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Summary of My Post-CPI Tweets (October 2019)

October 10, 2019 Leave a comment

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy. Or, sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments or Enduring Intellectual Properties (updated sites coming soon). Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • CPI day! Want to start today with a Happy Birthday to @btzucker , good friend and inflation trader extraordinaire at Barclays. And he does NOT look like he is 55.
  • We are coming off not one not two but THREE surprisingly-high core CPI prints that each rounded up to 0.3%. The question today is, will we make it four?
  • Last month, the big headliners were core goods, which jumped to 0.8% y/y – the highest in 6 years or so – and the fact that core ex-housing rose to 1.7%, also the highest in 6 years.
  • Core goods may have some downward pressure from Used Cars this month, as recent surveys have shown some softness there and we have had two strong m/m prints in the CPI, but core goods also has upward tariffs pressure, and pharma recently has been recovering some.
  • (The monetarist in me also wants to point out that we have M2 growth accelerating and near 6% y/y, and it’s also accelerating in Europe…but I also expect that declining interest rates are going to drag on money velocity. Neither of those is useful for forecasting 1 month tho)
  • Now, one thing I am NOT paying much attention to is yesterday’s soggy PPI report. There’s just not a lot of information in the broad PPI, with respect to informing a CPI forecast. I mostly ignore PPI!
  • The consensus forecast for today calls for a soft 0.2%. I don’t really object to that forecast. We are due for something other than 0.3%. But I would be surprised if we got something VERY soft. I think those 0.3%s are real.
  • Unless we get less than 0.12%, though, we won’t see core CPI decline below 2.4% (rounded). And if we get 0.222% or above, we will see it round UP to 2.5%. That’s because we are dropping off one more softish number, from Sep 2018, in the y/y.
  • Median, as a reminder, is 2.92%, the highest since late 2008. It’s going to take a lot to get back to a deflation scare, even if inflation markets are currently pricing a fairly rapid pivot lower in inflation. I don’t think they’re right. Good luck today.
  • Obviously a pretty soft CPI figure. 0.13% on core, 2.36% y/y.

  • This is not going to help the new 5yr TIPS when the auction is announced later. But let’s look at the breakdown. Core goods fell to 0.7% from 0.8%, and core services stable at 2.9%.
  • As expected, CPI-Used Cars and Trucks was soft. -1.63% m/m in fact. That actually raises the y/y slightly though, to 2.61% from 2.08%. There’s more softness ahead.

  • OER (+0.27%) and Primary rents (+0.35%) were both higher this month and the y/y increased to 3.40% and 3.83% respectively. So why was m/m so soft? Used cars is worth -0.05% or so, but we need more to offset the strong housing.
  • (Lodging away from home also rebounded this month, +2.09% m/m vs -2.08% last month).
  • Big drop in Pharma, which is surprising: -0.79% m/m, dropping y/y back to -0.31%. That’s still well off the lows of -1.64% a few months ago.
  • Core ex-shelter dropped to 1.55% y/y from 1.70% y/y. That’s still higher than it has been for a couple of years.
  • Apparel dropped -0.38% on the month. The new methodology is turning out to be more volatile than the old methodology, which is fine if apparel prices are really that volatile. I’m not sure they are. y/y for apparel back to -0.32%.
  • Yeah, apparel is just reflecting the strong dollar, but I’m still surprised that we haven’t seen more trade-tension effect.

  • So, Physicians’ services accelerated to 0.93% y/y from 0.71%. And Hospital Services roughly unchanged. Pharma as I said was down (in prescription, flat on non-prescription). Health Insurance still +18.8% y/y (was 18.6% last month).
  • A reminder that “health insurance” is a residual, and you’re likely not seeing that kind of rise in your premiums. But I suspect it means that there are other uncaptured effects that should be allocated into different medical care buckets, or perhaps this leads those movements.
  • So even with that pharma softness, overall Medical care (8.7% of the CPI) was exactly unchanged at 3.46% y/y.
  • College Tuition and Fees decelerated to 2.44% from 2.51%. But that’s mostly seasonal adjustment – really, there’s only 1 College Tuition hike every year, and it just gets smeared over 12 months. Tuition is still outpacing core, but by less.
  • Largest drops in core m/m were Women’s/Girls’ apparel(-18.7% annualized), Used Cars & Trucks(-17.9%), Infants’/Toddlers’ apparel(-13.4%), Misc Personal Goods(-12.1%), and Jewelry/Watches (-11.9%). Biggest gainers: Lodging away from home(+28.1%) & Men’s/Boys’ Apparel.(+25.5%)
  • Here’s the thing. Median? It’s a little hard to tell because the median categories look like the regional housing indices, but I think it won’t be lower than +0.25% unless my seasonal is way off. And that will put y/y Median CPI at 3%.

  • The big difference between the monthly median and core figures is because the core is an average, and this month that average has a lot of tail categories on the low side while the middle didn’t move much.
  • That’s why, when you look at the core CPI this month, there’s nothing that really jumps out (other than used cars) as being impactful. You have moves by volatile components, but small ones like jewelry and watches or Personal Care Products.
  • Here is OER, in housing, versus our forecast. There’s no real slowdown happening here yet, and that’s going to keep core elevated for a while unless non-housing just collapses. And there’s no sign of that – core ex-housing, as I noted, is still around 1.4%.

  • So, this is a fun chart. In white is the median CPI, nearing the highs from the mid-90s, early 2000s, and late 2000s. Now compare to the 5y Treasury yield in purple. Last time Median was near this level, 5s were 3-4%.

  • Another fun chart. Inflation swaps vs Median CPI. Not sure I’ve ever seen a wider spread. Boy are investors bearish on inflation.

  • Here is the distribution of inflation rates, by low-level components. You can see the long tails to the downside that are keeping core lower than where “most” prices are going. So inflation swaps aren’t as wrong as median makes them look…if the tails persist. Not sure?

  • So four pieces: food & energy, about 21% of CPI.

  • Core goods, about 19%. Backed off some, but still an important story.

  • Core services less rent of shelter. About 27% of CPI. And right now, meandering. Real question is whether rise in health care inflation is going to pass through eventually to other components or if it is transitory. If the former, there’s a big potential upside here.

  • And rent of shelter, about 33% of CPI. As noted, this ought to decelerate some, but no real indication it’s about to collapse. And you can’t get MUCH lower inflation unless it rolls over fairly hard.

  • Really, the summary today is that there isn’t anything that looks like a sea change here. Most prices continue to accelerate. Now, next month the comparison is harder as Oct 2018 core was +0.196%. Month after was +0.235%. So some harder comps coming for core.
  • That said, I continue to think that we’ll see steady to higher inflation for the balance of this year with an interim peak coming probably Q1-Q2 of next year. But the ensuing trough won’t be much of a trough, and the next peak will be higher.
  • That’s all for today. Thanks for tuning in.

I don’t think there is anything in this report that should change any minds. The Fed ought to be giving inflation more credit and be more hesitant to be cutting rates, but they are focused on the wrong indicator (core PCE) and, after all, don’t really want to be the guys spoiling the party. I think they’ll be slow, but we’re entering a recession (if we’re not already in one) and since the Federal Reserve utterly believes that growth causes inflation, they will tend to ignore a continued rise in inflation as being transitory. Since they said it was transitory when it dipped a couple of years ago – and it really was – they will be perceived as having some credibility…but back then, there really was some reason to think that the dip was transitory (the weird cell phone inflation glitch, among them), and there’s no real sign right now that this increase in inflation is transitory.

Yes, I think inflation will peak in the first half of 2020, but I’m not looking for a massive deceleration from there. Indeed, given how low core PCE is relative to better measures of inflation, it’s entirely possible that it barely declines while things like Median and Sticky decelerate some. Again, I’m not looking for inflation or, for that matter, anything that would validate the very low inflation expectations embedded in market prices. The inflation swaps market is pricing something like 1.5% core inflation for the next 8 years. Core inflation is currently almost a full percentage point higher, and unlikely to decline to that level any time soon! And breakevens are even lower, so that if you think core inflation is going to average at least 1.25% for the next 10 years, you should own inflation-linked bonds rather than nominal Treasuries. I know that everyone hates TIPS right now, and everyone will tell you you’re crazy because “inflation isn’t going to go up.” If they’re right, you don’t lose anything, or very little; if they’re wrong, you have the last laugh. And much better performance.

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The Neatest Idea Ever for Reducing the Fed’s Balance Sheet

September 19, 2018 14 comments

I mentioned a week and a half ago that I’d had a “really cool” idea that I had mentioned to a member of the Fed’s Open Market Desk, and I promised to write about it soon. “It’s an idea that would simultaneously be really helpful for investors and help the Fed reduce a balance sheet that they claim to be happy with but we all really know they wish they could reduce.” First, some background.

It is currently not possible to directly access any inflation index other than headline inflation (in any country that has inflation-linked bonds, aka ILBs). Yet, many of the concerns that people have do not involve general inflation, of the sort that describes increases in the cost of living and erodes real investment returns (hint – people should care, more than they do, about inflation), but about more precise exposures. For examples, many parents care greatly about the inflation in the price of college tuition, which is why we developed a college tuition inflation proxy hedge which S&P launched last year as the “S&P Target Tuition Inflation Index.” But so far, that’s really the only subcomponent you can easily access (or will, once someone launches an investment product tied to the index), and it is only an approximate hedge.

This lack has been apparent since literally the beginning. CPI inflation derivatives started trading in 2003 (I traded the first USCPI swap in the interbank broker market), and in February 2004 I gave a speech at a Barclays inflation conference promising that inflation components would be tradeable in five years.

I just didn’t say five years from when.

We’ve made little progress since then, although not for lack of trying. Wall Street can’t handle the “basis risks,” management of which are a bad use of capital for banks. Another possible approach involves mimicking the way that TIGRs (and CATS and LIONs), the precursors to the Treasury’s STRIPS program, allowed investors to access Treasury bonds in a zero coupon form even though the Treasury didn’t issue zero coupon bonds. With the TIGR program, Merrill Lynch would put normal Treasury bonds into a trust and then issue receipts that entitled the buyer to particular cash flows of that bond. The sum of all of the receipts equaled the bond, and the trust simply allowed Merrill to disperse the ownership of particular cash flows. In 1986, the Treasury wised up and realized that they could issue separate CUSIPs for each cash flow and make them naturally strippable, and TIGRs were no longer necessary.

A similar approach was used with CDOs (Collateralized Debt Obligations). A collection of corporate bonds was put into a trust[1], and certificates issued that entitled the buyer to the first X% of the cash flows, the next Y%, and so on until 100% of the cash flows were accounted for. Since the security at the top of the ‘waterfall’ got paid off first, it had a very good rating since even if some of the securities in the trust went bust, that wouldn’t affect the top tranche. The next tranche was lower-rated and higher-yielding, and so on. It turns out that with some (as it happens, somewhat heroic) assumptions about the lack of correlation of credit defaults, such a CDO would produce a very large AAA-rated piece, a somewhat smaller AA-rated piece, and only a small amount of sludge at the bottom.

So, in 2004 I thought “why don’t we do this for TIPS? Only the coupons would be tied to particular subcomponents. If I have 100% CPI, that’s really 42% housing, 3% Apparel, 9% Medical, and so on, adding up to 100%. We will call them ‘Barclays Real Accreting-Inflation Notes,’ or ‘BRAINs’, so that I can hear salespeople tell their clients that they need to get some BRAINs.” A chart of what that would look like appears below. Before reading onward, see if you can figure out why we never had BRAINs.

When I was discussing CDOs above, you may notice that the largest piece was the AAA piece, which was a really popular piece, and the sludge was a really small piece at the bottom. So the bank would find someone who would buy the sludge, and once they found someone who wanted that risk they could quickly put the rest of the structure together and sell the pieces that were in high-demand. But with BRAINs, the most valuable pieces were things like Education, and Medical Care…pretty small pieces, and the sludge was “Food and Beverages” or “Transportation” or, heaven forbid, “Other goods and services.” When you create this structure, you first need to find someone who wants to buy a bunch of big boring pieces so you can sell the small exciting pieces. That’s a lot harder. And if you don’t do that, the bank ends up holding Recreation inflation, and they don’t really enjoy eating BRAINs. Even the zombie banks.

Now we get to the really cool part.

So the Fed holds about $115.6 billion TIPS, along with trillions of other Treasury securities. And they really can’t sell these securities to reduce their balance sheet, because it would completely crater the market. Although the Fed makes brave noises about how they know they can sell these securities and it really wouldn’t hurt the market, they just have decided they don’t want to…we all know that’s baloney. The whole reason that no one really objected to QE2 and QE3 was that the Fed said it was only temporary, after all…

So here’s the idea. The Fed can’t sell $115bln of TIPS because it would crush the market. But they could easily sell $115bln of BRAINs (I guess Barclays wouldn’t be involved, which is sad, because the Fed as issuer makes this FRAINs, which makes no sense), and if they ended up holding “Other Goods and Services” would they really care? The basis risk that a bank hates is nothing to the Fed, and the Fed need hold no capital against the tracking error. But if they were able to distribute, say, 60% of these securities they would have shrunk the balance sheet by about $70 billion…and not only would this probably not affect the TIPS market – Apparel inflation isn’t really a good substitute for headline CPI – it would likely have the large positive effect of jump-starting a really important market: the market for inflation subcomponents.

And all I ask is a single basis point for the idea!


[1] This was eventually done through derivatives with no explicit trust needed…and I mean that in the totally ironic way that you could read it.

Alternative Risk Premia in Inflation Markets

July 25, 2018 1 comment

I’m going to wade into the question of ‘alternative risk premia’ today, and discuss how this applies to markets where I ply my trade.

When people talk about ‘alternative risk premia,’ they mean one of two things. They’re sort of the same thing, but the former meaning is more precise.

  1. A security’s return consists of market beta (whatever that means – it is a little more complex than it sounds) and ‘alpha’, which is the return not explained by the market beta. If rx is the security return and rm is the market return, classically alpha isThe problem is that most of that ‘alpha’ isn’t really alpha but results from model under-specification. For example, thanks to Fama and French we have known for a long time that small cap stocks tend to add “extra” return that is not explained by their betas. But that isn’t alpha – it is a beta exposure to another factor that wasn’t in the original model. Ergo, if “SMB” is how we designate the performance of small stocks minus big stocks, a better model isWell, obviously it doesn’t stop there. But the ‘alpha’ that you find for your strategy/investments depends critically on what model you’re using and which factors – aka “alternative risk premia” – you’re including. At some level, we don’t really know whether alpha really exists, or whether systematic alpha just means that we haven’t identified all of the factors. But these days it is de rigeur to say “let’s pay very little in fees for market beta; pay small fees for easy-to-access risk premia that we proactively decide to add to the portfolio (overweighting value stocks, for example), pay higher fees for harder-to-access risk premia that we want, and pay a lot in fees for true alpha…but we don’t really think that exists.” Of course, in other people’s mouths (mostly marketers) “alternative risk premia that you should add to your portfolio” just means…
  2. Whatever secret sauce we’re peddling, which provides returns you can’t get elsewhere.

So there’s nothing really mysterious about the search for ‘alternative risk premia’, and they’re not at all new. Yesteryear’s search for alpha is the same as today’s search for ‘alternative risk premia’, but the manager who wants to earn a high fee needs to explain why he can add actual alpha over not just the market beta, but the explainable ‘alternative risk premia’. If your long-short equity fund is basically long small cap stocks and short a beta-weighted amount of large-cap stocks, you’re probably not going to get paid much.

For many years, I’ve been using the following schematic to explain why certain sources of alpha are more or less valuable than others. The question comes down to the source of alpha, after you have stripped out the explainable ‘alternative risk premia’.

As an investor, you want to figure out where this manager’s skill is coming from: is it from theoretical errors, such as when some guys in Chicago discovered that the bond futures contract price did not incorporate the value of delivery options that accrued to the contract short, and harvested alpha for the better part of two decades before that opportunity closed? Or is it because Joe the trader is really a great trader and just has the market’s number? You want more of the former, which have high information ratios, are very persistent…but don’t come around that much. You shouldn’t be very confident in the latter, which seem to be all over the place but don’t tend to last very long and are really hard to prove. (I’ve been waiting for a long time to see the approach to fees suggested here in a 2008 Financial Analysts’ Journal article implemented.)

I care about this distinction because in the markets I traffic in, there are significant dislocations and some big honking theoretical errors that appear from time to time. I should hasten to say that in what follows, I will mention some results for strategies that we have designed at Enduring Intellectual Properties and/or manage via Enduring Investments, but this article should not be construed as an offer to sell any security or fund nor a solicitation of an offer to buy any security or fund.

  • Let’s start with something very simple. Here is a chart of the first-derivative of the CPI swaps curve – that is, the one-year inflation swap, x-years forward (so a 1y, 1y forward; a 1y, 2y forward; a 1y, 3y forward, and so on). In developed markets like LIBOR, not only is the curve itself smooth but the forwards derived from that curve are also smooth. But this is not the case with CPI swaps.[1]

  • I’ve also documented in this column from time to time the fact that inflation markets exaggerate the importance of near-term carry, so that big rallies in energy prices not only affect near-term breakevens and inflation swaps but also long-dated breakevens and inflation swaps, even though energy prices are largely mean-reverting.
  • We’ve in the past (although not in this column) identified times when the implied volatility of core inflation was actually larger than the implied volatility of nominal rates…which outcome, while possible, is pretty unlikely.
  • Back in 2009, we spoke to investors about the fact that corporate inflation bonds (which are structured very differently than TIPS and so are hard to analyze) were so cheap that for a while you could assemble a portfolio of these bonds, hedge out the credit, and still realize a CPI+5% yield at time when similar-maturity TIPS were yielding CPI+1%.
  • One of my favorite arbs available to retail investors was in 2012, when I-series savings bonds from the US Treasury sported yields nearly 2% above what was available to institutional investors in TIPS.

But aside from one-off trades, there are also systematic strategies. If a systematic strategy can be designed that produces excess returns both in- and out- of sample, it is at least worth asking whether there’s ‘alpha’ (or undiscovered/unexploited ‘alternative risk premia’) here. All three of the strategies below use only liquid markets – the first one, only commodity futures; the second one, only global sovereign inflation bonds; and the third one, only US TIPS and US nominal Treasuries. The first two are ‘long only’ strategies that systematically rebalance monthly and choose from the same securities that appear in the benchmark comparison. (Beyond that, this public post obviously needs to keep methods undisclosed!). And also, please note that past results are no indication of future returns! I am trying to make the general point that there are interesting risk factors/alphas here, and not the specific point about these strategies per se.

  • Our Enduring Dynamic Commodity Index is illustrated below. It’s more volatile, but not lots more volatile: 17.3% standard deviation compared to 16.1% for the Bloomberg Commodity Index.

That’s the most-impressive looking chart, but that’s because it represents commodity markets that have lots of volatility and, therefore, offer lots of opportunities.

  • Our Global Inflation Bond strategy is unlevered and uses only the bonds that are included in the Bloomberg-Barclays Global ILB index. It limits the allowable overweights on smaller markets so that it isn’t a “small market” effect that we are capturing here. According to the theory that drives the model, a significant part of any country’s domestic inflation is sourced globally and therefore not all of the price behavior of any given market is relevant to the cross-border decision. And that’s all I’m going to say about that.

  • Finally, here is a simple strategy that is derived from a very simple model of the relationship between real and nominal Treasuries to conclude whether TIPS are appropriately priced. The performance is not outlandish, and there’s a 20% decline in the data, but there’s also only one strategy highlighted here – and it beats the HFR Global Hedge Fund Index.

I come not to bury other strategies but to praise them. There are good strategies in various markets that deliver ‘alternative risk premia’ in the first sense enumerated above, and it is a good thing that investors are extending their understanding beyond conventional beta as they assemble portfolios. I believe that there are also strategies in various markets which deliver ‘alternative risk premia’ that are harder to access because they require rarer expertise. Finally, I believe that there are strategies – but these are very rare, and getting rarer – which deliver true alpha that derives from theoretical errors or systematic imbalances. I think that as a source of a relatively unexploited ‘alternative risk premium’ and a potential source of unique alphas, the inflation and commodity markets still contain quite a few useful nuggets.


[1] I am not necessarily claiming that this can be exploited easily right now, but the curve has had such imperfections for more than a decade – and sometimes, it’s exploitable.

Categories: Good One, Investing, Theory, TIPS Tags:

Forward Inflation is Nothing to be Alarmed About (Yet)

February 1, 2018 2 comments

Note: my articles are now released about 8 hours earlier on the blog site and on my private Twitter feed @inflation_guyPV, which you can sign up for here, than they are released on my ‘regular’ Twitter feed.


It’s time to get a little wonky on inflation.

Recently, I saw a chart that illustrated that 5y, 5y forward inflation – “what the Fed watches” – had recently risen to multi-year highs. While a true statement, that chart obscures a couple of important facts that are either useful, or interesting, or both. Although probably just interesting.

First, the fact that 5y, 5y forward inflation (for the non-bond people out there, this is the rate that is implied from the market for 5-year inflation expectations starting 5 years from now) has recently gone to new highs is interesting, but 5y5y breakevens are still at only 2.20% or so. Historically, the Fed has been comfortable with forward inflation (from breakevens) around 2.50%-2.75% even though its own target is 2% on core PCE (which works out to be something like 2.25%-2.35% on core CPI). That’s because yield curves are typically upward-sloping; in particular, inflation risk ought to trade with a forward premium because the inflation process exhibits momentum and so inflation has long tails. Ergo, long-dated inflation protection is much more valuable than shorter-dated inflation protection, not just because there is more uncertainty about the future but because the value of that option increases with time-to-maturity just like any option…but actually moreso since inflation is not naturally mean-reverting, unlike most financial products on which options are struck.

[As an aside, the fact that longer-term inflation protection is much more valuable than shorter-term inflation protection is one of the reasons it is so curious that the Treasury keeps wanting to add to the supply of 5-year TIPS, as it just announced it intends to do, even though the 5-year auction is usually the worst TIPS auction because not many people really care about 5 year inflation. On the other hand, 10-year TIPS auctions usually do pretty well and 30-year TIPS auctions often stop through the screens, because that’s very valuable protection and there isn’t enough of it.]

A second interesting point about 5y5y inflation is that it is only at recent highs if you measure it with breakevens. If you measure it with inflation swaps, forward inflation is still 10bps or so short of the 2016 highs (see chart, source Bloomberg and Enduring Investments calculations).

This chart also illustrates something else that is really important: actual 5y5y forward inflation expectations are up around 2.40%, not down at 2.20%. Inflation swaps are a much better way to measure inflation expectations because they do not suffer from some of the big problems that bond-based breakevens have. For example:

  1. The inflation swaps market is always trading a clean 5-year maturity swap and a clean 10-year maturity swap. By contrast, the ’10-year note’ is a 10-year note for only one day, but remains the on-the-run 10-year note until a new one is auctioned.
  2. The 5-year breakeven consists of a “5-year” TIPS bond and a “5-year” Treasury, even though these may have different maturities. They are always close, but not exact, and the duration of the TIPS bond changes at a different rate as time passes than the duration of the Treasury. In other words, the matching bonds for the breakeven don’t match very well.
  3. A minor quantitative point is that the “breakeven” is typically taken as the difference between the nominal Treasury yield and the real TIPS yield, but since the Fisher equation says (1+n) = (1+r)(1+i), the breakeven (i in this notation) should actually be (1+n)/(1+r)-1. At low yields this is a small error, but the error changes with the level of yields.
  4. A more important quantitative point is that the nominal bond’s yield not only has real rates and expected inflation, but also a risk premium which is unobservable. So, in the construction above, I ignored the fact that the Fisher equation is actually (1+n)=(1+r)(1+i)(1+p), with the breakeven therefore representing both the i and the p. Inflation swaps, on the other hand, represent pure inflation.
  5. But then why is the inflation swap always higher than the breakeven? This is the biggest point of all: the breakeven is created by buying a TIPS bond and shorting a nominal Treasury security. Shorting the Treasury security involves borrowing the bond and lending money in the financing markets; because nominal Treasuries are coveted collateral – especially the on-the-run security used for the breakeven – they very often trade at “special” rates in the financing markets. As a result, nominal Treasury yields are ‘too low’ by the value of this financing advantage, which means in turn that the breakeven is too low. If TIPS also traded “special” at similar rates, then this would be less important as it would average out. However, TIPS almost never trade special and in particular, they don’t trade as deep specials. Consequently, breakevens calculated as the spread between a TIPS bond and nominal bond understate actual inflation expectations.[1]

This is all a very windy way to say this: ignore 5y5y forward breakevens and focus on 5y5y forward inflation swaps. Historically the Fed is comfortable with that up around 2.75%-3.25%, although that’s probably partly because they are iffy on bond math. In any case, there is nothing the slightest bit alarming about the current level of forward inflation expectations; indeed, central bankers had much more cause to be alarmed when forward inflation expectations were down around 1.50% – implying that investors had no confidence that the Fed could get within 50bps of its own stated target when given half a decade to do it – than where they are now.

But check with me again in 50bps!


[1] This is widely known, although I think I get the credit for being the first person to point it out in 2006, only two years after the inflation swaps market in the US got started. I figured it out because I was a market maker in swaps and when I was paying inflation in the swap, and receiving a fixed rate higher than the breakeven, and hedged with the breakeven, I was breaking even. The answer was in the financing. I formalized my argument in this paper although my original article was credited and cited in this much more widely read article by Fleckenstein, Longstaff, and Lustig. But the bottom line is that as the Dothraki say, ‘it is known.’

Gold and TIPS – Related or Not?

September 27, 2017 6 comments

Because I spend so much time digging into inflation data and learning about how inflation works (and how securities and markets work, in different inflation regimes), I am always delighted when I come across something new, especially something simple and new that I could have previously stumbled on, but didn’t.

Recently, a friend sent me a link to an article by Scott Grannis (aka Calafia Beach Pundit). I occasionally read Scott’s stuff, and find it to be good quality. I’m not writing this article to either criticize or support most of his column, but rather to point to one particular chart he ran that amazed me. Specifically, he showed the 5-year TIPS yield against the nominal price of gold. Here is his chart:

He also showed the price of gold versus TIPS on a longer-term basis. I’ve replicated that here, although I’ve deflated gold by the CPI since the longer the time frame, the less the nominal price of gold will resemble its real price. It’s still basically the same picture:

This is an amazing chart, even allowing for the divergence in the 2000s (which some people would call prima facie evidence that the Fed eased too much back then). And it just tickles me because I’ve never noticed the correlation at all, and yet it’s really quite good. But here’s the really amazing part: there is no immediately obvious reason these two series should be related at all.

One of them is a price index. In Scott’s version, which isn’t adjusted for inflation, it should march upward to the right forever as long as the general price level continues to rise. Obviously, real yields will not march ever lower forever. When we adjust for the general level of prices, the real price of gold should, like real yields, oscillate (since the long-term real return to gold is approximately zero) so we have removed the tendency for nominal prices (unlike yields) to have a natural drift. But even in real terms, apples-to-apples, it’s an astonishing chart. What this chart seems to say is that when expected growth is poor, gold is worth more and when expected growth is strong, gold is less valuable. But that seems a bit crazy to me.

Okay, one possible interpretation is this: when expected returns from other asset classes such as stocks and bonds and inflation-linked bonds are low, then the expected return from gold should also be low, which means its price should be high. That makes sense, although it is hard to find many gold investors who think as I do that the expected forward-looking real return to gold right now is negative. Heck, I wrote about that last month (see “The Gold Price is Not ‘Too Low’”). It makes some sense, though. But the implication is that as inflation rises, and yields – both real and nominal – rise, then gold prices should fall. I think you’d discover it difficult to find an investor in gold who would think the gold price should fall if inflation picks up!

Where you would think to see more of a relationship is in inflation expectations versus gold. When inflation expectations are high, you’d think you would see gold prices high and vice-versa. But that chart has really nothing suggestive at all, possibly since inflation expectations have really been fairly grounded for the last twenty years. Gold prices, however, have not!

So going back to the original Grannis chart, I am still very suspicious. Fortunately, some time ago we developed a very long history of real interest rates, using a more advanced approach than had previously been applied (you can see the long-term series in this article). That series is derived, rather than observed as the TIPS series is, but it’s probably pretty close to where TIPS yields might have traded had they existed during that period. And when we look at real gold prices versus 5y TIPS yields…

…we get a pretty disappointing chart. What I see is that in the 1970s and early 1980s, high gold prices were associated with high real yields; in the 2000s and 2010s, a high gold price was associated with low real yields.

So, this is a bit of a bummer in one sense but a relief in another sense. That initial chart suggested some very weird dynamics happening between real yields, inflation expectations, and the price of a real commodity. I think this latter chart indicates that the relationship we saw was not some fundamental previously-undiscovered truth – sadly, I guess – but rather something more prosaic: an illustration of how the relative values of all assets tend to move more or less together. TIPS are expensive. Bonds are expensive. Stocks are expensive. Gold is expensive. Unfortunately, I don’t think that tells us a lot that we didn’t already know (although I have strong opinions about the relative ordering of the richness/cheapness of those asset classes).

Categories: Commodities, Gold, TIPS

Inflation-Linked Bonds: For the Wary, but the “Wise?”

Only a quick article at the moment. This is longer than a tweet-length answer, but didn’t need to be super long.

A friend sent me the link to the following article from the FT:

Will UK inflation-linked bonds be the choice of the wise?

I must confess I don’t know about the answer to that question, although it is true that UK linkers – especially long linkers – are perennially rich thanks to pension fund demand. Below is a chart (source: Enduring Investments) that shows our analytical rich/cheap series for 10-year UK linkers.

But the article also includes a common gripe about inflation-linked bonds that isn’t really fair, and should be addressed. The argument is that inflation-linked bonds don’t really protect against inflation, because changes in real yields are much more impactful to the return than are changes in inflation.

This is true. It is also true that changes in nominal yields are much more impactful to the return of nominal bonds than is the coupon rate or yield on the bond. If you buy a 10-year Treasury yielding, say, 3%, and hold it for two years, you will most likely get a return quite a bit different from 3% because changes in the yield-to-maturity over that period overwhelms the yield of the bond (especially now). You only get 3% if you hold to maturity. (Well, technically you get 3% if you hold for a period equal to the Macaulay duration, but that’s a discussion for another time.)

So it isn’t fair to criticize inflation-linked bonds for not being an inflation hedge over every time period. As with nominal bonds, they are a perfect inflation hedge if held to the proper horizon, and a less-than-perfect hedge over different time periods.

However, you shouldn’t be trying to hedge inflation over the next week or month. You should be trying to hedge inflation over the long term. Accordingly, the fact that returns vary due to changes in real yields is not a damning fact about linkers. Unless, of course, you’re a highly levered participant.

Categories: Bond Market, Quick One, Theory, TIPS, UK

Inflation Trading is Not for the Weak

June 27, 2017 1 comment

I was prepared today to write a column about horse racing and value investing…that will have to wait until tomorrow…when this article was sent to me by about a dozen people:

Deutsche Bank Said to Face Possible $60 Million Derivative Loss

The article was sent my way because the loss was tied to a trade that used US dollar inflation derivatives, and since that’s a market I basically started back in 2003 folks figured I might want to know. And I do.

The inflation derivatives market is not huge. The chart below shows rolling 12-month inflation derivative volumes (source: BGC Partners) through last September, which was the last time I went looking for the data for a presentation. Total interbank volumes are around $10-15bln per month; customer volumes are not included here but are not insignificant (any more).

Most inflation books, especially these Volcker Rule days, are run pretty close to the vest. Most of these volumes will be set against customer flows, or against bond breakevens, or against other positions on the inflation curve. Net risk positions for any derivative book, especially these days, are pretty small…which is why Deutsche is investigating whether risk limits were breached in this case. In principle this should be easy to figure out, since DB and every other bank has risk control specialists whose job it is to monitor these risks.

But inflation risks are complex. Our firm breaks fixed-income risks down into six basis risks that add up to the net risk of a bond. For a TIPS bond, there is just one risk; for a corporate bond there will be six. Our risk schematic starts from real rate risks and builds up – unlike in most risk systems, which start with nominal risks and try to force real bonds to fit. Inflation-linked derivatives also have commodity deltas implied, since they are tied to headline inflation and headline inflation is tied largely to energy prices. Geez, I could write a book on this – it would be a combination of “Inflation Risks and Products[1] and, in this case, “Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports.”

Suffice it to say that even really sharp investors don’t always quite get it when it comes to inflation. In early 2014, a prestigious investment management firm took a multi-billion-dollar bath on a “risk-parity” product that hadn’t truly understood how to figure out the risks of TIPS. How much more difficult, then, is it for risk control officers, many of whom have shiny new Ph.D.s and very little direct market experience? A fast-talking trader who knows something about the product can, if he is unscrupulous, persuade risk control that he is not really taking risks that he knows, or ought to know, he is taking.

In short, I am sympathetic with the risk control guys in this case. They were probably outgunned by a slick operator pushing the limits of his limits. It’s almost assuredly the case: the market, as large as it is, is too small in the Volcker Rule era to allow the accumulation of a prudent position of large enough size to cause this sort of loss – especially in the recent period of exceptionally low market volatility.

This, then, is an object lesson: if you’re running inflation risk, and you think it’s pretty much like running nominal rate risk – you’re wrong, and you should get help before your firm’s name is the one in the Bloomberg article.[2]

Tomorrow, we can talk about horse racing.

[1] In which I co-wrote a chapter, on commodities actually, with Bob Greer.

[2] To be fair, in this case the problem was the combination of ignorance and what appears to be malfeasance. If you’re careful with your control structures and only hire high-quality people of sterling reputation, you shouldn’t have a problem with the second part of this formula.

Categories: Bond Market, TIPS, Trading
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