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Need a Jedi to Blow Up the R-Star

September 6, 2016 Leave a comment

I haven’t written an article for a couple of weeks. This is not entirely unusual: I have written this commentary, in some form, since about 1996 and there are occasional breaks in the series. It happens for several reasons. Sometimes it is simple ennui, as writing an analysis/opinion article for twenty years can occasionally get boring especially when markets are listless as they frequently are in August. Other times, it is because work – the real work, the stuff we get paid for – is too consuming and I have not time or energy left to write  a few hundred words of readable prose. Maybe that’s part of the reason here, since the number of inflation-investing-related inquiries has definitely increased recently, along with some new client flows (and not to mention that we are raising capital for Enduring Investments through a 506(c) offering – you can find details on Crowdfunder or contact me through our website). Finally, in recent years as the ability to track the number of clicks/eyeballs on my writing has improved, I’ve simply written less during those times…such as August…when I know that not many people will read the writing.

But this time is a little different. While some of those excuses apply in some measure, I’ve actually skipped writing over the last two weeks because there is too much to say. (Fortunately, I said some of it on two Bloomberg TV appearances, which you can see here and here.)

Well, my list of notes is not going to go away on its own so I am going to have to tackle some of them or throw them away. Unfortunately, a lot of them have to do with the inane nattering coming out of Federal Reserve mouthpieces. Let’s start today with the publication that gathered a lot of ink a couple of weeks ago: San Francisco Fed President John Williams’ FRBSF Economic Letter called “Monetary Policy in a Low R-star World.”

The conclusion that Williams reached was sensational, especially since it resonates with the “low return world” meme. Williams concluded that “The time has come to critically reassess prevailing policy frameworks and consider adjustments to handle new challenges, specifically those related to a low natural real rate of interest.” This article was grating from the first paragraph, where Williams casts the Federal Reserve as the explorer/hero:

“As nature abhors a vacuum, so monetary policy abhors stasis. Instead of being a rigid set of precepts, it follows the adage, that which survives is that which is most adaptive to change… In the wake of the global financial crisis, monetary policy has continued to evolve… As we move forward, economic conditions require that central banks and governments throughout the world carefully reexamine their policy frameworks and consider further adjustments in terms of monetary policy strategy—both in its own right and as it relates to other policy arenas—to successfully navigate these new seas.”

One might give the Federal Reserve more credit if subsequent evolutions of policy prescriptions were not getting progressively worse rather than better. Constructive change first requires critical evaluation of the shortcomings of current policy, doesn’t it?

Williams carries on to argue that the natural rate of interest (R-star) is lower now than it has been in the past. Now, Fed watchers should note that if true, this implies that current monetary policy is not as loose as has been believed. This is a useful conclusion for the Fed, since it would explain – within their existing model framework – why exceptionally low rates have not triggered better growth; it also would allow the Fed to raise rates more slowly than otherwise. I’ve pointed out before the frustrating tendency of groupthinking economists to attribute persistent poor model predictions to calibration issues rather than specification issues. This is exactly what Williams is doing. He’s saying “there’s nothing wrong with our model! If we had simply known that the natural rate was lower, we would have understood that we weren’t as stimulative as we thought.” Possible, but it might also be that the whole model sucks, and that the monetarists are right when they say that monetary policy doesn’t move real variables very well. That’s a hypothesis that at least bears examining, but I haven’t seen any fancy Fed papers on it.

What is really remarkable is that the rest of the paper is largely circular, and yet no one seems to mind. Williams attributes the current low r-star to several factors, including “a more general global savings glut.” Note that his estimates of r-star take a sharp turn lower in 2008-9 (see chart below, source FRBSF Economic Letter, figure 1).

williams

Wow, I wonder what could have caused an increase in the global savings glut starting in 2008? Could it be because the world’s central banks persistently added far more liquidity than was needed for the proper functioning of the economy, leading to huge excess reserves – aka a savings glut?

So, according to Williams, the neutral interest rate is lower at least in part because…central banks added a lot of liquidity. Kind of circular, ain’t it?

Since according to Williams this fact explains “uncomfortably low inflation and growth despite very low interest rates,” it must mean he is bravely taking responsibility – since, after all, quantitative easing caused the global savings glut which, in his construct, caused low growth and inflation. Except that I don’t think that’s what he wants us to conclude.

This isn’t research – it’s a recognition that what they did didn’t work, so they are backfilling to try and find an excuse for why their theories are still good. To the Fed, it is just that something happened they didn’t realize and take account of. Williams wants to be able to claim “see, we didn’t get growth because we weren’t as stimulative as we thought we were,” because then they can use their old theories to explain how moving rates around is really important…even though it didn’t work this time. But the problem is that low rates don’t cause growth. The model is wrong. And no amount of calibration can fix a mis-specified model.

Twits and Brits

June 27, 2016 1 comment

I want to talk today about some of the really important pieces of information that circulated this weekend. First, I am certain that everyone is familiar with the following chart, which made the rounds after the Brexit vote. It shows an enormous surge in the search term “What is the EU” after the Brexit vote was completed:

noaxisThis chart, or something very much like it, was all over the place. Oh, wait! I just realized that I forgot to put the axes on the chart! Here it is with a few more relevant pieces of information – incidentally the same information that was left off the original chart. It turns out that it wasn’t the chart I thought it was. Sorry about that…they looked the same.

waxis

(For the record, after an extended period of indolence, on Thursday I went for a run; on Friday I went for a run before putting on any other shoes first; on Saturday I went for a run and then later put on different shoes to go to a cocktail party.)

Is it too much to ask that people seeking to insult the British voters at least put some effort into their attempt? Ignore for a moment the simple fact that we don’t know who was searching this – it might well have been the people who voted to Remain, after all – and so the story line that the people who voted Leave were just morons gets no support from this chart. It also turns out that this was the second-most-searched term only for one small time segment: early in the morning after the vote. By 5am it was eclipsed by questions about the weather. Oh my – it seems the Britons also don’t know what weather is! Also, as the Telegraph’s skeptical story (linked above) points out, the raw number of people asking the question was only on the order of 1,000 – it was just a massive increase since it hadn’t been previously asked very much. This is where not having axes matters…it turns out this is a non-story, and nonsense.

Another piece of nonsense I want to point out is more general. I have seen several Twitter polls and other polls in something like this form:

Q: What effect do you think that Brexit will have on the global economy?

a) Deeply contractionary

b) Moderately contractionary

c) Somewhat contractionary

d) Expansionary

Now this is nonsense because the actual result not only has nothing to do with opinion, it’s not even clear why we would care about people’s opinion in this case (unless we are trying to show how pervasive the negative news stories are, or something). Polls work comparatively well when there is not a lot of information inequality – for example, when each person is asked about his or her own vote. But the poll above is analogous to this poll:

I submit that only me, and my valet, have the information sought by this poll; all other respondents have zero information. Therefore…what’s the value of the poll? Unless I or my valet are respondents, precisely zero; if we are, then the value is inverse to the number of other respondents diluting the response of the people who know.

Similarly, there is likely some information asymmetry among respondents to the poll about the effect of Brexit on the global economy. I would respectfully suggest that most people who are responding are saying what they have heard, or what they fear, or what they hope, while some people – macroeconomists, for example – might have actual models. To be sure, those models are probably only slightly better than the fearful and hopeful assumptions put into them, but the point is that this poll is nonsense in the same way that polling people about what they expect inflation next year to be is nonsense. The vast majority of respondents have no way to evaluate the question in a structured way, so what you are capturing is no more and no less than what people are worried about, which is itself just a reflection of what they’re seeing and hearing…for example, on Twitter.

(For what it’s worth, I think that thanks to the weakening of sterling Brexit is likely to be mildly stimulative to the UK economy, as well as somewhat inflationary, and slightly contractionary and disinflationary to the rest of the world. But the question about global effects is a trick question. Obviously, global production and consumption are unlikely to change much in real terms just due to the arrangement of trade flows. More friction in the system to the extent that Europe puts up significant trade barriers against the UK – something I don’t view as terribly likely – will lower global output slightly and raise global prices.)

These flash polls and Google trends data are part and parcel of the Twitterization of discourse. They have in common the fact that they can be snapshot and draw eyeballs and clicks, whether or not there is any content to the observations. In these cases, and in many others, there isn’t.

Here’s a thought: why don’t we wait a few months, or better yet a few years, before we judge the impact of Brexit? Sometimes, having actual data is even better than a Twitter poll.

Categories: Analogy, Europe, Good One, Rant, UK

Obamacare, Monopsonies, and Inflation – Nice Try!

June 9, 2016 1 comment

Recently, the San Francisco Federal Reserve published an Economic Letter in which they described why “Medicare Payment Cuts Continue to Restrain Inflation.” Their summary is:

“A steady downward trend in health-care services price inflation over the past decade has been a major factor holding down core inflation. Much of this downward trend reflects lower payments from public insurance programs. Looking ahead, current legislative guidelines imply considerable restraint on future public insurance payment growth. Therefore, overall health-care services price inflation is unlikely to rebound and appears likely to continue to be a drag on inflation.”

The article is worth reading. But I always have a somewhat uncomfortable reaction to pieces like this. On the one hand, what the authors are discussing is well known: healthcare services held down PCE inflation, and core CPI inflation, due to sequestration. Even Ben Bernanke knew that, and it was one reason that it was so baffling that the Fed was focused on declining core inflation in 2012-2014 when we knew why core was being dragged lower – and it was these temporary effects (see chart, source Bloomberg, showing core and Median CPI).

baffling

But okay, perhaps the San Francisco Fed is now supplying the reason: these were not one-off effects, they suggest; instead, “current legislative guidelines” (i.e., the master plan for Obamacare) are going to continue to restrain payments in the future. Ergo, prepare for extended lowflation.

This is where my discomfort comes in. The article combines these well-known things with questionable (at best) assumptions about the future. In this latter category the screaming assumption is the Medicare can affect prices simply by choosing to pay different prices. In a static analysis that’s true, of course. But it strikes me as extremely unlikely in the long run.

It’s a classic monopsonist pricing analysis. Just as “monopoly” is a term to describe a market with just one dominant seller, “monopsony” describes a market with just one dominant buyer. The chart below (By SilverStar at English Wikipedia, CC BY 2.5, https://commons.wikimedia.org/w/index.php?curid=13863070) illustrates the classic monopsony outcome.

217px-Monopsony-static-partial-equilibrium.svg

The monopsonist forces an equilibrium based on the marginal revenue product of what it is buying, compared to the marginal cost, at point A. This results in the market being cleared at point M, at a quantity L and a price w, as distinct from the price (w’) and quantity (L’) that would be determined by the competitive-market equilibrium C. So, just as the San Fran Fed economists have it, a monopsonist (like Medicare) forces a lower price and a lower quantity of healthcare consumed (they don’t talk so much about this part but it’s a key to the ‘healthcare cost containment’ assumptions of the ACA neé Obamacare). Straight out of the book!

But that’s true only in a static equilibrium case. I admit that I wasn’t able to find anything relevant in my Varian text, but plain common-sense (and observation of the real world) tells us that over time, the supply of goods and services to the monopsonist responds to the actual price the monopsonist pays. That is, supply decreases because period t+1 supply is related to the reward offered in period t. There is no futures market for medical care services; there is no way for a medical student to hedge future earnings in case they fall. The way the prospective medical student responds to declining wages in the medical profession is to eschew attending medical school. This changes the supply curve in period t+1.

Any other outcome, in fact, would lead to a weird conclusion (at least, I think it’s weird; Bernie Sanders may not): it would suggest that the government should take over the purchase and distribution of all goods, since they could hold prices down by doing so. In other words, full-on socialism. But…we know from experience that pure socialist regimes tend to produce higher rates of inflation (Venezuela, anyone?), and one can hardly help but notice that when the government competes with private industry – for example, in the provision of express mail service – the government tends to lose on price and quality.

In short, I find it very hard to believe that mere “legislative guidelines” can restrain inflation in medical care, in the long run.

The Destination Currency in the Global Carry Trade: USD?

If you are an investor of the Ben Graham school, you’ve lived your life looking for “value” investments with a “margin of safety.” Periodically, if you are a pure value investor, then you go through long periods of pulling your hair out when momentum rules the day, even if you believe – as GMO’s Ben Inker eloquently stated in last month’s letter – that in the long run, no factor is as important to investment returns as valuation.

This is one of those times. Stocks have been egregiously overvalued (using the Shiller CAPE, or Tobin’s Q, or any of a dozen other traditional value metrics) for a very long time now. Ten-year Treasuries are at 1.80% in an environment where median inflation is at 2.5% and rising, and where the Fed’s target for inflation is above the long-term nominal yield. TIPS yields are significantly better, but 10-year real yields at 0.23% won’t make you rich. Commodities are very cheap, but that’s just a bubble in the other direction. The bottom line is that the last few years have not been a great time to be purely a value investor. The value investor laments “why?”, and tries to incorporate some momentum metrics into his or her approach, to at least avoid the value traps.

Well, here is one reason why: the US is the destination currency in the global carry trade.

A “carry trade” is one in which regular returns can be earned simply on the difference in yields between different instruments. If I can borrow at LIBOR flat and lend at LIBOR+2%, I am in a carry trade. Carry trades that are riskless and result from one’s market position (e.g., if I am a bank and I can borrow from 5-year CD customers at 0.5% and invest in 5-year Treasuries at 1.35%) are usually more like accrual trades, and are not what we are talking about here. We are talking about positions that imply some risk, even if it is believed to be small. For example, because we are pretty sure that the Fed will not tighten aggressively any time soon, we could simply buy 2-year Treasuries at 0.88% and borrow the money in overnight repo markets at 0.40% and earn 48bps per year for two years. This will work unless overnight interest rates rise appreciably above 88bps.

We all know that carry trades can be terribly dangerous. Carry trades are implicit short-option bets where you make a little money a lot of the time, and then get run over with some (unknown) frequency and lose a lot of money occasionally. But they are seductive bets since we all like to think we will see the train coming and leap free just in time. There’s a reason these bets exist – someone wants the other side, after all.

Carry trades in currency-land are some of the most common and most curious of all. If I borrow money for three years in Japan and lend it in Brazil, then I expect to make a huge interest spread. Of course, though, this is entirely reflected in the 3-year forward rate between yen and real, which is set precisely in this way (covered-interest arbitrage, it is called). So, to make money on the Yen/Real carry bet, you need to carry the trade and reverse the exchange rate bet at the end. If the Real has appreciated, or has been stable, or has declined only a little, then you “won” the carry trade. But all you really did was bet against the forward exchange rate. Still, lots and lots of investors make precisely this sort of bet: borrowing money is low-interest rate currencies, investing in high-interest-rate currencies, and betting that the latter currency will at least not decline very much.

How does this get back to the value question?

Over the last several years, the US interest rate advantage relative to Europe and Japan has grown. This should mean that the dollar is expected to weaken going forward, so that someone who borrows in Euro to invest in the US ought to expect to lose on the future exchange rate when they cash out their dollars. And indeed, as the interest rate advantage has widened so has the steepness of the forward points curve that expresses this relationship. But, because investors like to go to higher-yielding currencies, the dollar in fact has strengthened.

This flow is a lot like what happens to people on a ship that has foundered on rocks. Someone lowers a lifeboat, which looks like a great deal. So people begin to pour into the lifeboat, and they keep doing so until it ceases, suddenly, to be a good deal. Then all of those people start to wish they had stayed on the ship and waited for help.

In any event, back to value: the chart below (source: Bloomberg) shows the difference between the 10-year US$ Libor swap rate minus the 10-year Euribor swap rate, in white and plotted in percentage terms on the right-hand scale. The yellow line is the S&P 500, and is plotted on the left-hand scale. Notice anything interesting?

carry1

The next chart shows a longer time scale. You can see that this is not a phenomenon unique to the last few years.

carry2

Yes, the correlation isn’t perfect but to me, it’s striking. And we can probably do better. After all, the chart above is just showing the level of equity prices, not whether they are overvalued or undervalued, and my thesis is that the fact that the US is the high-yielding currency in the carry trade causes the angst for value investors. We can show this by looking at the interest rate spread as above, but this time against a measure of valuation. I’ve chosen, for simplicity, the Shiller Cyclically-Adjusted P/E (CAPE) (Source: http://www.econ.yale.edu/~shiller/data.htm)

capevsspread

Now, I should take pains to point out that I have not proven any causality here. It may turn out, in fact, that the causality runs the other way: overheated markets lead to tight US monetary policy that causes the interest rate spread to widen. I am skeptical of that, because I can’t recall many episodes in the last couple of decades where frothy markets led to tight monetary policy, but the point is that this chart is only suggestive of a relationship, not indicative of it. Still, it is highly suggestive!

The implication, if there is a causal relationship here, is interesting. It suggests that we need not fear these levels of valuation, as long as interest rates continue to suggest that the US is a good place to keep your money (that is, as long as you aren’t afraid of the dollar weakening). That, in turn, suggests that we ought to keep an eye on rates of change: if the ECB tightens more, or eases less, than is priced into European markets (which seems unlikely), or the Fed tightens less, or eases more, than is priced into US markets (which seems more likely, but not super likely since not much is presently priced in), or the dollar trend changes clearly. When one of those things happens, it will be a sign that not only are the future returns to equities looking unrewarding, but the more immediate returns as well.

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

Book Review: “Where Keynes Went Wrong”

April 11, 2016 1 comment

Last week I mentioned something about what Keynes said in the General Theory, and promised to expand on that a bit this week. I will do so, in the form of a book review.

I can’t remember who it was, and I’m sorry, but one of the people who read my articles suggested a book to me a year or so ago published in 2009 and called Where Keynes Went Wrong: And Why World Governments Keep Creating Inflation, Bubbles, and Busts  by Hunter Lewis, and I finally got around to reading it. I am very glad I did – this book is terrific, and is a must-read if you are either pro-Keynes or anti-Keynes.

Of course, readers will know from my articles that I am anti-Keynes, although more precisely I am anti-Keynesian in the modern sense of that word. I never read very much of the General Theory, because honestly it is poorly written in the sense of its prose, and I always assumed that Keynes probably had some great insights and it was the later Keynesians that screwed up what he said.

Oh, I was so wrong. Keynes was looney tunes. A bona fide lunatic. He proved masterful in manipulating the cult of personality that existed at the time he was writing, however; he was adept at destroying his opponents in ways that sounded erudite and like certain later personalities the media adored him. All of this is well-documented by Mr. Lewis, although the looney tunes conclusion is my own.

The book is put together brilliantly. The author quotes passages from Keynes, using actual quotes interspersed with paraphrasing – which is necessary because, as I said above, the General Theory is poorly written and opaque. But it isn’t the paraphrasing that is damning. When Mr. Lewis wants to indict Keynes, he does it with his own words. For example, in unraveling the absurd (and often self-contradictory) prescriptions that Keynes had for managing the macro economy, Mr. Lewis declares that Keynes thought government should never raise interest rates. That’s right, never.[1] But you needn’t take Lewis’ word for it. Here’s Keynes, cited in the book:

“The remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.”[2]

If you are anything like me, that sent a shiver down your spine right now. Does that sound at all familiar? Keep in mind that Lewis wrote this book in 2009. He could not possibly have anticipated that interest rates would not move away from zero for seven years (and counting, in some countries). And yet this quote sounds to me so much like what the Mount Rushmore of Fed speakers seemed to be suggesting last week. “It worked,” Bernanke was saying. “We’re not in a bubble economy,” said Yellen. None of them saw any signs of serious imbalances, except Volcker (and he was fairly circumspect about how worrisome they were).

In my own book, I indict Keynesianism in the simplest way: I simply point out that the prescription of the Keynesians hasn’t only not worked, it also has failed in every major prediction since, basically forever. But Lewis attacks Keynes himself, with his own words, from the original source. He explains, very clearly, where Keynes went wrong. If you wonder why world governments keep screwing up economies…you should read this book.

[1] Apparently elsewhere Keynes said different things but in the General Theory he was consistent on this point.

[2] Keynes, General Theory, p. 322; quoted on page 20 of Where Keynes Went Wrong by Hunter Lewis.

Categories: Book Review, Economy, Good One

TIPS and Gold – Cousins, Not Brothers

April 6, 2016 1 comment

A longtime reader (and friend) today forwarded me a chart from a well-known technical analyst showing the recent correlation between TIPS (via the TIP ETF) and gold; the analyst also argued that the rising gold price may be boosting TIPS. I’ve replicated the chart he showed, more or less (source: Bloomberg).

gctip

Ordinarily, I would cite the analyst directly, but in this case since I’m essentially calling him out I thought it might be rude to do so! His mistake is a pretty common one, after all. And, in fact, I am going to use it to illustrate an important point about TIPS.

The chart shows a great correlation between TIPS and gold, especially since the beginning of the year. But here’s the problem with drawing the conclusion that rising inflation fears are boosting TIPS – TIPS are not exposed to inflation.

Bear with me, because this is a key point about TIPS that is widely misunderstood. Recall that nominal interest rates represent two things: first, an amount that represents the return, in real terms, that the lender needs to realize in order to defer consumption and instead lend to the borrower. This is called the real interest rate. The second component of the nominal interest rate represents the compensation the lender demands for the fact that he will be paid back in dollars that (in normal times) will be able to buy less. This is the inflation compensation.[1] Irving Fisher said that nominal interest rates are approximately equal to the sum of these two components, or

n ≈ r + i

where n is the nominal interest rate, r is the real interest rate, and i is the inflation compensation.[2]

In a world without TIPS, you can only trade nominal bonds, which means you can only access the whole package and nominal interest rates may change when real rates change, expected inflation changes, or both change. (And when interest rates are negative, this leads to weird theoretical implications – see my recent and fun post on the topic.) Thus changes in real interest rates and changes in expected inflation affect nominal bonds, and roughly equally at that.

But once you introduce TIPS, then you can now separate out the pieces. By buying TIPS, you can isolate the real interest rate; and by trading a long/short package of TIPS and nominal bonds (or by trading an inflation swap) you can isolate the inflation expectations. This is a huge advance in interest rate management, because an investor is no longer constrained to own a fixed-income portfolio where his exposure to changes in real rates happens to be equal to his exposure to changes in inflation expectations. Siegel and Waring made this argument in a famous paper called TIPS, the Dual Duration, and the Pension Plan in 2004,[3] although it should be noted that inflation derivatives books were already being managed using this insight by then.

Which leads me in a roundabout way to the point I originally wanted to make: if you own TIPS, then you have no exposure to changes in inflation expectations except inasmuch as there is a (very unstable) correlation between real rates and expected inflation. If inflation expectations change, TIPS will not move unless real rates change.[4]

So, if gold prices are rising and TIPS prices are rising, it isn’t because inflation expectations are rising. In fact, if inflation expectations are rising it is more likely that real yields would also be rising, since those two variables tend to be positively correlated. In fact, real yields have been falling, which is why TIP is rising. The first chart in this article, then, shows a correlation between rising inflation expectations (in gold) and declining real interest rates, which is certainly interesting but not what the author thought he was arguing. It’s interesting because it’s unusual and represents a recovery of TIPS from very, very cheap levels compared to nominal bonds, as I pointed out in January in a piece entitled (argumentatively) “No Strategic Reason to Own Nominal Bonds Now.”

Actually (and the gold bugs will kill me), gold has really outstripped where we would expect it to go, given where inflation expectations have gone. The chart below (source: Bloomberg) shows the front gold contract again, but this time instead of TIP I have shown it against 10-year breakevens.

breaksgold

No, I don’t hate gold, or apple pie, or America. Actually, I think the point of the chart is different. I think gold is closer to “right” here, and breakevens still have quite far to go – eventually. The next 50bps will be harder, though!

[1] I abstract here from the third component that some believe exists systematically, and that is a premium for the uncertainty of inflation. I have never really understood why the lender needed to be compensated for this but the borrower did not; uncertainty of the real value of the repayment is bad for both borrower and lender. I believe this is an error, and interestingly it’s always been very hard for researchers to prove this value is always present and positive.

[2] It’s technically (1+n)=(1+r)(1+i), but for normal levels of these variables the difference is minute. It matters for risk management, however, of large portfolios.

[3] I expanded this in a much less-famous paper called TIPS, the Triple Duration, and the OPEB Liability: Hedging Medical Care Inflation in OPEB Plans in 2011.

[4] What the heck, one more footnote. I had a conversation once with the Assistant Treasury Secretary for Financial Markets, who was a bit TIPS booster. I told him that TIPS would never truly have the success they deserve unless the Treasury starts calling ‘regular’ bonds “Treasury Inflation-Exposed Securities,” which after all gets to the heart of the matter. He was not particularly amused.

Categories: Gold, Good One, Theory, TIPS
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