I am sure that in my career I have seen weirder reactions, but when the Durable Goods number came out and plainly was significantly weaker-than-expected and energy rallied I must admit it was hard to think of one.
Presumably the reaction was an indirect one: weaker growth means the Fed is less likely to tighten, which means a lower dollar and hence, higher global demand for oil. But that seems a wild overthink. If there is a recession in the offing, and if we care about demand in oil markets (and I think we should), then weak economic growth from one of the world’s largest economies probably ought to be reflected in lower oil prices.
There is part of me that wants to say “maybe investors have finally realized that any given month of Durable Goods Orders is almost meaningless because the volatility of the number makes it hard to reject any particular null hypothesis.” I haven’t done this recently, but many years ago I discovered that a forecast driven by the mechanical rule of -0.5 times last month’s Durables change had a better forecasting record than Street economists. Flip the sign, divide by two. However, I don’t really think the market suddenly got wise.
I also don’t think it’s that a bunch of people got the API report, which came out at 4:30pm to subscribers only, early. That report supposedly showed a large draw in crude inventories when a build was expected – but I’m not into conspiracy theories. That would be too obvious, anyway.
The perspective of analysts on Bloomberg was that the oil market will “rebalance” this year, a point which isn’t very far from the point I made last week in my article “Don’t Forget Oil Demand Elasticity!” But rebalancing doesn’t mean that prices should go higher. They have, after all, already gone quite a bit off the lows. By our proprietary measure, the real price of oil is at a level which implies a 10-year expected real return of about 1% per annum. In other words, it’s within about 10% of fair value quantitatively; given the immense supply overhang that doesn’t seem to promise lots of upside from these levels.
It isn’t just energy. The Bloomberg Commodity Index is 15% off its January lows (see chart, source Bloomberg). Precious metals, industrial metals, softs, grains, and meats are all above their lows of the last 1-2 quarters.
Unfortunately, much of this is simply a function of the dollar’s retracement. The chart below (source: Bloomberg) shows the Bloomberg Commodity Index (left axis, inverted) against the broad trade-weighted dollar. Heck, arguably commodities are still lagging.
But the winds of change do seem to be about. Last week, the Treasury auctioned 5y TIPS; though this isn’t an event in and of itself, the fact that the auction was strongly bid is certainly unusual. The 5y TIPS are a difficult sell. People who are concerned about inflation are typically looking to protect against the long-term. But TIPS also represent real interest rate risk, and if you think inflation is going to be rising near-term then you probably don’t want to own lots of interest rate risk. Sure, you’ll prefer inflation-linked real rates to nominal rates (see my timely comment from January, “No Strategic Reason to Own Nominal Bonds Now”: since then, 10y real yields have fallen 40bps while 10y nominal yields have fallen 7bps), but if you really think inflation is about to rear its ugly head then you don’t want any real or nominal duration but only inflation duration.
And inflation duration has lately been doing really well. The chart below (source: Bloomberg) shows the marked rebound in the 10-year breakeven inflation rate since February 9th.
I think there’s some evidence that the pendulum of complacency on inflation has begun finally to swing back the other way. Core inflation is rising in Europe, the UK, Japan, and the US, and it was inevitable that someone would notice. Ironically, it took energy’s rally to make people notice (and energy, of course, isn’t in core inflation). But what do I care?
If in fact the pendulum of complacency and concern has finally reversed, then both stocks and bonds are in for a rough ride. Bonds may be marginally protected by a dovish Fed, but that only works as long as the inscrutable Fed stays dovish…or inscrutable.
(**Administrative Note: Get your copy of my new book What’s Wrong with Money: The Biggest Bubble of All! Here is the Amazon link.)
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: My new book What’s Wrong with Money: The Biggest Bubble of All has been launched. Here is the Amazon link. Please kindly consider buying a copy for yourself, for your neighbor, and for your library! If you are moved to write a review, or if you wander across a review that you think I may not have seen, please let me know. And thanks in advance for your support.)
Yesterday I wrote about the crowded short trade that boosted energy futures 40-50% from the lows of only a few weeks ago. A related crowded trade was the short-inflation trade, and it also was related to carry.
TIPS, as many readers will know, accumulate principal value based on realized inflation; the real coupon rate is then paid on this changing principal amount. As a rough shorthand, TIPS thus earn something like the real interest rate plus the realized inflation (which goes mainly to principal, but slowly affects the coupon over time). So, if the price level is declining, then although you will be receiving positive coupons your principal amount will be eroding (TIPS at maturity will always pay at least par, but can have a principal amount less than par on which coupons are calculated). And vice versa, of course – when the price level is increasing, so does your principal value and you still receive your positive coupons.
This means that, neglecting the price change of TIPS, the earnings that look like interest – those paid as interest, and those paid as accumulation of principal, which an owner receives when he/she sells the bond or it matures – will be lower when inflation is lower and higher when inflation is higher. It acts a little bit like a floating-rate security, which is one reason that many people believe (incorrectly) that FRNs hedge inflation almost as well as TIPS. They don’t, but that’s something I’ve addressed previously and it’s not my point today.
My point is that TIPS investors behave as if this carry is a hot potato. When carry is increasing, everyone wants to own TIPS; when carry is decreasing no one wants to own TIPS. The chart below (Source: BLS) shows the seasonal adjustment factor used by the Bureau of Labor Statistics to adjust the CPI. The figure implies that prices tend to rise into the summer and then decline into year-end, compared to the average trend of the year, so we should expect higher increases in nonseasonally-adjusted CPI in the summer and lower increases or even outright decreases late in the year.
Now, the next chart (Source: Enduring Investments) shows what 10-year breakevens have done over the last 16 years, on average, compared to the year’s average.
Do these two pictures look eerily similar?
From a capital markets theory perspective, this is nuts. It says that breakevens expand (TIPS outperform) when everyone knows carry should be increasing, and narrow (TIPS underperform) when everyone knows carry should be decreasing. And from a P&L perspective, a 30bp increase in 10-year breakevens swamps the change in accruals that happens as the result of seasonal changes in CPI. Moreover, these are known seasonal patterns; one should not be able to ‘outsmart’ the market by buying breakevens in January and shorting them in May. Theory says that while you’re owning negative carry, you should make it up in the rise of the price of the bond to meet the forward price implied by the carry. Nevertheless, for years you were able to beat the carry, at least if you were a first mover. (Incidentally, an investor doesn’t try to beat the average seasonal, but the actual carry implied by movements in energy too – which are also reasonably well-known in advance).
But as liquidity in the market has suffered (not just in TIPS, but in many non-benchmark securities, thanks to Dodd-Frank and the Volcker Rule), it has become harder for large accounts to do this. More importantly, the market has tended to drastically overshoot carry – either because less-sophisticated investors were involved, or because momentum traders (aka hedge funds) were involved, or because investor sentiment about inflation tends to overshoot actual inflation. Accordingly, as energy has fallen over the last year-and-a-half, TIPS have gotten cheaper, and cheaper, and cheaper relative to fair value. In early January 2015, I put out a trade recommendation (to select institutional clients) as breakevens were about 90bps cheap. The subsequent rally never extinguished the cheapness, but it was a profitable trade.
On February 11th of this year, TIPS reached a level of cheapness that we had only seen in the teeth of the global financial crisis (ignoring the period prior to 2002, when TIPS were not yet a widely-held asset class). The chart below shows that TIPS recently reached, by our proprietary measure, 120bps cheap.
But, as with energy, the short trade was overdone. 10-year breakevens got to 1.20% – an almost inconceivable level that would signal a massive failure not only of Fed policy, but of monetarism itself. Monetarism doesn’t make many claims, but one of these is that if you print enough money then you can create inflation. Since then, as the chart below (source: Bloomberg) shows, 10-year breakevens rallied about 35 bps before falling back over the last couple of days. And we still show breakevens as about 100bps cheap at this level of nominal yields.
Yesterday I noted that the structural negative carry for energy markets at present was likely to limit the rally in crude oil, as short futures positions get paid to stay short. But this is a different type of carry than the carry we are talking about with TIPS. With TIPS, the carry is caused by movement in spot energy (mostly gasoline) prices; with crude oil markets, the carry is caused by rolling futures positions forward. The TIPS carry, in short, will eventually stop being so miserable – spot gasoline is unlikely to continue to decline without bound. But even if spot gasoline stabilizes, short futures positions can still be profitable if oversupply into the spot market keeps futures curves in contango. Accordingly, while I think energy futures will slip back down, I am much more confident that TIPS breakevens have seen the worst levels we are likely to see.
Unfortunately, for the non-institutional investor it is hard to be long breakevens. The CME has never re-launched CPI futures, despite my many pleadings, and most ETF products related to breakevens have been dissolved – with the notable, if marginal, exception of RINF, which tracks 30-year breakevens but has a very small float. It appears to be approximately fair, however. Other than that – your options are to be long a TIPS product and long an inverse-Treasury product, but the hedge ratios are not simple, not static, and the fees would make this unpleasant.
However, as I wrote recently what this means for the individual investor is that there is no strategic reason to own nominal bonds now. If I own nominal Treasury bonds, I would be moving into TIPS in preference to such a low-coupon, naked-short-inflation-risk position.
Today I presented our 2016 inflation forecast to the investment committee for a multifamily office, and when I was putting the presentation together I developed one slide that really is a must-see for investors in my opinion.
For some time, TIPS have been too cheap. Really, it has been more than a year that our metrics have shown inflation-linked bonds as not just cheap, but really cheap compared to nominal bonds. I don’t mean that real yields will fall – so this isn’t a statement about whether I am bullish or bearish on fixed-income. Frankly, I am somewhat conflicted on that point at this moment.
Rather, it is a statement about what sort of fixed-income instruments to own, for that part of your portfolio that needs to be in fixed-income. If you are running a diversified portfolio, then you can’t really avoid owning some bonds even if you are bearish on the bond market. For risk-reduction reasons if for no other, it makes sense to own some bonds.
But you don’t have to own fixed-coupon nominal bonds (or, for that matter, floating-coupon nominal bonds which are still exposed to inflation through the principal of the instrument). In fact, right now it is hard for me to imagine betting on nominal bonds for the portion of my portfolio that is in fixed-income.
A picture is worth a thousand words, so here is the picture:
The chart shows rolling, compounded 10-year inflation rates for as far back as we have reasonable data. And it shows the current level of 10-year inflation “breakevens.” What this means is that if you are long Treasuries, rather than TIPS, you will do better over the next ten years if inflation is below 1.34% and above roughly zero. If we have big deflation, TIPS will do just about as well since they are also principal protected; if we have any inflation over 1.34%, TIPS will do better.
And as the chart points out, since the Fed has been formed we have literally had almost zero 10-year periods in which inflation was in the 0-1.34% zone. Perhaps the 10-year periods ending early in the Great Depression, en route to big deflation, or coming out of the Great Depression heading into WWII. But otherwise, inflation has always been either higher or, in a Fed-screw-up scenario, much lower.
Put another way, it means that if you choose to own nominal bonds instead of inflation-linked bonds for the next 10 years, you are short a straddle on inflation, and you’re not being paid much to be short it. (Technically, you’re short a zero-cost ratio call spread since you don’t lose in deflation, but I’m trying to keep it simple!)
There may be tactical reasons to prefer nominal bonds to inflation-linked bonds. But to me, there is no clear strategic reason to be long nominal bonds for that portion of your portfolio that you intend to keep in fixed-income.
The illiquid trading of December is already well in evidence – and we haven’t even reached the bad part yet. One we are past the CPI report and the Fed meeting, there will be a few days where serious traders are squaring up based on what they now believe after those data points. After that, it will get truly quiet for the last couple of weeks.
A little quiet is what the energy market needs. On Monday front Crude broke to new six-year lows. Not since oil bottomed at $32.40 in December 2008 have prices been this low. Prior to that, the last time we saw sub-$40 oil was in July 2004. Ditto with gasoline prices, which are averaging just a touch above $2/gallon nationwide. This is truly amazing, and is causing all sorts of carnage in energy and energy service companies as has been widely reported.
What is interesting, though, and has been widely unreported has been the impact these recent price declines have had on inflation expectations as impounded in the price of inflation derivatives and TIPS breakevens. In short: not very much.
In prior episodes, such as last year at about this time, plunging energy quotations affected not only near-term inflation expectations but also long-term inflation expectations. The reason that near-term breakevens, or say 1-year inflation swaps, respond to energy prices is very simple: these contracts are pegged to headline inflation, which includes energy; while the market tends to overreact to the energy effect it tends to price fairly efficiency the near-term effect of movements in gasoline on actual inflation outturns.
But it makes very little sense that even very large moves in gasoline prices should be reflected in long-term inflation expectations. This is for two reasons: first, energy prices are mean-reverting, so declining prices in one year are more likely to see appreciating prices the following year (or, at least, big declines tend not to be followed by big declines). Second, even a significant change in energy prices, amortized over ten years for example, ends up not being a very big movement per year when you then also take into account how low the pass-through is from energy prices to inflation swap prices.
A bunch of this is sort of “inside baseball” talk to inflation traders, which I know isn’t my audience for the most part. But you can readily understand, I think, that if gasoline prices drop 50% in one year – and if we don’t expect them to continue to drop 50% in every year – then that’s only around a 5% movement per year in energy prices, averaged over ten years. That’s like saying gasoline prices rise a dime per year for ten years. Do you think that would have, or should have, a big effect on your overall inflation expectations?
In practice, it turns out to affect the market. The chart below (source: Bloomberg) shows the national average gasoline price (in white) from the American Automobile Association versus the 10-year breakeven (that is, the difference in the 10-year Treasury yield minus the 10-year TIPS yield, a number that approximates the inflation required to break even between these two investments). You can see that this is a fairly tight relationship in the grand scheme of things. When gasoline prices fell from $3.60 to $2.00 in 2014-15, breakevens plunged from 2.20% to 1.60%. As I have just pointed out, that’s larger than makes sense but the direction makes sense.
This phenomenon, incidentally, is why we (meaning me, and my company when we are doing analysis) strip out the implied energy effect by using futures quotes, so as to come up with an implied core inflation curve. (And you can actually hedge, so you can create something that looks very much like core inflation rather than headline inflation). By doing this, we can often see when the inflation market is overpricing the energy effect or underpricing it, and indeed this can be traded as part of an institutional investment strategy.
But recently, we haven’t really needed to be so fine with the calculation. Notice on the right side of the chart above that over the last couple of months inflation expectations (breakevens) have risen even as crude and gasoline prices have continued to slide. The chart illustrates how unusual this is. What this means is that expectations for long-term core inflation have been rising – investors are actually looking past the near-term energy washout and saying “we don’t believe this will be sustained, and even if it is we don’t believe that core inflation will average 1.25% for five years.” That’s what was being priced in late October; now that figure is a still low but much more-sensible 1.5%.
Will investors be right? I must say that we have been aggressive in saying that being long at these breakeven levels leaves few ways to lose, at least for investors who can hold through the bumps. And inflation has long upper tails, so that even if you think 1.50% for five years is fair, you should be willing to pay a bit more simply because a miss on the high side is likely to be a worse miss than a miss on the low side.
Sadly, the only way for retail investors to position explicitly for this is through the ETF RINF, which is the Proshares 30y breakeven spread, and the bid/offer is intimidating as is the expense ratio. But it’s something.
What I find fascinating is that this is happening at all. Everyone professes to believe that the Fed is ahead of the curve and will surely squash inflation. But that isn’t how they’re positioning.
Whoever is selling stocks these days is really appreciative of those who are pushing the market higher. Thanks to overnight rallies in China and Japan on Tuesday night, US stocks launched higher at the open on Wednesday. Now, neither the modest rally in Shanghai (led by official buying) and the bigger rally in Japan (on Prime Minister Abe’s pledge to cut corporate taxes next year) had the slightest thing to do with items that impact the US, but the rally led a wave that rolled through futures markets around the globe until about seven minutes after traditional stock trading hours opened in New York, when the high of the day was set. The next six-and-a-half hours saw a 440-point decline in the Dow and around 50 in the S&P to a net loss of about 1.4% on the day.
“Gee, thanks!” said the pension fund guys who got to unload stocks about 3% higher than they otherwise would have. Who says the fast money monkeys don’t have salutatory effects?
The clue that today’s rally was not going to be sustained was actually in the energy markets. Prior equity oscillations had been mirrored with quite reasonable fidelity in the last week or two, but this morning energy markets were noticeably flat-to-down. Equities soon joined them.
Now, yesterday I mentioned that real yields are near their highest levels of the last five years, and that nominal yields are essentially in the middle of that range. I didn’t illustrate the latter point; but see below (source: Bloomberg).
So it is clear, to me, where you would rather place your bets in fixed-income: with real yields around 65bps and nominal yields at 2.20, you only want to own nominal bonds if inflation is less than 1.55% for ten years. Note that if inflation is negative, then you do approximately the same with TIPS as with nominal bonds, since in both cases your nominal principal is preserved. So it is a narrow set of circumstances in which you do better owning nominals, and you don’t do much better. On the other hand, there are long tails on the other side: ways that by owning TIPS you will do dramatically better.
I mention this, even though both nominal bonds and TIPS offer poor prospective returns, because it is the time of year when seasonally it is difficult to lose by owning fixed-income. The chart below (source: Bloomberg) shows the average change in nominal 10-year yields over the course of a calendar year for the last 30 years (gold), 10 years (white), and 5 years (red). Note that this isn’t a pure seasonal chart because it doesn’t correct for the average drift over the course of the year, but it suffices to show that buying bonds after the early-September backup has been a good strategy for many years…really, until the last five years, and even then it was a push between mid-Sep and mid-Nov.
So what I want to do in a period of uncertainty, headed into the fourth quarter, is to own TIPS, either outright or via an ETF like TIP. If the market comes unglued, then all interest rates should decline; if the market drops because real growth is weakening, then real rates should fall more than nominal rates (and in any event, owning TIPS gives you the positive tail exposure I mentioned above). If the market turns around and rallies, then energy probably recovers somewhat and this will help TIPS compared to nominals. But in any event, I am reducing risk into a very risky period.
Money: How Much Deflation is Enough?
Once again, we see that the cure for all of the world’s ills is quantitative easing. Since there is apparently no downside to QE, it is a shame that we didn’t figure this out earlier. The S&P could have been at 200,000, rather than just 2,000, if only governments and central banks had figured out a century ago that running large deficits, combined with having a central bank purchase large amounts of that debt in the open market, was the key to rallying assets without limit.
That paragraph is obviously tongue-in-cheek, but on a narrow time-scale it really looks like it is true. The Fed pursued quantitative easing with no yet-obvious downside, and stocks blasted off to heights rarely seen before; the Bank of Japan’s QE has added 94% to the Nikkei in the slightly more than two years since Abe was elected; and today’s announcement by the ECB of a full-scale QE program boosted share values by 1-2% from Europe to the United States.
The ECB’s program, to be sure, was above expectations. Rather than the €50bln per month that had been mooted over the last couple of days with little currency-market reaction, the ECB pledged €60bln. And they promised to continue until September 2016, making the total value of QE around €1.1 trillion. (That’s about $1.3 trillion at today’s exchange rate, but of course if it works then it will be much less than $1.3 trillion at the September 2016 exchange rate). To be sure, a central bank always has the prerogative to change its mind, but on the risks of a sudden change in policy please see “Swiss National Bank”. It really is remarkable that Draghi was able to drag the Bundesbank kicking and screaming into this policy choice, and it is certain to end the threat of primary deflation in Europe just as it did in the U.S. and in Japan. It will likely also have similar effects on growth, which is to say “next to nothing.” But in Europe, deflation risks stemming from slow money growth had been a risk (see chart, source Bloomberg).
Interestingly, y/y money growth had already been accelerating as of late last year – the ECB releases M2 with a very long lag – but this puts the dot on the exclamation point. The ECB has said “enough!” There will be no core deflation in Europe.
Commodities: How Much Deflation is Enough?
Last week, in “Commodities Re-Thunk” and “Little Update on Commodities Re-Thunk”, I presented the results of using a generalization of the Erb & Harvey approach to forecast expected long-term real returns for commodities. It occurred to me that, since I have previously played with long-term real equity returns, and we have the real yield on 10-year TIPS as well, that it would be interesting to see if using these figures might produce a useful strategy for switching between assets (which doesn’t change the fact that I am a long-term investor; this is still based on long-term values. We merely want to put our assets in whatever offers the best long term value at the moment so as to maximize our expected long-term return).
The answer is yes. Now, I did a more-elegant version of what I am about to show, but the chart below shows the results of switching 100% of your assets between stocks, commodities, and TIPS based on which asset class had the highest expected real yield at a given month-end. Each line is an asset class, except for the blue line which shows the strategy result.
The labels at the top show the asset class that dominated for a long period of time. In 2005 there were a couple of quick crossovers that had little impact, but by and large there were three main periods: from 1999-2005, commodities offered excellent expected real returns; from mid-2005 through early-2008 the strategy would have been primarily in TIPS, and subsequent to that the strategy would have been primarily in equities. Fascinating to me is that the overall strategy does so well even though it would have been invested in equities throughout the crash in 2008. The crash in commodities was worse.
Now what is really interesting is that there is a vertical line at the far right-hand side of the chart. That is because at the end of December, the expected real return to commodities finally exceeded that of equities for the first time in a very long time. For this “selling out” strategy, that means you should be entirely out of stocks and TIPS and entirely in commodities.
As I said, that is the coarse version of this approach. My more-elegant version optimized the portfolio to have a constant expected risk in real terms. It was much less risky as a result (10.5% annualized monthly standard deviation compared to 15.5% for the strategy shown above), had lower turnover, but still sported returns over this period of 9.5% compounded compared to 11.2% for the strategy above. I am not, in other words, suggesting that investors put 100% of their assets in commodities. But this method (along with lots of other signals) is now suggesting that it is time to put more into commodities.
Balls: How Much Deflation is Enough?
Being a football fan, I can’t keep from weighing in on one mystery about deflate-gate (incidentally, why do we need to put ‘gate’ on the end of every scandal? It wasn’t Water-gate, it was the Watergate Hotel that proved Nixon’s undoing. “Gate” is not a modifier). Really, this part isn’t such a mystery but I have seen much commentary on this point: “How did the balls get deflated during the game since they were approved before the game?”
The answer is really simple in the real world: the official picked up one of the balls, said “fine”, and put them back in the bag. He has a million things to do before the championship game and in years of refereeing he has probably never found even one ball out of spec. This sort of error happens everywhere there are low reject rates, and it’s why good quality control is very difficult. (Now, if you fired the ref every time a bad ball got through, you damn betcha those balls would be measured with NASA-like precision – which is perhaps a bad metaphor, since similar issues contributed to the Challenger disaster). The real mystery to me is: if the Patriots truly think they are the better team, why would they cheat, even a little? As with the CHF/EUR cross that we discussed yesterday, the downside is far worse than the gain on the upside.
Or, is it? The NFL will have a chance to establish the cost of recidivism in cheating. Maybe the Patriots were simply betting that the downside “tail” to their risky behavior was fairly short. If the NFL wants to put a stop to nickel-and-dime cheats, it can do that by dropping the hammer here.