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Britain Survived the Blitz and Will Survive Brexit

June 24, 2016 4 comments

So I see today that former Fed Chairman Alan Greenspan says this is the worst crisis he has seen. Bigger than the 1987 Crash? Bigger than Long Term Capital? Bigger than the internet bubble collapse? Bigger than the Lehman (et. al.) collapse? Really?

As humans, we tend to have short memories and (ridiculously) short planning horizons. Greenspan, especially in his apparent dotage, has a shorter memory even than he had previously – maybe this is convenient given his record. I don’t want to comment on his planning horizon as that would seem uncharitable.

Why is Brexit bad? The trade arrangements and treaties do not suddenly become invalid simply because the UK has voted to throw off the shackles of her overlords and return to being governed by the same rules they’ve been governed by basically since the Magna Carta. But Jim Bianco crystallized the issue for me this week. He pointed out that while Brussels could let this be a mostly painless transition, it has every incentive to make it as painful as possible. In Jim’s words, “if it isn’t painful then hands shoot up all over Europe to be the next to leave.” That’s an astute political observation, and I think he’s right. The EU will work hard to punish Britain for having the temerity to demand sovereignty.

But Britain survived the Blitz; they will survive Brexit.

Indeed, Britain will survive longer than the Euro. The sun is beginning to set on that experiment. The first cracks happened a few years ago with Greece, but the implausibility of a union of political and economic interests when the national interests diverge was a problem from the first Maastricht vote. Who is next? Will it be Greece, Spain, Italy, or maybe France where the anti-EU sentiment is higher even than it is in the UK? The only questions now are the timing of the exits (is it months, or years?) and the order of the exits.

As I said, as humans we not only have short memories but short planning horizons. From a horizon of 5 or 10 years, is it going to turn out that Brexit was a total disaster, leading to a drastically different standard of living in the UK? I can’t imagine that is the case – the 2008 crisis has had an effect on lifestyles, but only because of the scale and scope of central bank policy errors. In Iceland, which addressed the imbalances head-on, life recovered surprisingly quickly.

These are all political questions. The financial questions are in some sense more fascinating, and moreover feed our tendency to focus on the short term.

A lot of money was wagered over the last few weeks on what was a 52-48 proposition the whole way. The betting markets were skewed because of assumptions about how undecideds would break, but it was never far from a tossup in actual polling (and now perhaps we will return to taking polling with the grain of salt it is usually served with). Markets are reacting modestly violently today – at this writing, the US stock market is only -2.5% or so, which is hardly a calamity, but bourses in Europe are in considerably worse shape of course – and this should maybe be surprising with a 52-48 outcome. I like to use the Kelly Criterion framework as a useful way to think about how much to tilt investments given a particular set of circumstances.

Kelly says that your bet size should depend on your edge (the chance of winning) and your odds (the payoff, given success or failure). Going into this vote, betting on Remain had a narrow edge (52-48) and awful odds (if Remain won, the payoff was pretty small since it was mostly priced in). Kelly would say this means you should have a very small bet on, if you want to bet that outcome. If you want to bet the Leave outcome, your edge was negative but your odds were much better, so perhaps somewhat larger of a bet on Brexit than on Bremain was warranted. But that’s not the way the money flowed, evidently.

Not to worry: this morning Janet Yellen said (with the market down 2.5%) that the Fed stood ready to add liquidity if needed. After 2.5%? In 1995 she would have had to come out and say that every week or two. A 2.5% decline takes us back to last week’s lows. Oh, the humanity!

Just stop. The purpose of markets is to move risk from people who have it to people who want it. If, all of a sudden, lots of people seem to have too much risk and to want less, then perhaps it is because they were encouraged into taking too much risk, or encouraged to think of the risk as being less than it was. I wonder how that happened? Oh, right: that’s what the Fed called the “portfolio balance channel” – by removing less-risky assets, they forced investors to hold more-risky assets since those assets now constitute a larger portion of the float. In my opinion (and this will not happen soon), central banks might consider letting markets allocate risk between the people who want it and the people who don’t want it, at fair prices. Just a suggestion.

One final point to be made today. I have seen people draw comparisons between this episode and other historical episodes. This is refreshing, since it reflects at least some thoughtful attempt to remember history. Not all of these are apt or useful comparisons; I saw one that this is the “Archduke Ferdinand” moment of this generation and that’s just nuts. Europe is not a military powderkeg at the moment and war in Europe is not about to begin. But, to the extent that trade barriers begin to rise again, the idea that this may be a “Smoot-Hawley” moment is worth consideration. The Smoot-Hawley tariff is generally thought to have added the “Great” to the phrase “Great Depression.” I think that’s probably overstating the importance of this event – especially if everybody decides to respect Britons’ decision and try to continue trade as usual – but it’s the right idea. What I want to point out is that while rising tariffs tend to produce lower growth and lower potential growth, they also tend to produce higher inflation. The fall of the Berlin Wall and the opening of Eastern Europe is one big reason that inflation outcomes over the last few decades have been lower than we would have expected for the amount of money growth we have had. The US has gone from producing all of its own apparel to producing almost none, for example, and this is a disinflationary influence. What would happen to apparel prices if the US changed its mind and started producing it all domestically again? Give that some thought, and realize that’s the protectionist part of the Brexit argument.

We can cheer for a victory for independence and freedom, while continuing to fight against any tendency towards economic isolationism. But I worry about the latter. It will mean higher inflation going forward, even if the doomsayers are right and we also get lower growth from Brexit and the knock-on effects of Brexit.

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.

Math is Bad for Equities

June 7, 2016 4 comments

In recent years, equities have been carried higher by several compounding effects: the growth of the economy, expanding profit margins, and expanding multiples.

These three things, by definition, determine equity prices (if we assume that gross sales are tied to economic growth):

Price = Price/Earnings x Earnings/Sales x Sales

When all three are rising, as they have been, it is a strong elixir for stock prices. Now, this explains why stock prices are so high, but the devil lies in predicting these components of course – no mean feat.

Yet, we can make some observations. It has been the case for a while that P/E ratios have been extremely high by historical measures, with the Shiller Cyclically-Adjusted P/E ratio (CAPE) roughly doubling since the bottom in 2009. With the exception of the equity bubble in 1999-2000, the CAPE has never been very much higher than it is now, at 26.4 (see chart, source Gurufocus). This should come as no surprise to anyone who follows markets regularly.

chart

Somewhat less obviously, recently sales have been declining. However, on a rolling-10-year basis, the rise has been reasonably steady as the chart below (Source: Bloomberg) illustrates. Over the last 10 years, sales per share have risen about 2.85% per year.

sales

Finally, profit margins have recently been elevated. In fact, they have been elevated for a long time; the 10-year average profit margin for the S&P 500 (see chart, source Bloomberg) has risen to 8% from 6% only a few years ago. Recently, however, profit margins have been receding.

profmgn

Both the rise in profit margins and the current drop in them make some sense. Value creation at the company level must be divided between the factors of production: land, labor, and capital. When there is substantial unemployment, labor has little bargaining power and capital tends to claim a higher share. Moreover, labor’s share is relatively sticky, so that speculative capital absorbs much of the business-cycle volatility in the short run. This is ever the tradeoff between the sellers of labor and the buyers of labor.

I used 10-year averages for all of these so that we can use CAPE; other measures of P/E are fraught. So, if we take 26.4 (CAPE) times 7.84% (10-year average profit margin) times 1005.55 (10-year average sales), we get an S&P index value of 2081, which is reasonably close to the end-of-May value of 2097. That’s not surprising – as I said, these three things make up the price, mathematically.

So let’s look forward. Recently, as the Unemployment Rate has fallen – and yes, I’m well aware that there is more slack in the jobs picture than is captured in the Unemployment Rate, but the recent direction is clear – wages have accelerated as I have documented in previous columns. It is unreasonable to expect that profit margins could stay permanently elevated at levels above all but a few historical episodes. Let’s say that over the next two years, the average drops from 7.84% to 7.25%. And let’s suppose that sales continue to grow at roughly 2.85% per year (which means no recession), so that sales for the S&P are at 1292 and the 10-year average at 1064.15. Then, if the long-term P/E remains at its current level, the S&P would need to decline to 2037. If the CAPE were to decline from 26.4 to, say, 22.5 (the average since 1990, excluding 1997-2002), the S&P would be at 1736.

None of this should be regarded as a prediction, except in one sense. If stock prices are going to continue to rise, then at least one of these things must be true: either multiples must expand further, or sales growth must not only become positive again but actually accelerate, or profit margins must stop regressing to the mean. None of these things seems like a sure thing to me. In fact, several of them seem downright unlikely.

The most malleable of these is the multiple…but it is also the most ephemeral, and most vulnerable to an acceleration in inflation. We remain negative on equities over the medium term, even though I recently advanced a hypothesis about why these overvalued conditions have been so durable.

Categories: Investing, Stock Market, Theory

Inflation with Deflationary Overtones?

The Employment report was weak, with jobs coming in below consensus with a downward revision to prior months. It wasn’t abysmally weak, and not enough to change the a priori trajectory of the Fed. If the number had been 125k below expectations or 125k above it, then it may have had implications for the FOMC. But this is a number that has big swings and is revised multiple times. Getting 160k rather than 200k isn’t cause for celebration, but neither is it cause for panic. So whatever the Fed was getting ready to do didn’t change because of this number.

To be sure, no one knows what the Fed was planning to do, so this mainly has implications for the day’s volatility…which is to say that the market quickly went to sleep for the day.

Now, interestingly the Average Hourly Earnings number ticked higher to 2.5%, continuing the post-crisis upswing. At 2.5%, hourly earnings growth is slightly higher than median inflation and thus potentially “supportive of the inflation dynamic” from the standpoint of the Committee. Yes, wages follow inflation but not in the Fed models – so, while I don’t think this has any implications for future inflation it will eventually have implications for Fed policy. But this is a dovish Fed, and 2.5% earnings growth is not going to scare another tightening out of them…unless they were already planning to tighten.

Wages are actually a bit higher than that. Back in April I highlighted the Atlanta Fed’s Wage Growth Tracker and summarized how this measures is better than Hourly Earnings. I hadn’t been aware of this index previously but I follow it now. It stands at 3.2%. The difference between average hourly earnings and the Atlanta Fed Wage Tracker is summarized below (Source: Bloomberg). Again, though: I don’t think we have seen anything today which will change the Fed’s collective opinion about the need for different monetary policy.

wages

Earlier this week, I promised that I would revisit the question of how we can have both deflation and inflation, and how these concepts are confused. I first posted an article summarizing this point in January 2014, and in re-reading it I think it is good enough to pretty much cut-and-paste with only mild edits. So here it is:

How Inflation and Deflation Can Peacefully Coexist

In the discussion about whether the economy is exhibiting “inflationary tendencies” or “deflationary tendencies,” I find that many, many observers grow confused by the fact that we measure prices in dollars, which are themselves subject to changes in relative value due to supply and demand.

It helps to forget about dollars as the unit of measure. Just because it says “One Dollar” does not mean that it is an ever-fixed mark. With apologies to Shakespeare, dollars are not the star to every wandering bark, whose worth’s unknown although its dollar price be taken.[1]  There are two ways to look at the “inflation/deflation” debate. Depending on which one you are referring to, deflationary tendencies are not inconsistent with price inflation, and price inflation is not inconsistent with deflationary tendencies.

One is the question of dollar price; and here we are mainly concerned with the supply of dollars and the number of times they are spent, compared to the amount of stuff there is to buy. More dollars chasing the same goods and services imply higher prices. Of course, this is just another way of stating the monetarist equation: P ≡ MV/Q. This is an identity and true by definition. Moreover, it is true in practice: rapid money growth over some moderate length of time always corresponds with rapid deterioration in the purchasing power of the money unit – in other words, inflation. At least, we have no examples of (a) extremely high money growth without high inflation, or (b) extremely high inflation without high money growth.

But this is not the same discussion as saying that “the aging demographic [or debt implosion in a recession] means we will have deflation,” as many economists will have it. Deflation, in that sense, can still happen: if you have fewer workers making the same amount of GDP, then goods (and services) prices will fall relative to wages, which would be deflation the way we typically mean it if the overall price level was otherwise unchanged. However, if the money supply increases by a factor of 10, then nominal prices will increase no matter what else is going on. It may be, though, that in this case wages will increase slightly more than prices, so that there will be “deflation” in the unitless sense.

So, these are not inconsistent statements: (a) there will be increasing inflation next year, and (b) large amounts of private debt and demographic “waves” around the world are a deflationary force. The resolution to the seeming inconsistency is that (b) causes downward pressure on certain prices relative to other prices or, if you ignore the unit of exchange, it causes downward pressure in the ratio of one good that can be exchanged for another. Yet at the same time (a) implies that the overall increase in output in goods and services will be outstripped by the number of dollars spent on them, driving prices higher.

So you should cheer for the “good” sort of deflation. At least, you should cheer for it if you are still earning wages. But do not confuse that concept with the notion that prices in dollar terms will fall. That is wholly different, and unless central banks screw up pretty badly it is not going to happen. Indeed, despite all of the so-called “deflationary tendencies” – most of which I agree are important – I believe prices are going to rise in dollar terms and in fact they are going to rise at increasing rates (higher inflation) over the next few years.[2]

P.S. Don’t forget to buy my book! What’s Wrong with Money: The Biggest Bubble of All. Thanks!

[1] See Sonnet 116, in case you missed out on a liberal arts education and don’t get the reference!

[2] I kept this sentence…it was true in January 2014, as median inflation moved from 2.06% in Dec 2013 to 2.4% today, but I also believe this to be still true. Only the next leg will probably be faster.

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

Don’t Forget Oil Demand Elasticity!

April 18, 2016 3 comments

The big story of the weekend was that a meeting of OPEC and non-OPEC producers, at which an agreement was supposed to be signed to freeze oil production at recent levels, ended without an agreement being signed. This was not an enormous surprise, since Iran didn’t even attend the conference and the Saudis had said they wouldn’t sign unless Iran agreed, but oil prices initially took a significant hit before recovering some later in the day.

The economic significance of the lack of agreement is fairly small; most producers are producing near their maximum output, except for important non-attendees like the United States and Iran. (The Saudis claim to be able to put 1mm barrels per day online in short order, too).  But the psychological significance was thought to be important.

I’m not so sure about the importance of mind-games in an efficient global market for a commodity product. The market is oversupplied, by a significant amount, and no amount of posturing will change that. However, basic economics may.

Overlooked by many is the fact that OPEC’s problem is one that automatically diminishes over time even if OPEC does nothing. This is because the demand for oil is short-term inelastic, but long-term elastic.

The elasticity of demand describes how quickly the quantity demanded responds to price. If demand is very elastic, then changes in price cause large changes on the quantity demanded. On the other hand, inelastic demand curves indicate that the quantity demanded changes very little when the price on offer changes.

The elasticity of demand has a very significant consequence for the question of how revenues change when prices change. Revenue is simply price times quantity. So, if a small change in price causes a large change in quantity (that is, an elastic demand curve), it is a good strategy (for example, as an individual company) to cut one’s price: the company will sell lots more product and give up only a little revenue on each one, so that total revenues rise with price declines if a producer faces an elastic demand curve. On the other hand, if demand is inelastic, then a price cut doesn’t change the quantity sold very much, but decreases revenue on each unit. If a producer faces an inelastic supply curve, total revenues decline with price decreases. And, conversely, total revenues increase with price increases in such a case. This is the reason that cartelization of the oil industry is an apparently attractive strategy: oil demand is, at least in the short-run, price inelastic. If gasoline prices rise $1 per gallon next week, you will still drive almost as much as before.

But static equilibria cannot fully describe dynamic markets! It turns out that for most products, demand elasticity in the long-run is higher, and often much higher, than in the short run. Consumers adjust to changing prices by adjusting their consumption mix! This is also true with energy markets: while you won’t drive a lot less next week if gasoline prices are much higher, if they stay higher you will start to carpool, buy more energy-efficient vehicles, and so on. This is one reason that cartelization ends up failing. In the short run, it makes sense to band together and hike prices, raising overall revenue, but this has deleterious effects on long-run revenue and creates incentives to cheat to grab more of the (diminishing) demand.

Analysis of the energy markets tends to focus on supply, but as prices increase and decrease over extended periods of time, it is important to remember that demand eventually responds. From 2011 until mid-2014, retail gasoline averaged about $3.50 per gallon (see chart, source Bloomberg). But it has been below that level for almost two years, and averaged more like $2.30 per gallon since then.

retailgasoline

Similarly, WTI crude oil averaged around $100/bbl in 2011-mid2014, but only about $60 since then. And most of that was well below $60. The picture for Brent is of course very similar.

wtic

In the short run, with inelastic demand, these large declines represent a very large drop in OPEC producer revenues. But in the long run – and after two years, we are much closer to the long run – demand will increase even if the global economy doesn’t grow at all because there is a demand response to lower prices. OPEC, in other words, initially sold the same amount of oil at lower prices, but as time passes they will sell larger amounts of oil at these lower prices. While that’s not as good as selling those larger amounts of oil at higher prices, it is better than what it had been after the initial, sharp decline.

So oil producers will have more total revenue over the next year, even if price doesn’t change and even if the global economy stops growing, than they did last year. The need for a production freeze becomes less urgent all the time.

Of course, the supply overhang is huge, and it won’t go away overnight and probably won’t go away from demand response alone. But, as we are dealing with the long run, we shouldn’t neglect the demand response, either.

Categories: Commodities, Economics, Theory

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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