This is an interesting chart I think. It shows the spot CPI swap curve (that is, expected 1y inflation, expected 2y compounded inflation, expected 3y compounded inflation), which is very, very steep at the moment because of the plunge in oil. It also shows the CPI swap curve one year forward (that is, expected inflation for 1y, starting in 1y; expected inflation for 2y, starting in 1y; expected inflation for 3y, starting in 1y – in other words, what the spot curve is expected to look like one year from today). The x-axis is the number of years from now.
Basically, after this oil crash passes through the system, the market thinks inflation will be exactly at 2% (a bit lower than the Fed’s target, adjusting for the difference between CPI and PCE, but still amazingly flat) for 6-7 years, and then rise to the heady level of 2.10-2.15% basically forever.
That demonstrates an amazing confidence in the Fed’s power. Since inflation tails are longest to the high side, this is equivalent to pricing either no chance of an inflation tail, or that the Fed will consistently miss on the low side by just about exactly the same amount, and that amount happens to be equal to the value of the tail more or less.
But what is really interesting to me is simply how the wild spot curve translates so cleanly to the forward curve, at the moment.
Today’s column is a brief one, as I need to post a correction. Not a correction to my stuff, mind you, but to others.
Pictures like the below have been circulating now for a couple of weeks. This is a chart of the 2-year inflation “breakeven” on Bloomberg, illustrating how a “deflation warning” is sounding as they go negative.
Unfortunately, it ain’t so. I wrote to the authors of the original Bloomberg piece referenced above, and called Bloomberg (more on that later), and figured that when I pointed out that 2-year inflation expectations are nowhere near zero, the story would at least die quietly even if pride prevented a retraction. Unfortunately, that hasn’t happened and other “analysts” and news outlets have picked up the story. So, I need to print a correction for them. Unconventional, I know, but I stand for Truth.
The simple fact is that 2-year inflation expectations have fallen deeply, but remain well above zero. The chart below, also from Bloomberg, shows 2-year inflation swaps over the same period. You will notice that it has fallen mightily but remains at about 0.70%.
It turns out that the difference between the Jan-17 TIPS (which have 2 years to maturity) and the Jan-17 nominal Treasuries that are their comparator bond – taking the difference between real and nominal rates gives you the “breakeven” inflation rate that makes them equivalent investments; thus the name – is also about 0.70%.
So why does Bloomberg say the 2-year breakeven is negative? Well, Bloomberg’s “policy” is to track the April-2016 TIPS as the “2-year” TIPS until the new April-2020 TIPS are auctioned in April At that time, they will roll to using the April-2017 TIPS, which will have two years to maturity, and will use that bond for a year. While I applaud Bloomberg for having a policy, that’s no excuse for a stupid policy. There is no place in this universe where the April-16s are a 2-year note. Not even close. And not the “best we can do.”
In truth, especially for short-dated inflation expectations there is no reason not to use inflation swaps. The 2-year inflation swap is evergreen each day with a new 2-year maturity, and there are no idiosyncrasies (such as the fact that the April issues often trade cheap because of the bad seasonality associated with them, so they will usually understate true inflation expectations if you use them) to worry about.
So the story is false. The market is not discounting two years of deflation. Indeed, the reality is quite a bit different. The chart below (source: Enduring Investments – we know stuff like this) shows the 1-year inflation rate, starting 1 year from now (the 1y1y or 1×2 if you like), derived from CPI swaps. While it has come down substantially since the summer, it is not particularly out of line. In fact, it’s pretty much right where core inflation is, which makes sense: the energy spike lower is not going to continue year after year, which means that once it stops then headline inflation will return to the neighborhood of core…unless there’s a rebound in gasoline, of course. But the point is that the best guess of inflation one year from now has little to do with gasoline.
Actually, the even-deeper point is that it is appalling how little general knowledge there is about inflation, and how journalists and even many analysts have scant idea how to get to the real story. (Hint: calling an inflation expert is a good start.)
In keeping with the topic of the month, I present this chart.
I really wanted to make the x-axis the compounded inflation rate since the World Cup began, but the data is just too difficult to find for many of these countries. Nevertheless, we see the broad outlines of the thesis in this chart. If you want to be excellent at soccer, inflate your economy.
The correlation between soccer wins and inflation (I arbitrarily decided to only include countries which have appeared in eight or more World Cups, so that there is some chance that they have some wins) is only 0.31, but notice the two blue dots at the upper left. I would argue that at least Germany has an inflation-driven history, although since the 1980s they have had fairly low inflation. One might argue the same with Italy, albeit to a lesser extent. If we exclude those two aberrations, the correlation rises to a whopping 0.67!
Ok, sure, this is somewhat spurious – it is largely driven by the fact that two of the winningest teams are Brazil and Argentina, which have quite a history of inflation as well as of soccer. But if the ECB discovers this, it should make sure all of the retail shops in Europe know…and they’ll have widespread support for inflation.
As expected, and as I’ve been saying for a long time, (a) median inflation is rising and now is at 2.3% y/y, the highest level since 2009, and (b) core inflation is converging to median inflation as the one-off effects of the sequester on Medicare payments is removed from the data.
I haven’t written in a couple of weeks – a combination of quiet markets, and a lack of intersection between stuff that’s interesting to write about and my having time to write – but I thought I would “global cc” everyone on something I just wrote in a private email about some common misconceptions regarding the CPI:
A friend and longtime reader (name withheld) writes:
I thought you might find these interesting….
My response is below:
Thanks. Unfortunately Stockman doesn’t understand what he’s talking about. He understands better than most, but then he starts saying how the BLS asks homeowners what their homes would rent for…which they do, but only to determine weights, every couple of years, not to determine OER. It says this very clear in a paper on the BLS website called “Treatment of Owner-Occupied Housing in the CPI:”
“To obtain the expenditure weights for the market basket…Homeowners are asked the often-cited question:
If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?
This is the only place where the answers to this question is used; in determining the share of the market basket. We do not use this question in measuring the change in the price of shelter services.”
For that purpose – calculating inflation itself – a survey of actual rents is used. I can understand how the casual observer doesn’t ‘get’ this, but there’s no excuse for Stockman not to know, especially if he is railing about the CPI…he should take some time to understand its main piece.
In short, Stockman writes a good populist screed, but he avoids the main questions:
1. Is headline inflation a better predictor of future inflation than core inflation? Answer: No, even if we can now realize that the rise in energy prices was a permanent feature of the decade ended in 2010, it tells us exactly nothing about whether those are likely to persist. The Fed uses core CPI not because they don’t think people use cars (whenever a columnist uses that silly argument, I know they’re just writing to please a certain audience), but because core CPI is persistent statistically in a way that headline is not. In fact, some Fed statisticians prefer median, or trimmed-mean, neither of which proscribes any particular category. So whining about how the Fed doesn’t include the particular brand of inflation that concerns you misunderstands how and why policymakers actually use measures of inflation in policymaking.
2. Suppose the CPI represents a miserable mis-estimation of actual inflation. Then, pray tell, why does a trillion-dollar market based on that index get priced as if it is accurate? In Argentina, where the inflation numbers are made up, the inflation-linked bonds trade very cheap because they will pay off in a number that is assumed to be too low. And the bond yields are too high by roughly the amount that inflation is assumed to be understated in the future. Markets are efficient, especially big markets. How did the Fed manage to convince at least $1T in private money to misprice the bond market?
3. If the CPI is so wrong, so manipulated, then why to measures of inflation that the government has nothing to do with, like the Billion Prices Project, come up with the same number?
It’s nice that Stockman has a following. And he’s gotten the following partly by ranting about a number people love to hate. That gets him read, but it doesn’t make him right.
Today’s article will be brief (some might say blessedly so). The topic is the publication of an article on the NY Fed’s blog entitled “Convexity Event Risks in a Rising Interest Rate Environment.”
Long-time readers may recall that I wrote an article last year, with 10-year notes at 2.12%, called “Bonds and the ‘Convexity Trade’,” in which I commented that “the bond market is very vulnerable to a convexity trade to higher yields…the recent move to new high yields for the last 12 months could trigger such a phenomenon. If it does, then we will see 10-year note rates above 3% in fairly short order.” Within a few weeks, 10-year note yields hit 2.60% and eventually topped out at 3%.
Now, the Fed tells me that this selloff was “more gradual and therefore inconsistent with a sell-off driven primarily by convexity hedging.” I suppose in a way I can agree. The sell-off was primarily driven by the fact that the Fed had abused the hell out of the bond market and pushed it to unsustainable levels. But I don’t think that’s what they’re saying.
Indeed, the Fed is actually claiming credit for the fact that the selloff was only 140bps. You see, the reason that we didn’t get a convexity-based selloff – or at least, we only got the one, and not the one I was really concerned about, on a push over 3% – is because the Fed had bought so many mortgage-backed securities that there weren’t enough current-coupon MBS left to cause a debacle!
How wonderfully serendipitous it is that even the most egregious failures of the Federal Reserve turn out to benefit society in heretofore unexpected ways. You will recall that one of the main reasons given by the Federal Reserve to purchase mortgages in the first place was to help unfreeze the mortgage market, and to provoke additional mortgage origination. In that, it evidently failed, for if it had succeeded then the total amount of negative convexity in public hands would not have changed very dramatically. In fact, it would have been worse since the new origination would have been current coupons and replacing higher coupons.
The real reason that the convexity-spurred selloff wasn’t worse isn’t because the Fed had taken all of the current coupon MBS out of the market, but because the Fed continued to buy even in the move to higher yields. A negative-convexity selloff has two parts: the increased demand for hedging, and the decreased supply of counterparties to take the other side as the ball gets rolling. In this case, one big buyer remained, which emboldened dealers who knew they wouldn’t be stuck “holding the bag.” That is the reason that the selloff was “only” 140bps and not worse.
However, the observation that the Fed’s policy was a failure, as it did not stimulate vast amounts of new mortgage activity, remains. It is true that there is less negative convexity in the mortgage market than there would otherwise have been in the absence of Fed buying. But that’s an indictment, not exoneration.