what looks very likely to be a global recession (albeit not as bad as the last one), we are likely to see inflation rates rising rather than falling. The only caveat is that if interest rates remain low, then the uptick in inflation will not be terrible. And interest rates are likely to remain relatively low everywhere, especially if the Fed operates on the basis of its expectations rather than on the basis of its eyeballs and holds off on further “tightenings.”

Because the Fed has really put itself in the position where most of the things it would normally do are either ineffective (such as draining reserves to raise interest rates) or harmful (raising rates without draining reserves, which would raise velocity and not slow money growth) if the purpose is to restrain inflation. It would be best if the Fed simply worked to drain reserves while slack in the economy holds interest rates (and thus velocity) down. But that is the sort of thinking you won’t see from economists but rather from engineers looking to get Apollo 13 safely home.

Want to try and get Apollo 13 safely back home? Go to the MV≡PQ calculator on the Enduring Investments website and come up with your own M (money supply growth), V (velocity change), and Q (real growth) scenarios. The calculator will give you a grid of outcomes for the average inflation rate over the period you have selected. Remember that this is an identity – if you get the inputs right, the output will be right by definition. Some numbers to remember:

  • Current velocity is 1.49 or so; prior to the crisis it was 1.90 and that is also the average over the last 20 years. The all-time low in velocity prior to this episode was in the 1960s, at about 1.60; the high in the 1990s was 2.20.
  • As for money supply growth, the y/y rate plunged to 1.1% or so after the crisis and it got to zero in 1995, but the average since 1980 including those periods is roughly 6% where it is currently. Rolling 3-year money growth has been between 4% and 9% since the late 1990s, but in the early 80s was over 10% and it declined in the mid-1990s to around 1%.
  • Rolling 3-year GDP growth has been between 0% and 5% since the 1980s. In the four recessions, the lows in rolling 3-year GDP were 0.2%, 1.7%, 1.7%, and -0.4%. The average was about 3.9% in the 1980s, about 3.2% in the 1990s, about 2.7% in the 2000s, and 1.8% (so far) in the 2010s.

Remember, the output is annualized inflation. Start by assuming average GDP, money growth, and ending velocity for some period, and then look at what annualized inflation would work out to be; then, figure out what it would have to be to get stable inflation or deflation. You will find, I think, that you can only get disinflation if money growth slows remarkably (and unexpectedly) and velocity remains unchanged or goes to new record lows. Try putting in some “normal” figures and then ask yourself if the Fed really wants to get back to normal.

And then ask yourself whether you would want Greenspan, Bernanke, and Yellen in charge of getting our boys back from the moon.

Surprising Surprises

December 23, 2015 2 comments

If posting on December 22nd was a bad idea, imagine how stupid it is to post on December 23rd?

But I noticed something unusual and thought to point it out. Yesterday, I observed that the data has generally been weakening, and while some commentators are optimistic on the outlook for 2016 I am not one of them. Actually, it appears that perhaps commentators as a whole are not only too optimistic now, but have been too optimistic all year.

The Citi Economic Surprise Index is an interesting data series that measures how data releases have generally compared to economists’ prior expectations. When data is coming in weaker than expected, it declines; when data is coming in stronger than expected, it rises. This doesn’t necessarily mean that it declines when the economy is weakening, just when the data is surprising on the downside. I’ve always had trouble figuring out just how to use this information, because of that. Is the indicator rising because conditions are getting better, or just because economists are morose? Is it falling because conditions are getting worse, or because economists are too optimistic? Hard to tell.

With that said, here is what the indicator has done over the last three years (source: Bloomberg).

cesiusd

Nothing to see here, right? Well take a look at this! The table below shows the proportion of the time, by year (since the index was created in 2003), that the index was above zero.

2003 57%
2004 49%
2005 68%
2006 43%
2007 57%
2008 36%
2009 67%
2010 56%
2011 54%
2012 63%
2013 61%
2014 54%
2015 8%

Now that, as they would say on Mythbusters, is a result. I have no idea what it means, that economic data has been consistently undershooting expectations all year so that the index has been negative 92% of the time. The second-worst outcome was 2008, but that was clearly a situation in which the economy was getting worse lots faster than economists anticipated.

I am inclined to think that this represents the optimism that economists seem to have that the Fed’s move to tighten policy reflects a response to actual underlying strength. I should add that I believe this is an unfounded, irrational, and borderline psychotic optimism given the historical prognosticative powers of the Federal Reserve…but if that is indeed what is happening then the optimism that these same economists have about the number of rate hikes we will see in 2016 is probably misplaced.

Categories: Federal Reserve, Quick One

A Good Time to Remember

December 16, 2015 7 comments

Some days make me feel so old. Actually, most days make me feel old, come to think of it; but some days make me feel old and wise. Yes, that’s it.

It is a good time to remember that there are a whole lot of people in the market today, many of them managing many millions or even billions of dollars, who have never seen a tightening cycle from the Federal Reserve. The last one began in 2004.

There are many more, managing many more dollars, who have only seen that one cycle, but not two; the previous tightening cycle began in 1999.

This is more than passing relevant. The people who have seen no tightening cycle at all might be inclined to believe the hooey that tightening is bullish for stocks because it means a return to normalcy. The people who have seen only one tightening cycle saw the one that coincided with stocks’ 35% rally from 2004-2007. That latter group absolutely believes the hooey. The fact that said equity market rally began with stocks 27% below the prior all-time high, rather than 32% above it as the market currently is, may not have entered into their calculations.

On the other hand, the people who dimly recall the 1999 episode might recall that the market was fine for a little while, but it didn’t end well. And you don’t know too many dinosaurs who remember the abortive tightening in 1997 in front of the Asian Contagion and the 1994 tightening cycle that ended shortly after the Tequila crisis.

Moreover, it is a good time to remember that no one in the market today, or ever, can remember the last time the Fed tightened in an “environment of abundant liquidity,” which is what they call it when there are too many reserves to actually restrain reserves to change interest rates. That’s because it has never happened before. So if anyone tells you they know with absolute certainty what is going to happen, to stocks or bonds or the dollar or commodities or the economy or inflation or anything else – they are relying on astrology.

Many of us have opinions, and some more well-informed than others. My own opinion tends to be focused on inflationary dynamics, and I remain very confident that inflation is going to head higher not despite the Fed’s action today, but because of it. I want to keep this article short because I know you have a lot to read today, but I will show you a very important picture (source: Bloomberg) that you should remember.

coreandfedfunds

The white line is the Federal Funds target rate (although that meant less at certain times in the past, when the rate was either not targeted directly, as in the early 1980s, or the target was represented as a range of values). The yellow line is core inflation. Focus on the tightening cycles: in the early 1970s, in the late 1970s, in 1983-84, in the late 1980s, in the early 1990s, in 1999-2000, and the one beginning in 2004. In every one of those episodes, save the one in 1994, core inflation either began to rise or accelerated, after the Fed began to tighten.

The generous interpretation of this fact would be that the Fed peered into the future and divined that inflation was about to rise, and so moved in spectacularly-accurate anticipation of that fact. But we know that the Fed’s forecasting abilities are pretty poor. Even the Fed admits their forecasting abilities are pretty poor. And, as it turns out, this phenomenon has a name. Economists call it the “price puzzle.”

If you have been reading my columns, you know this is no puzzle at all for a monetarist. Inflation rises when the Fed begins to tighten because higher interest rates bring about higher monetary velocity, because velocity is the inverse of the demand for real cash balances. That is, when interest rates rise you are less likely to leave money sitting idle; therefore, investors and savers play a game of monetary ‘hot potato’ which gets more intense the higher interest rates go – and that means higher monetary velocity. This effect happens almost instantly. After a time, if the Fed has raised rates in the traditional fashion by reducing the growth rate of money and reserves, the slower monetary growth rate comes to dominate the velocity effect and inflation ebbs. But this takes time.

And, moreover, as I have pointed out before and will keep pointing out as the Fed tightens: in this case, the Fed is not doing anything to slow the growth rate of money, because to do that they would have to drain reserves and they don’t know how to do that. I expect money growth to remain at its current level, or perhaps even to rise as higher interest rates provoke more bank lending without and offsetting restraint coming from bank reserve scarcity. By moving interest rates by diktat, the Fed is increasing monetary velocity and doing nothing (at least, nothing predictable) with the growth rate of money itself. This is a bad idea.

No one knows how it will turn out, least of all the Fed. But if market multiples have anything to do with certainty and low volatility – then we might expect lower market multiples to come.

 

Summary of My Post-CPI Tweets

December 15, 2015 2 comments

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments. Plus…sign up to receive notice when my book is published! The title of the book is What’s Wrong with Money?: The Biggest Bubble of All, and if you would like to be on the notification list to receive an email when the book is published, simply send an email to WWWM@enduringinvestments.com. You can also pre-order online.

  • #CPI +0.0%/+0.2%. Y/y on headline goes to +0.5%, highest since December. Welcome to base effects!
  • Core was actually +0.18% m/m, a bit higher than expected. y/y on core goes to 2.02% from 1.91% as we dropped off a weak mo.
  • Next month, core #CPI will go to 2.1% or 2.2% y/y, simply because we drop off last December’s +0.06% aberration.
  • The rise in core seems dramatic (highest since 2012 now), but it’s just catching up with Median. Expected.

coremed

  • Primary Rents actually decelerated to 3.64% from 3.74%, and OER roughly unch at 3.08% from 3.09%. So core was held DOWN somewhat.
  • Even with that, overall Housing subindex was 2.14% y/y from 2.12% y/y. Big jump in Lodging Away from Home helped that.
  • Medical Care 2.95% from 2.98%. Boost to core came from “Other” (2.08% from 1.86%) and Education/Communication (1.32% from 0.97%).
  • Core #CPI, ex-housing, 1.18% from 1.00%. That’s the story here. Highest since mid-2014.
  • Core services 2.9%, highest since Nov 2008; core goods -0.6%, partial retrace from last month but still very weak.
  • The internals here not pleasant. We know housing will continue to accelerate. Core goods will not deflate forever.
  • Love this picture of core goods and core services. Note services is usually the stickier piece.

coregoodsserv

  • Early guess at Median CPI: 0.18%, keeping y/y at 2.47%. But median component looks like South Urban housing; hard to seasonally adj.
  • The categories that are mainly non-core: Food & Beverages 1.2% from 1.6% y/y; Transportation -6% from -7.9%.
  • Transport improvement notjust fuel (-24.2% from -27.9%), but also insurance (5.5% v 4.7%) and new/used vehicles (-0.1% v -0.4%)
  • …and airline fares (-3.8% v -5.2%), which is astonishing given the decline in jet fuel prices: down 67% v mid-2014.
  • Nothing in the #CPI today is soothing. But nothing here could change the Fed outcome tomorrow anyway.
  • FOMC has done nothing to dissuade the market from assuming a tightening. But important to remember the surprise risk is asymmetrical.
  • That is, the FOMC is much more likely to be willing to surprise the market dovishly than hawkishly. I do think they will tighten tho.
  • Last fun chart of the day. Weight of #CPI components rising faster than 3% per annum.

wgtover3

The CPI report today was mainly interesting because while core rose as expected – actually, a little bit more than expected – that was not due to primary rents and Owners’ Equivalent Rent, which have been the driving force for some time. Indeed, Primary Rents actually decelerated, so the rise in core CPI came despite sluggishness in one of the formerly-leading components.

So what happened? Well, other elements of core services took the reins. Un-sexy elements like Information and Information Processing (-0.8% from -1.5%, and compared to a 2-year compounded rate of -1.3%), Personal Care Services (3.1% vs 2.7%), Medical Care – Professional Services (2.0% vs 1.8%), and Health Insurance (3.6% vs 3.0% – see chart below, source Bloomberg).

healthins

It is worth pointing out that health insurance is only 0.75% of the CPI because the BLS measures the costs of medical provision more directly. This is a residual. But still very interesting given what we know anecdotally is happening in the ACA marketplace.

Here is the chart of core inflation, ex-shelter (Source: Enduring Investments).

corexshelt

This doesn’t look alarming, but the story of the low core inflation over the last few years can be thought of this way: shelter prices going up; core services ex-shelter decelerating somewhat; core goods deflating. We can’t count on core goods deflating forever (although our models have them deflating at roughly this pace for a little while yet), and they tend to move around more than core goods. But the core services ex-shelter piece, filled with things like medical care, has played a major role. Those pieces are now re-accelerating.

Nothing that happened today, as I note in the tweet-feed, will change what the Fed does tomorrow. While I was long skeptical that the Committee would tighten in December, the market priced it in and no Fed speaker (with any weight) tried to signal otherwise. That tacit agreement with market pricing has historically meant that the FOMC was prepared to do what the market had priced in. But there are four caveats worth noting.

First, as I said in the tweet-stream the Fed is always more likely to surprise on the dovish side than on the hawkish side. Thus, if the market was pricing in no action but the Committee wanted to tighten, they would be much more aggressive about speaking out so as not to surprise the markets. They never seem to care about surprising them in the dovish direction. So there’s that.

Second, this would be the first tightening of the Yellen regime. We don’t know that she operates in the same way that prior Fed Chairmen have operated; perhaps she is less worried (or aware) about surprising the markets. It is worth keeping in mind although I doubt very much she wants to be a rebel in this way, especially with high yield markets in what can generously be called “disarray.”

Third, whatever happens tomorrow the second tightening is very much up in the air. We are starting to see failures of high yield funds and we will see failures of high yield companies. If this gets particularly ugly, it is possible the Fed will take a pass in the first or possibly the first couple of meetings in 2016. If that happens, it will be harder to get started again. So I’d be careful to price a long string of tightening actions here.

Fourth, and finally: I have been calling it “tightening” but the Fed of course is not tightening policy. They are only raising interest rates. There will still be plenty of money in the system, and rates will be going up not because demand for money outstrips its supply, but because the Fed says so. The result of this will be very different from the results that followed prior Fed tightenings. Inflation will rise, because velocity rises when interest rates rise and that leads to higher inflation – and this generally happens when the Fed starts to tighten – but since the Fed will not be reining in money growth inflation will continue to rise. That’s unusual, but it will happen because the deviation from the script is important: ordinarily, it is the slowing of money growth rather than the increasing of interest rates that restrains inflation; the increase of interest rates actually accelerates inflation. The Fed has no plans to slow money growth, nor any way to really do it – so inflation will continue to rise.

Subtle Clues: Not Everyone Thinks the Fed Will Win

December 8, 2015 Leave a comment

The illiquid trading of December is already well in evidence – and we haven’t even reached the bad part yet. One we are past the CPI report and the Fed meeting, there will be a few days where serious traders are squaring up based on what they now believe after those data points. After that, it will get truly quiet for the last couple of weeks.

A little quiet is what the energy market needs. On Monday front Crude broke to new six-year lows. Not since oil bottomed at $32.40 in December 2008 have prices been this low. Prior to that, the last time we saw sub-$40 oil was in July 2004. Ditto with gasoline prices, which are averaging just a touch above $2/gallon nationwide. This is truly amazing, and is causing all sorts of carnage in energy and energy service companies as has been widely reported.

What is interesting, though, and has been widely unreported has been the impact these recent price declines have had on inflation expectations as impounded in the price of inflation derivatives and TIPS breakevens. In short: not very much.

In prior episodes, such as last year at about this time, plunging energy quotations affected not only near-term inflation expectations but also long-term inflation expectations. The reason that near-term breakevens, or say 1-year inflation swaps, respond to energy prices is very simple: these contracts are pegged to headline inflation, which includes energy; while the market tends to overreact to the energy effect it tends to price fairly efficiency the near-term effect of movements in gasoline on actual inflation outturns.

But it makes very little sense that even very large moves in gasoline prices should be reflected in long-term­ inflation expectations. This is for two reasons: first, energy prices are mean-reverting, so declining prices in one year are more likely to see appreciating prices the following year (or, at least, big declines tend not to be followed by big declines). Second, even a significant change in energy prices, amortized over ten years for example, ends up not being a very big movement per year when you then also take into account how low the pass-through is from energy prices to inflation swap prices.

A bunch of this is sort of “inside baseball” talk to inflation traders, which I know isn’t my audience for the most part. But you can readily understand, I think, that if gasoline prices drop 50% in one year – and if we don’t expect them to continue to drop 50% in every year – then that’s only around a 5% movement per year in energy prices, averaged over ten years. That’s like saying gasoline prices rise a dime per year for ten years. Do you think that would have, or should have, a big effect on your overall inflation expectations?

In practice, it turns out to affect the market. The chart below (source: Bloomberg) shows the national average gasoline price (in white) from the American Automobile Association versus the 10-year breakeven (that is, the difference in the 10-year Treasury yield minus the 10-year TIPS yield, a number that approximates the inflation required to break even between these two investments). You can see that this is a fairly tight relationship in the grand scheme of things. When gasoline prices fell from $3.60 to $2.00 in 2014-15, breakevens plunged from 2.20% to 1.60%. As I have just pointed out, that’s larger than makes sense but the direction makes sense.

bei and gasoline

This phenomenon, incidentally, is why we (meaning me, and my company when we are doing analysis) strip out the implied energy effect by using futures quotes, so as to come up with an implied core inflation curve. (And you can actually hedge, so you can create something that looks very much like core inflation rather than headline inflation). By doing this, we can often see when the inflation market is overpricing the energy effect or underpricing it, and indeed this can be traded as part of an institutional investment strategy.

But recently, we haven’t really needed to be so fine with the calculation. Notice on the right side of the chart above that over the last couple of months inflation expectations (breakevens) have risen even as crude and gasoline prices have continued to slide. The chart illustrates how unusual this is. What this means is that expectations for long-term core inflation have been rising – investors are actually looking past the near-term energy washout and saying “we don’t believe this will be sustained, and even if it is we don’t believe that core inflation will average 1.25% for five years.” That’s what was being priced in late October; now that figure is a still low but much more-sensible 1.5%.

Will investors be right? I must say that we have been aggressive in saying that being long at these breakeven levels leaves few ways to lose, at least for investors who can hold through the bumps. And inflation has long upper tails, so that even if you think 1.50% for five years is fair, you should be willing to pay a bit more simply because a miss on the high side is likely to be a worse miss than a miss on the low side.

Sadly, the only way for retail investors to position explicitly for this is through the ETF RINF, which is the Proshares 30y breakeven spread, and the bid/offer is intimidating as is the expense ratio. But it’s something.

What I find fascinating is that this is happening at all. Everyone professes to believe that the Fed is ahead of the curve and will surely squash inflation. But that isn’t how they’re positioning.

Categories: Federal Reserve, Theory, TIPS
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