Today the 1-year CPI swap rate closed at 1.77%, the highest rate since 2014 (see chart, source Bloomberg).
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).
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):
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).
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.)
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. 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.”
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.
 Apparently elsewhere Keynes said different things but in the General Theory he was consistent on this point.
 Keynes, General Theory, p. 322; quoted on page 20 of Where Keynes Went Wrong by Hunter Lewis.
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).
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. 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.
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, 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.
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.
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!
 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.
 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.
 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.
 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.
(**Administrative Note: Get your copy of my new book What’s Wrong with Money: The Biggest Bubble of All! Here is the Amazon link.)
In the long list of nightmares that market risk managers have to wrestle with on a daily basis, some have gradually receded. For competently-run banks and large trading institutions, the possibility of a rogue trader making undiscovered trades or mis-marking his own book – another Nick Leeson – is increasingly remote given the layers of oversight. But one nightmare in particular has been increasing in frequency since 2009, especially as Volcker Rule and Dodd-Frank restrictions have been implemented.
The concern is market illiquidity. Every year that goes by, liquidity in the financial markets is declining. This is not apparent to the casual observer, or casual investor, who faces a tight market for his hundred- or thousand-lot. But probably every institutional investor has a story of how his attempt to hit a bid on the screens resulted in his trading the minimum size while the rest of the bid fled with sub-millisecond dispatch. And so the question is: if your mutual fund is hit by redemptions at the same time that its market (equities, emerging markets, credit?) is falling apart – and that is the normal time that redemptions swell – then at what price will it be able to get out? And what if there is no bid at all that is big enough?
Banks and other dealing institutions have responded to both the new regulatory restrictions themselves, and to the effects of the restrictions, by decreasing the size of their balance sheet dedicated to trading. Much of the apparent ‘liquidity’ in the market now is provided by the algos (the algorithmic trading systems) who as we have seen can be there and gone in an eyeblink. I am not aware of anything that has been done in the wake of the various “flash crashes” we have seen that would lead me to have great confidence that in the next big market discontinuity markets will function any better than they did in 2008. In fact, public liquidity is quite a bit smaller and I would expect them to function a fair bit worse.
Yes, many institutions have begun to access “dark pools” where they face anonymous counterparties in crossing large trades, rather than chasing hair-trigger algos for a fraction of the size they need. But nothing is particularly soothing about the dark pools, either (starting with their name). The whole point of a market discontinuity is that flow traders end up all on the same side of the flow; in these times we want the speculative traders with big balance sheets to take the other side of trades at a price that reflects a reasonable return on their capital. Those spec traders, or at least the big-balance-sheet banks, aren’t providing extra liquidity in dark pools either.
Banks have also responded to the beat-down regularly administered by socialists like Bernie Sanders and by sympathetic ears in the press (and among the populist splinters of the right as well) – by cutting the experienced and expensive traders who have more experience in pricing scarce liquidity, and perhaps finding it sometimes. Again, none of this makes me optimistic about how we will handle the next “event.”
None of this rant is new, really. But what is interesting and new is that the illiquidity is starting to show up in very visual ways. Regular readers know that my primary area of domain expertise is in rates, and specifically in inflation. Consider the chart below (source: Enduring Investments), which I would consider strong evidence that market liquidity in inflation is worse now than it was two years ago. The chart shows 1-year inflation forward from various points on the inflation curve. That is, the point on the far left is 1 year inflation, 0 years forward (in other words, today’s 1-year inflation swap). The next point is 1 year inflation, 1 year forward. And so on, so that the last point is 1 year inflation, 29 years forward.
Ignore the level of inflation expectations generally – that isn’t my point here. Obviously, inflation expectations are lower and that is not news. But the curve from two years ago shows a nice, smooth, “classic rates derivatives” shape. Inflation is priced in the market as rising in smooth fashion. This doesn’t mean that anyone really expects that inflation will rise smoothly like that; only that such is the best single guess and, moreover, one that has nice characteristics in terms of derivatives pricing and transparency.
The blue curve shows the curve from last Thursday. Now, I could have chosen any curve in the last month or two and they would have been similarly choppy. You can see that the market is evidently pricing in that inflation will be 1.72% over the next year, and then decline, then rise, then decline, then rise irregularly until 9 years from now when it will abruptly peak and descend.
That’s a mess, and it is an indication that liquidity in the inflation swaps market is insufficient to pull the curves into a nice, smooth shape. This is analogous to one important characteristic of a planet, from an astrophysicist’s point of view: any body that is not sufficiently massive to pull itself into a sphere is not a planet, by definition. I would argue that the inability of the market to pull the inflation curve into a nice and smooth “derivatives” shape is an early warning sign that the “mass” of liquidity in this market – and in others – is getting worse in a visually-apparent way.
(**Administrative Note: Get your copy of my new book What’s Wrong with Money: The Biggest Bubble of All! Here is the Amazon link.)
Last week, one of the curious parts of the CPI report was the large jump (1.6% month/month, or nearly 20% annualized) in Apparel. At the time, I dismissed this rise with a hand-wave, pointing out that it Apparel is only 4% of core and so I don’t worry as much about Apparel as I do, say, Medical Care or Housing.
But a Twitter follower called to my attention the words of @IanShepherdson, one of the real quality economists out there (and one whom I read regularly when he was with High Frequency Economics, and I was at Natixis). He hasn’t always been on top of the inflation story, but he nailed the housing bubble story in 2008 and I have great respect for him. Ian apparently said of Apparel that it could be the proverbial “canary in the coal mine” when it comes to inflation, since apparel tends to respond more quickly to inflationary pressures since it is a very competitive and very homogeneous category.
So I figured it was worth taking a longer look at inflation.
Now, I should point out that I probably have a bias about getting over-excited about inflation. Back in 2011-12, Apparel prices started to accelerate rapidly for the first time in a generation- and that’s no hyperbole. As the chart below (Source: Bloomberg) shows, the price index for seasonally-adjusted apparel prices went sideways-to-down-to-sideways between 1992 and 2012.
You can see from this why I may have gotten excited in 2012. Between 1970 and 1992, apparel prices rose at a very steady rate. Then, as post-Cold War globalization kicked into high gear, apparel manufacture moved from being largely produced in the US to being largely produced outside of the US; the effect on prices is apparent on the chart. But in 2011-2012, the price index began to move higher at almost the same slope as it had been moving prior to the globalization dividend. My thought back then was that the dividend only happens once: at first, input costs are stable or declining because high-cost US labor is replaced with low-cost overseas labor – but eventually, once all apparel is produced overseas, then the composition effect is exhausted and input prices will rise with the cost of labor again. In 2012, I thought that might be happening.
And then Apparel flattened out.
You can see, though, from the right side of the chart the latest spike that has Ian (and maybe me) so excited. The month/month rise was the third largest in the last 30 years, exceeded only by February 2009 and February 2000. As an aside, the fact that the three largest monthly spikes were all in February ought to make you at least a little suspicious that some of what is going on may be a seasonal-adjustment issue, but let’s leave that aside for now because I’m rolling.
What about the assertion that Apparel may be the ‘canary in the coal mine,’ giving an early indication on inflation? The chart below (source: Bloomberg, and Enduring Investments calculations) shows the year-over-year change in Apparel prices (on the right-hand scale) versus core CPI (on the left-hand scale).
I do have to admit, there is something suggestive about that chart although it is at least somewhat visual since I can’t find a consistent lag structure in the data. But the clear turns do seem to happen first in Apparel, often. Ah, but here is the fun chart. For the next chart, I’ve also taken out Shelter from core inflation, since Shelter especially in recent years has been largely driven by pretty crazy monetary policy, as I have pointed out before many times. (And if you want to read what I think that’s likely to lead to, read my book.) To make it fair, I also removed Apparel itself since once Shelter and Food and Energy are all removed, Apparel is starting to matter.
In this chart, you can start to see a pretty interesting tendency for Apparel to perhaps lead, slightly – and so, perhaps, Ian is right. In this case, I certainly wouldn’t want to bet against him since I think that’s where inflation is going too. I just wasn’t sure that Apparel was a strong part of the argument. (But at the same time, notice the big spike in Apparel inflation in 2012 preceded a rise in ex-housing core, but not a large or sustained rise in ex-housing core).
The table below shows the breakdown of Apparel into its constituent parts. The first column is the category, the second column is the weight (in overall CPI), the third column is the current y/y change, and the fourth column is the previous y/y change.
|Category||Weights||y/y change||prev y/y change|
|Boys’ and girls’ footwear||0.17%||2.506%||-0.046%|
I look at this to see whether there’s just one category that is having an outsized move; if there were, then we would worry more about one-off effects (say, the rollout of a new kind of women’s blouse that is suddenly all the rage). It is interesting that Men’s apparel and Boys’ apparel decelerated, while most everything else accelerated, but this happens all the time in the Apparel category. Actually, this is a pretty balanced set of sub-indices, for Apparel.
Now, I’m still not 100% sure this isn’t a seasonal-adjustment issue. It could be related to weather, or day count (29 days in February!), or some bottleneck at a port that caused a temporary blip in prices. I want to see a few more months before getting excited like I did in 2012! But we have had a couple of bad core CPI prints, and we also saw pressure in Medical Care so it is fair to say the number of alarm bells has broadened from one (Housing) to several (Housing, Medical Care, Apparel). It is fair to be concerned about price pressures at this point.
The ECB fired its “bazooka” today, cutting official rates more into negative territory, increasing QE by another €20bln per month, expanding the range of assets the central bank can buy to now include corporate bonds, and creating a new 4-year program whereby the ECB will loan long-term money to banks at rates that could be negative (based on bank credit extended to corporate and personal borrowers).
My point today is not to opine on the power or wisdom of these policy moves. The main thing I want to observe is this: the inflation market is pricing in what amounts to success for global central banks, with consumer inflation averaging something between 1 and 2 percent per year for the next decade (a bit lower in Japan; a bit higher in the UK). Not only are inflation swaps prices much lower than would be expected from a pure monetarists’ standpoint – but options prices are also very low. The chart below (source: Enduring Investments) shows normalized volatilities over the last five years for a 10-year, 2% year-over-year inflation cap. That is, every year you take a look and see if inflation was over 2%. If it was, then the owner of this option is paid the difference between actual inflation and 2%; if it was not, the owner gets zero. So you get to look ten times at whether inflation has gotten above 2%, and get paid each time it has.
The chart shows that whatever inflation is expected to be, the price to cover the risk that inflation is actually somewhat higher is very low. So, not only is inflation expected to be low, but it is expected to be not volatile either.
Look, we’re talking about bazookas, helicopters…does something not seem right about pricing in very little risk of screwing up?
Whether you believe my thesis in my freshly-released book What’s Wrong With Money? that the likely course of inflation over the next few years is higher and potentially much higher, or you agree with those who think deflation is imminent, shouldn’t we agree that bazookas introduce volatility?
Central banks are attempting to do something that has never been done. Shouldn’t we at least be a teensy bit nervous, as they line up to perform the first-ever quintuple-lutz, that no one has ever landed one before? That no one has ever landed a commercial passenger jet on an aircraft carrier?
Uncertainty is supposed to lower asset values, all else being equal. So even if you think stocks at these levels are “fair,” in an environment with earnings and interest rates where they are now and projected earnings following a certain path, an increase in the volatility of those outcomes should lower the clearing price of those assets since the buyer of the asset (which has positive value) is also assuming the volatility (which has a negative value).
But the market also says that uncertainty right now is low. Yes, the VIX is well off its lows and seems to suggest greater short-term uncertainty (see chart below, source Bloomberg) – but I would argue that the long-term volatility of the economic fundamentals has rarely been this high.
Supposedly you can’t roller skate in a buffalo herd, but we also have never tried to do it. There’s a reason we haven’t tried to do it!
But the Fed, and the rest of the world’s central banks, are not only roller skating in a buffalo herd – the world’s markets seem to be suggesting that investors are sure they’re going to succeed. Regardless of whether you’re optimistic about the outcome, I would argue it’s nearly impossible to be both optimistic and highly confident!
 This means something to options traders but can be glossed over by non-options traders. Essentially the point is that you can’t use a regular Black-Scholes model to price options if the strike and/or the forward can have a negative value!
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Would you rather have a bar of chocolate today, or one year from today?
Most of us, if we like chocolate, would prefer to have a bar of chocolate today rather than at some point in the future. If you don’t care for chocolate, how about money? Would you rather have $100 today, or $100 next year?
The reason that Wimpy’s “I’ll gladly pay you Tuesday for a hamburger today” ploy doesn’t work is that we would prefer to have the money today compared to the money on Tuesday. If Wimpy wants his burger today, but doesn’t have the money for it, then he must borrow the money and pay that money back on Tuesday. Because of our time preference for money, this will cost Wimpy something extra, as he needs to incentivize us to part with the money today so that he can get his burger now.
This is where it gets weird.
We are now in a Wimpy world. Not only can Wimpy get his burger today, it costs him less if he borrows the money because interest rates are negative. That is, “I’ll gladly pay you less money than the burger costs, and not until Tuesday, for the burger today.” And we are enthusiastically answering, “Sure! Sounds like a great deal!”
This is one weird implication of negative interest rates. If the yield curve was flat at a negative interest rate, it would imply that the further in the future something is, the more valuable it is. A dollar next week is worth more than a dollar today. With negative discount rates, a chocolate bar next year is preferable to a chocolate bar today. And poor Wimpy…being forced to have a hamburger today when a hamburger on Tuesday would be so much better!
It gets even weirder if the yield curve is initially negative but slopes upwards and eventually becomes positive. That implies that discount rates (time preferences) are negative at first, but then flip around and become normal at some point in the future. So there is one day in the future where value is maximized, and it’s less valuable to get money after that date or before that date.
You think this is mere theory, but this is happening internally to derivatives books even as we speak. The models are implying that money later is worth more than money now, because money now costs money to have. And from the standpoint of bank funding, that is absolutely true.
Another strange implication: in general, stocks that do not pay dividends should trade at lower multiples (relative to the firm’s growth) because, being valued only on some terminal cash flow date (when a dividend is paid or when the company is bought out), they’re worth less. But now it is better for a stock to not pay dividends; those dividends have negative value. Technically speaking, this means that companies which cut their dividends should trade at higher prices after the cut.
I can think of more! Ordinarily, if your child enters college the institution will offer you an incentive to pay four years’ tuition at a reduced rate, up front (or at a frozen rate). But, if interest rates are negative, the college should demand a premium if you want to pay up front. Similarly, car companies should insist that you take out a zero-interest-rate loan or else pay a premium if you feel you must pay cash.
In this topsy-turvy world, it is good to be in debt and bad to have a nest egg.
Neighbors appreciate you borrowing a cup of sugar and frown at you when you return it.
Burglars put off burglaries. Baseball teams sign the worst players to the longest deals. Insurance companies pay out life insurance before you die.
And all thanks to negative interest rate policies from your friendly neighborhood central bank. I will thank them tomorrow, when they’ll appreciate it more.