Posts Tagged ‘commodity indices’

This ‘Cycle’ Certainly Hasn’t Been Super

April 14, 2013 5 comments

Five years into the biggest money-printing exercise of all time, and commodities are (incredibly) approaching the status of being universally loathed. On Friday, gold provided a great illustration of one reason I always say that investors should have a position in diversified commodity indices. A Goldman Sachs report released a couple of days ago (with gold 20% off the highs) suggested that prices may have further to fall; more important to Friday’s rout, though, was the increase in the European assessment of how much more money Cyprus will have to raise for itself (€6bln, or about 35-40% of annual Cypriot GDP) to complete the bailout, and the speculation that Cypriot gold reserves will have to be sold.

Add to this the fact that Friday’s economic data was weak with ex-Auto Retail Sales -0.4% and the Michigan Confidence figure showing a surprising drop. Clearly, investors believe this to be a death knell for inflation (as opposed to the “death bell” – I’m not sure what that is – that Citigroup says has been sounded for the commodity supercycle).

But all of the data, and the European sovereign crisis, apparently does support rapidly rising home prices and equities at disturbing multiples of 10-year earnings!

Considering that commodities have been around far longer than equities, bonds, or even money itself, it is incredible how little understanding there is about them.

One misunderstanding, and key to understanding the current situation, is not peculiar to commodities. It is simply the common confusion of nominal and real quantities. In a nutshell, the change in any good’s nominal price over time consists of two things: a real price change, and a change in the price that recognizes that the value of the currency unit measuring stick has changed – that is, inflation. We’re familiar with this construction in the form of the Fisher equation, which tells us that nominal yields represent the combination of a real return that is the cost of money plus a premium (or, less frequently, a discount) for the expected change in the price level over the holding period. But that construction applies to all price changes.

So if the price of your ham sandwich rises 3% this year, is there a bull market in ham sandwiches? Well, in all likelihood not – it’s just that the overall price level is rising by roughly that amount. What about if the price of the ham sandwich rises by only 1%, because ham is becoming cheaper? Then we would say that there was a 2% decline in the real price of the ham sandwich, plus 3% inflation.

Now, if prices instead rose 15%, the ham sandwich in this latter scenario would not still be only rising in price by 1%. It would likely rise by 13% or so: the 15% inflation, minus the 2% decline in the real price of a ham sandwich. Even if a ham sandwich glut was forcing a 10% decline in real prices, the nominal price of a ham sandwich would still be rising in that case.

So, when groups trumpet the “end of the commodity cycle,” they seem to be confused. It is possible that they are saying that real commodity prices should decline over time, but I wonder whether their clients would be awed by that prediction since it has been the norm for hundreds of years. Moreover, if they were referring to real prices, then if CPI goes up 10% and commodity prices go up 5%, they will be right – but clients might not see it the same way.

But I don’t think that’s what they are saying. If it is, then those groups are also a bit late to the party – commodity indices, which include additional sources of return, have underperformed inflation by 28% since 2004 and are down about half from the 2008 highs. Frankly, in the chart below (Source: Bloomberg), which shows the DJ-UBS commodity index divided by the NSA CPI, I don’t see anything which looks like an up-leg of a supercycle, except perhaps the doubling from 2003-2008. Is a 100% gain over five years a “supercycle”?


Now, in the SP-GSCI, which has a much greater weight in energy, it looks plausibly like a “supercycle,” as prices tripled in real terms off the lows in 1999 (see Chart, source Bloomberg), and admittedly the chart looks a little feeble at the moment. But that difference is, as I just suggested, mostly due to energy. And if you think the energy supercycle has ended…just short energy, don’t paint all commodities with the ugly brush!


And, by the way, it seems like a pretty wimpy supercycle if the peak in real terms doesn’t even approach the earlier peak.

In nominal terms, all of these charts look different, with the downswings being dampened and the upswings accentuated, because of inflation. But that’s certainly not the right way to look at commodities (or any asset) over time. We don’t care about the nominal return. We care about the real return. And viewed through a real return lens, commodities are much closer to being really cheap than to being really rich!

Obviously, I disagree with all of these groups when it comes to commodities generally. About gold I have no firmly-held opinion about its valuation at the moment, but commodities generally we see as cheap – in fact, we expect triple the real returns from investing in commodities indices over the next ten years compared to equity investing. This is a function of both the very rich absolute valuations of equities and the very cheap absolute valuations of commodities indices.

Moreover, if inflation does in fact accelerate – something which has nothing to do with the weak Michigan or Retail Sales numbers – then commodities will also have terrific nominal returns while equities might well have negative nominal returns.

Conform Or Be Cast Out

October 22, 2012 9 comments

I like unloved assets. I can be a patient investor when I find an asset or an asset class that is unloved, but not truly loathed. When an asset class is loathed, it can take an enormous amount of time to realize value from it although if one’s horizon is long enough and one’s patience deep enough, this is where the best risk-adjusted returns are hiding. But for most of us, finding unloved assets where value is realized over a handful of years is the best we can hope for.

One of the reasons is that asset managers (ahem) tend to be a very impatient lot, and most of their clients even more so. I heard it said once that “the patience of the client is three point zero zero years,” meaning that assets whose value may take more than three years to unlock are potential poison to the asset manager’s business. This is, therefore, where investors with longer time horizons, such as family offices, foundations, and pension funds, ought to focus. The problem is that most of these institutional investors lack the expertise to analyze deep-value propositions in all of the different possible fields, so they tend to rely on sell-side analysts and buy-side firms that clearly have a vested interest in persuading them that, say, farmland is still undervalued after years of being hot, or high-tech stocks are still worth buying back in 1999 because new metrics apply.

I am continually surprised in this context by how few people “get” something as simple as commodity indices. Perhaps it’s because most people think they understand the basic idea: a commodity is something that you can feel, like corn or cattle or copper. Seems simple enough, and since these assets have no cash flows associated with them, our discounted-cash-flow-trained brains tend to view them suspiciously. “If I can’t value tech stocks, because they don’t pay a dividend,” the thought seems to run, “then how can I value commodities? If I rely on another buyer coming along to purchase it from me, isn’t this the same as holding and hoping another buyer comes along?” Deceptive similarities like this make investors treat commodities as much riskier than at root they are. The difference, of course, is that there may be value ascribed to solely because someone else will pay for it, whereas the commodity item itself has value-in-use. That is, you can grind the corn into meal, you can slaughter the cow to make hamburgers, or you can draw the copper into industrial cabling. If you’re the last buyer of, you may have nothing at all; but you will never be the last buyer of corn because there will always be Orville Redenbacher standing behind you. is much more like a dollar bill, when you think about it – it’s only worth something because someone else accepts it as being worth something. You can’t use it, per se, if you don’t like the price.

But commodities – and even worse, commodity futures – seem more ephemeral than stocks. You feel like you own something concrete when you own MF Global stock, or Lehman, or Enron, or General Motors… well, you get the point. What you own is a small part of a business that may or may not be there tomorrow, as the result of management decisions, government action, or a global financial crisis.

Now, all of this doesn’t mean that commodities are automatically undervalued. Some commodities are actually well-liked, such as gold. You either have to look at an independent measure, such as the ones we have developed that relate commodities to currency in circulation, or compare returns to some other asset class that we think we understand better.

And it is here that it becomes really obvious that commodities are really disliked. As of today, the S&P in real terms is just about exactly where it was at the end of the month Bear Stearns collapsed. Yet the DJ-UBS commodity index is still down 34% in real terms. (See chart, source Bloomberg, with 3/31/2008=100).

Equity bulls will tell you this is because stocks got cheap in 2009, and earnings rebounded with the economy. But these same people will tell you that commodities are languishing because of the risk of weak global growth. And commodities, too, were beaten up in 2009 (in fact, the DJ-UBS fell further than stocks). Where is their bounce?

The chart below shows a slightly longer time-frame, dating from roughly the lows of the post-equity-bubble bear market. You can see in this picture that these two markets move together much better, especially in the days since early 2009. The brief (oil induced) commodity bubble shows up in early 2008, but then the current period can only be called a negative commodity bubble (or, perhaps, the beginning of an equity bubble).

So I like commodities, and I like people telling me why they’re dead money. Those people are wrong, or they’re too impatient and that’s the same as wrong. By our measures, commodity indices are between 15% and 25% cheap to fair value while stocks are somewhat rich.

Is Inflation Flowering?

July 30, 2012 1 comment

To know that you’re standing before a cherry tree, you needn’t have cherries; cherry blossoms suffice. The seasons are long, so if you want to be able to harvest the fruit you need to look early for the signs.

So it is with inflation, and some would say it is with markets in general. We look for the early hints (a less-poetic scribe might call them ‘green shoots’) that signal when the season has turned. With inflation, indeed, the season has turned long ago, when core inflation bottomed in Europe, the U.S., and Japan in 2010 (and in the UK even earlier). But as we have seen, markets have not yet internalized this turning, or in some cases (as with nominal yields) have begun the recognition and then reversed it.

Consider now the humble 7.5% gain this month in the DJ-UBS commodity index (and comparably large moves in many other indices). It isn’t the size of the move, or its consistency, that is interesting to me; rather, it is that the movement has come partnered with a break of commodities’ relationship to the dollar.

Since commodities for the most part are priced in dollars, it is natural that they tend to move in the opposite direction from the greenback. When the dollar strengthens, then commodities are more expensive to non-dollar consumers, and they demand less. Yes, of course there are other factors, but when there are no stronger underlying currents then commodity indices tend to move inversely to the dollar. The chart below (Source: Bloomberg) illustrates the strong coupling of the dollar index (here inverted) and the DJ-UBS Commodity Index in yellow, both normalized to August 1st, 2011.

But note that this recent movement in commodities has come not in conjunction with a weakening in the dollar, but in spite of a strengthening (albeit a modest one) of the unit. This, I think, may be the first blossoms of spring in commodity-land.

Some may object that the rise in commodity prices is primarily driven by grains, but this is not the source of this divergence. The chart below (Source: Bloomberg) shows the dollar index again (and again inverted) against the DJ-UBS ex-Agriculture Commodity Index.

I am not a disinterested observer of the Commodity Spring, as readers well know; our models have for some time now indicated that commodities were the only outright-cheap major asset class and our main strategy has been heavily overweight them for quite a while. So perhaps I will be accused of seeing blossoms where none have yet bloomed. But as commodity indices approach their highs of the year, they are still only 14-15% off their lows, and far below their highs of a few years back. They remain the cheap asset class.


Moving to inflation more-broadly, it seems the market is growing comfortable with the notion that core inflation may have topped since it hasn’t risen appreciably in a few months. It is certainly useful for those expecting QE3 – as am I – if that perception gains currency (no irony intended) since de-fanging the hawks on the Federal Reserve Board would seem to be a sine qua non for loosening policy appreciably. But I believe that comfort is ill-placed.

I had been expecting, based on the lagged effect of the large inventory of unsold homes last year, for the housing portion of core inflation to ebb from its recent pace. It has merely flattened out, and while inventories are coming down those declines shouldn’t begin to push shelter CPI up for another quarter or two. But long-lag relationships are inherently difficult since the lags can shift over time. So let’s look at a shorter-lag relationship.

The housing component of CPI is driven by rents, both for consumers who rent their residence (“Primary Rents”) and for the consumption value of owner-occupied housing (“Owners’ Equivalent Rent” or OER). The chart below shows the relationship between OER and the CBRE index of rents on multifamily property, lagged 2 quarters (the red dot marks the last OER point). The goodness of fit of this relationship, shown for the period 2001-present in the Chart below (Source: Bloomberg and BLS), is quite reasonable[1] but interestingly, the recent rises in rents suggests that OER is significantly understated.

The number for the rental series ending in Q1 suggests that OER, which was last at 2.03% year-on-year in June, should be more like 3.4%. Since OER has a 23.5% weight in CPI and a 30.7% weight in core CPI, if OER were to converge it would be worth 0.4% on core inflation. And rental increases do not yet show much sign of ebbing. In short, the flattening out of core inflation over the last few months may represent the extent of what we can get out of housing at this point.


The last piece of evidence is really more corroboration of a speculation I’ve previously mentioned here.  The sudden revival in apparel pricing this year has caught many analysts by surprise, and most have been expecting for the series to relapse soon (the price of cotton is often blamed, as if cotton hasn’t had any previous spikes in the last twenty years). My speculation was that the flattening and declining of apparel prices beginning in the early 1990s could plausibly be related to the opening of the U.S. textile industry to global competition, but if that is true then there must eventually come a time when the globalization has run its course and there are no more gains to be had from the declining domestic labor content in apparel. Thereafter, the rise in prices going forward should reflect rising wages in the source economies, without the dilution of changing composition.

Now Morgan Stanley has published a piece, by Joachim Fels et. al., called “Margin Call” (July 25, 2012). The authors illustrate that the U.S. margins of Chinese exporters have shrunk by 20-30% between 2004 and 2010, and argue among other things that “Price increases for Chinese imports and the spillover effects these are likely to generate may contribute to meaningful upward pressure on inflation.” This is not inconsistent with my speculation above, but adds a separate potential cause for the rise in apparel prices and other China-sourced prices (significant among them, incidentally, resin prices).


All in all, these pieces of evidence contribute to my belief that as consumers we ought to take time to smell the flowers, because the harvest of cherries is likely to follow in train. And in this case, that would be the pits.

[1] The R2 should be taken with a grain of salt, however, since these are overlapping observations.

What If There Was No Cash?

July 28, 2012 7 comments

Bonds, stocks, inflation-linked bonds, commodities, real estate, MLPs, hedge funds, and cash. That is essentially the asset class universe we face as investors. Now, before reading further, think about what you would do with your investments if it were no longer possible to invest in cash, or if some aspect of “cash” made it inadvisable to hold. What would you do with your wealth that is currently sitting in money market funds?

You would clearly invest in riskier assets, since (with the exception of inflation-linked bonds held to your investing horizon) there isn’t a less-risky asset than cash in most cases. You may choose to buy a short-duration bond fund, or you might trickle some extra funds into stocks you feel are undervalued or into commodity indices that I feel are undervalued.

The reason this is a relevant thought-experiment is that the New York Fed, in a little-covered report issued last week,  has recommended that investors in money market funds be prohibited from withdrawing 100% of their funds without significant advance notice. The staff of the New York Fed recommended that 5% of an investor’s balance in a money market fund be stuck for thirty days, in order to “protect smaller investors” from the sort of runs on money funds that caused investors in the Primary Reserve Fund to lose the awesome sum of 1% of their money when Lehman obligations went bust in the worst credit crisis in a century. Furthermore, they “suggest a rule that would subordinate a portion of a redeeming shareholders MBR [what the Fed calls the “minimum balance at risk”], so that the redeemer’s MBR absorbs losses before those of non-redeemers.” In other words, if you hear that your money fund is 100% invested in Lehman 2.0 as it teeters on the edge of bankruptcy, you get to choose between taking 95% of your money out now and potentially losing the rest before anyone else loses money, or leaving it all in the fund – in which case you’ll get the second loss, but all of your money is at risk.

Clearly, the New York Fed’s suggestion is a solution in search of a problem given the historical rarity of losses and of the insignificance of those losses, but it is chilling for a couple of reasons. Reason number one is that it pretty much eliminates the main reason for holding a money market fund, which is ready access to cash. People aren’t holding assets earning 0.01%, with 2.2% inflation eating away the real value every year, because they like the return. If you tell investors that they need to have 5% of their principal at risk, and that they may have to choose a gamble between a high-likelihood loss that would be capped at 5% and a lower-likelihood loss that is capped at 100%,  the rational investors will simply leave. They may invest in short bond funds, commodity funds, or equity funds where there is much more risk, but at least their money is available with no advance notice. While this development is in a sense bullish for all other assets since it pushes potentially trillions of dollars out the risk spectrum, it isn’t clear to me that our biggest societal problem is that investors aren’t taking enough risk.

Reason number two that I hate this idea is that one destination for money market fund cash will be bank deposits. However, savings deposits are time deposits, and technically can be subject to similar sequestration. Some of the money will go into checking accounts, where it will doubtless burn a hole in many investors’ pockets. The biggest question about the inflation challenge that has been rising over the last year or two is, “how fast will velocity rise, when it rises?” If the Fed effectively forces money into checking accounts, among other things, the velocity of money will surely rise and the pace of the rebound in velocity will become that much more difficult to predict than it already is.

Speaking of velocity, Friday’s GDP figures allow us to make preliminary estimates about what M2 velocity was in Q2. The velocity of the transactional money supply last quarter fell slightly, to 1.5766 (Bloomberg calculation that closely matches my own). The pace of decline is slowing. The quarterly decline was -0.5%.

It doesn’t make a lot of sense to focus too much on quarterly wiggles, but since the big risk here is that velocity abruptly begins to rise (contributing to, rather than blunting, the rise in transactional money in terms of generating inflation) it is worth keeping in the front of our minds. Of course, velocity is a plug number so this doesn’t tell us anything we didn’t already know: we deduce it from the M, the P, and the Q. The trick is in knowing when V is turning and has turned, and as I have said before (see here, for example) there are some reasons for concern on that score.

Going back to the NY Fed study that I discussed above, here is another thought to ponder. Remember that the biggest single objection that the Fed has made against dropping the interest on excess reserves (IOER) charge is that it might damage the money market fund industry by making it impossible to preserve “the buck” if there are no instruments with yields that exceed the cost of operating the fund. And yet, this proposal puts those very same money funds precisely in the crosshairs. Personally, I think it would be just fine to have good-as-cash funds that didn’t guarantee a $1 price and indeed had a negative yield over time, so I don’t think dropping short yields would kill good-as-cash funds even if they weren’t technically money market funds because they traded on price. But changing the contract so that investors can’t get their money back immediately – that’s much worse, in my view; moreover, I don’t know why the reasoning couldn’t be extended to bond funds which are, after all, just as vulnerable to runs. That slippery slope makes me nervous.


Price action on Thursday and Friday in bonds and stocks was surely frustrating to observers of the macroeconomy. Weak economic data on Thursday and uninspiring data on Friday didn’t prevent 10-year nominal bond yields from rising 15bps (to 1.55%), real 10-year note yields yields from rising 7bps (to -0.61%), and equity prices rising 3.6% (basis the S&P). ECB President Draghi’s apparent determination to support the Euro with every tool at his disposal is mainly to credit for the mid-week about-face. The question that the markets have to consider, and Mr. Draghi as well, is the question of what that toolkit actually contains. There is some evidence that the Bundesbank doesn’t believe Mr. Draghi has quite the authority he thinks he does, and this weekend Draghi and the Bundesbank President are meeting to discuss their differences.

I think that equity markets are overvalued and are over-anticipating QE3 (although I agree that it is coming soon). There isn’t much going for stocks other than QE3, although if the Fed starts taking potshots at low-risk investing alternatives it will help them. I can come up with arguments for extending this rally further, but they all depend on a bunch of faith and a little luck. I am trimming what small equity investments I have, and raising cash allocations. Since the VIX is also quite low considering the kaleidoscope of large risks, I may also buy puts on the S&P.

The Weak Ahead?

January 31, 2012 2 comments

All in all, January wasn’t too bad. The S&P gained 4.4%. The DJ-UBS and SP-GSCI commodity indices rose 2.5% (USCI rose 4.9%). The 10y Treasury note yield fell 8bps. The yield of the July-21 TIPS fell 30bps to -0.43% – although, thanks to the roll, the current 10-year yield fell “only” 15bps.

The 10-year inflation swap rate rose 26bps to 2.53%.

So, basically, if you were long just about anything in the U.S., you made money in January. So then why was everyone so depressed? Consumer Confidence, which had been expected to rise to 68.0, instead dropped to 61.1. The “Jobs Hard to Get” subcomponent, which tends to move coincident with the Unemployment Rate, rose to 43.5 (see Chart, source Bloomberg). While that’s a 3-month high, it’s still well below the worst levels of the last few years although it should also be said that it doesn’t help the argument that Employment is on a steadily-improving trend.

Commodities prices being up is a good thing if you own commodity indices, it isn’t such a good thing if you don’t. Gasoline futures were up 7.5% over the month, and prices at the pump were up 15 cents (see Chart, source Bloomberg). Precious metals rallied 12.7%, but Industrial Metals jumped 10.9%. And I’m not saying these things are related, but M2 is up 1.3% (22.9% annualized) in the first three weeks of 2012, while European M2 rose 1.3% in December (15.2% annualized), the last data we have available.

Alas, this rising tide isn’t yet lifting all boats. The Case-Shiller Home Price Index fell -0.70%, more than expected. This takes the index perilously close to the lows from last spring, which optimists had believed were left behind us for good by summer. (The good news is that this will help restrain the inexorable rise in core inflation, so that central bankers bent on looking for an excuse to ease will probably get one if they don’t look too hard for what’s happening besides housing).

I should point out that the 61.1 reading in consumer confidence, and the weaker-than-expected Chicago Purchasing Managers’ report (60.2 vs 63.0 expected and my expectation of slightly better than that), while not cause for celebration, are also not disastrous. Taken together, they may shake the faith of economists predicting a smooth acceleration in the economy, but are not cause to reject a null hypothesis of a choppy, gradual, improvement in the economy.

That hypothesis will also not take much water if tomorrow’s ADP figure is 182k, which prior to last month’s best-ever print of 325k would have been regarded as quite respectable. Unfortunately, I suspect that there is some payback coming, and the figure will look weak. Prior to last month’s number, the prior six months had only averaged 136k. A modest improving trend to, say, 175k would suggest 150k needs still to be ‘paid back’ through revision or a shockingly low print tomorrow. I don’t expect that, but with the preponderance of the evidence on the labor market (including the Jobs Hard to Get number) indicating stability but not strength, I would be surprised if ADP exceeds expectations counting revisions.

Also out tomorrow is the ISM survey. The consensus of Bloomberg-surveyed economists is 54.5, but there’s a caveat here. The median estimate of economists who updated their estimate today after Chicago PM and after the ISM released new seasonal factors is 54.0. And frankly, that seems high. Last month’s number, which was originally reported at 53.9, has been revised downward to 53.1 and Chicago PM showed weakness. Be careful here, because a print of, say, 53.5 would look like a weak print to those who mechanically compare it to the consensus that includes stale data, but would still represent a slight strengthening trend.

I am anything but a bull on the economy at the moment, but that’s mainly because of the impending implosion of Greece and/or Portugal and/or who knows what other country. It is fair, though, to observe that the economy in the last few months is doing passably. It’s not strong enough to shrug off bad news from the Continent or meaningfully higher gasoline prices, but it’s also not collapsing. At the moment, anyway. Unfortunately, I think stocks are priced for much better than “an economy that’s not collapsing,” and are counting on the QE3 wind in their sales. Valuation is dicey here but I am reluctant to fight the Fed until the inflation numbers tick up a few more times.

After all, it doesn’t take as much hope to move the stock market as it once did. Today’s equity volume was the heaviest of the month at almost a billion shares traded on the NYSE. Note the word “almost”: the last month during which there were no pan-billion-share days was last April, but January’s volume is weak even compared to that (15.2bln shares versus 16.9bln last April). Prior to last April, I can’t find another month with no billion-share days to at least 2005 (which is the earliest data I have), and I suspect we have to go back into the 1990s to find one. Again, this isn’t very healthy.

And that’s why investors continue to flee into Treasuries and TIPS. That’s a very crowded trade at a very high price, and not a place I want to be. Bonds are in fact priced for depression. The 30-year TIPS yield has reached an all-time low of … wait for it … 0.60%. Think about that – if the economy grows at a feeble 2.1% for the next three decades, you are giving up 1.5% real growth versus just sitting around and participating pari passu in the economy.[1] With nominal 30-year bond yields at 2.94%, markets are also forecasting very weak long-term inflation.[2] Both Treasury and TIPS yields are going to go higher eventually, and not only will investors be selling them but so will the Fed, and all the while the Treasury will be trying to sell still more. I want to be on the side of the angels on that one, and am willing to risk the ‘Japan outcome’ (being carried out due to your bond short) to be short here.

[1] This isn’t technically exactly right, since TIPS are based on CPI. Since the GDP deflator is usually about 0.25% lower than CPI over time, CPI+0.6% is like PCE+0.85%. But you get the point.

[2] Again, not to get too technical, but there are two offsetting effects here. One is that breakevens (Treasury yields minus TIPS yields) isn’t the best way to look at expected inflation; inflation swaps are cleaner and don’t suffer from the funding disadvantage of being short Treasuries so they are a better indicator of inflation expectations. The offsetting effect is that the 30-year breakeven or inflation swap probably includes a risk premium due to the length of the structure – that is, you’re willing to pay a bit per year more for 30-year protection than for 10-year protection.

How To Exceed Expectations (Or At Least Keep Up)

January 11, 2012 8 comments

As we wait for something interesting to happen in the markets – or at least for some volume! – I thought I would write about a way that investors can, should they choose to, invest in a security that is directly linked to inflation expectations. Tomorrow there is useful economic data in the form of Retail Sales (Consensus: 0.3%/0.3% ex-auto) and Initial Claims (Consensus: 375k vs 372k last), although this last is subject to huge error bars because the weeks just before and just after the new year are very hard to seasonally adjust. Still, it’s data. Otherwise, the market continues to chop around with little volume and seemingly little conviction. It’s a good time to consider other approaches, so I am going to do that today.

With monetary policymakers in virtually every corner of the globe furious pumping liquidity into the world’s economies, it is no surprise that many asset markets are not cheap. Equities are expensive, although less so than they were last year; nominal bonds are terribly expensive. Inflation-linked bonds generally sport real yields below zero (out to 10 years) and insubstantial real yields beyond that. Commodities look cheap as a whole, but even though commodity indices are as diversified as equity indices many investors have a hard time putting a huge weight in commodities because of the sense that they are “risky.” Corporate inflation-linked bonds are doubly expensive, with real rates quite low and credit spreads tighter than they should be given the economic outlook. How then can an investor protect him/herself from the possibility of inflation moving higher?

I have been an advocate for commodity indices, of course, which tend to do well when real yields are low and in the early stages of inflationary surprises. But there is another way now that retail investors can fairly easily be long inflation expectations.

First, let me explain some basics. When we talk about nominal yields, such as normal Treasuries have, we recognize that they are made up of several parts. If I borrow money from you, you will first assess the real cost of money – how much more stuff do you want to have at the end of the loan, in order to convince you to defer consumption and lend me the money? That is the real interest rate. Second, you will evaluate how much less the dollars you receive from me at the end of the deal are likely to be worth, compared to the dollars you pay me at the beginning of the deal. This is an adjustment for expected inflation. There is a third adjustment, probably, that relates to the uncertainty of the real return when the nominal yield is fixed; this extra premium is called the inflation risk premium.[1] The Fisher equation is approximately:

y=r + i,

where y is the nominal yield, r is real yield, and i is expected inflation plus the risk premium. Because this latter quantity is what you need to realize if you buy an inflation-indexed bond with a real yield of r, in order to break even against a nominal investment that pays a yield of y, this is called breakeven inflation, or BEI.

This background is necessary to understand the following statement: TIPS are not “inflation-protected” in the sense that they do better when inflation rises. TIPS are real rate instruments, whose real price depends only on the real yield to maturity. The nominal value of a TIPS bond depends on the actual inflation realized over time, but this just means that a TIPS bond is immune to inflation. The real return of a TIPS bond depends only on the yield of the bond at purchase, if it is held to maturity.[2]

And so, a TIPS bond is just like a nominal bond in the sense that if its yield rises, its price falls. The Barclays Capital 1-10y TIPS Index returned 9.00% for 2011. That wasn’t because inflation was 9%, but rather it was mostly because real yields fell over the course of the year. The flip side is also true: if real yields rise, then TIPS will decline in value (although as I said, if held to maturity you will receive the real yield the bond sported when you bought it). And guess what will happen when inflation really picks up? You got it: real yields, along with nominal yields, will likely rise. While real yields should rise less than nominal yields in such a circumstance, it will not feel like “inflation protection” if your TIPS lose 9% when inflation is positive 4%.[3]

Now, I’m concerned about inflation, and while I think TIPS will beat nominal bonds handily over the next five years they may both have negative returns. I could simply short nominal bonds (and I have, via the TBF ETF), but if I am wrong – or if the Fed simply holds down nominal yields forever – that won’t produce the outcome I want. I would like to be long “i”, or inflation expectations. An institutional investor can do that by buying inflation swaps, or buying TIPS and shorting nominal bonds. A retail investor can buy a TIPS ETF (such as TIP) and short nominal bonds with a different ETF (such as TBF), but this is clunky, and since the durations may not match up well it requires a fair amount of work to get the right hedge. But there’s another way, which I will discuss in one moment.

Before I do, let me show one or two charts as context for what I have said recently. Quoting again from my week-ago comment,

It is incredible to me that with monetary conditions as accommodative, globally, as they have been in decades, inflation swaps are still nearly as cheap as they have ever been. That’s truly striking. What is the 10-year downside to a long inflation position from these levels? One-half percent per annum? Seventy-five basis points per annum? How low can inflation be over the next 10 years, especially with central banks apparently willing (and even anxious) to produce as much liquidity as is needed?

Let me provide a graphical answer to that question.

The chart below (source: Shiller and BLS) shows compounded 10-year inflation rates since the late 1800s.

Compounded inflation below 2% has been very rare since 1914, and the Fed is clearly leaning one way here.

I have drawn two lines on this chart. The vertical line indicates the date of the formation of the Federal Reserve; the horizontal line shows the current level of 10-year inflation breakevens (Treasury yields minus TIPS yields). Since the formation of the Federal Reserve, you can see that a 10-year period of inflation below 2% has been exquisitely rare, with the exception of the Depression when the Federal Reserve erred and tightened policy. So, if you are buying inflation below 2%, your realistic downside (especially with a Chairman who is acutely aware of the Fed’s failing in the Great Depression) over ten years is probably on the order of 50bps.[4]

The institution of the Federal Reserve created an institution whose purpose is to prevent deflationary depressions, and who has historically pushed prices higher – sometimes gently, and sometimes not so gently – over a long period of time. What may be surprising to see is how oftenwe have experienced periods of high inflation compared to episodes of tame inflation. While this histogram isn’t necessarily the purest way to address that question, since the periods overlap, it gives some sense for how frequent the “tails” of inflation are:

A frequency distribution breakdown of the previous chart (since 1914).

The maximum 10-year inflation rate was 8.8%, with about 30% of all observations above 5%. Note that these are not 1-year inflation numbers, but 10-year compounded inflation. The compounding matters. 2% compounded for 10 years is 21.9%. 8% compounded for 10 years is 115.9%.

This is what you’ll get if you own TIPS for 10 years. You’ll get the real yield of TIPS (currently negative out to 10 years) plus compounded inflation. If you think we can get 6% or 8% inflation, then the fact that the real yield is 0% instead of 1% isn’t that big a deal. But I would like to put on a trade that responds when inflation expectations themselves start to rise.

Deutsche Bank recently issued a pair of PowerShares exchange-traded notes (ETNs) that trade with the symbols INFL and DEFL. Information, and the prospectus, can be found at links here, here, and here. In full disclosure, I have bought some INFL for my own portfolio.

These instruments are an interesting way for retail investors to play for a potential increase in inflation expectations. The notes, which are issued by Deutsche and so are exposed to Deutsche Bank credit,[5] are designed so that they expect to rise $0.10 if inflation expectations rise 0.01% (1 basis point – I am here, and henceforward, speaking of INFL although the inverse holds for DEFL). So a 1bp rise in inflation expectations equals (if the security is at $50, as it is now) a 0.20% rise in the security’s price. Put another way, the buyer of INFL has roughly a 20 modified duration, which is pretty long for a bond-like instrument. The underlying index consists of 5-year, 10-year, and 30-year TIPS and short positions in 5-year Note, 10-year Note, and Ultra Treasury futures, in roughly the proportions TIPS are represented in the bond universe. The ETN also earns a T-Bill return and carries fees of 0.75% per annum.

The securities are supposed to maintain that 1bp=$0.10 relationship even as price rises and falls within some bounds, so that if INFL declines to $30, the modified duration rises to 33.

(Because this would eventually cause modified duration to head towards infinity as the price declines, the securities have a feature that causes the security to split if the price goes above $100 or reverse-split if the price goes below $25; however, the 1bp:$0.10 relationship would remain the same, so that if the price declines below $25 for a few days your modified duration will suddenly decline from 40 to 20; if the price rises above $100 your duration will go from 10 to 20. This is not necessarily a bad feature, since it means you will eventually get longer in a rally, but it isn’t analogous to normal convexity since with normal positive convexity you would get long in a rally, then less-long as price declined again. In this case, if price went to $100 and then reversed, you’d essentially have double the duration on the way down. So I suggest keeping a close eye on the ETN and being sure to adjust your exposure manually from time to time to remain within your risk tolerance. Having your exposure change via a split is also quintessentially unlike a normal equity’s behavior in a split, in which your exposure remains constant even though the number of shares doubles.)

There is a market-maker who presents orderly two-sided markets some $0.12 wide, or roughly 1.2bp on breakevens. That’s not bad at all – professional inflation traders don’t face markets much tighter than that. I don’t know the size commitment of the market-maker and have no direct knowledge of his dedication to maintaining these markets.

Are there warts to the structure? Sure. The weird ‘convexity’ is off-putting, although it can be managed. The float is currently smaller than I’d like (only $4mm each side at issue), although that’s true of any new ETF or ETN and I would expect it to increase over time. The use of futures instead of cash for the nominal position complicates analysis somewhat, although there is probably no easy way around it. There is an additional drag on return that comes from the financing of the long-TIPS position at LIBOR. Ordinarily, you would finance TIPS at the repo rate (about 20-40bps lower over time), and then you would earn a somewhat lower repo rate on the short Treasuries position. By selling futures, the repo rate earned on the bond short is embedded in the futures convergence, which makes it quite difficult to analyze the true total cost of the structure. The long-INFL investor earns T-Bills, plus implied repo on the futures position, minus Libor, minus fees. When T-bills are at zero and LIBOR at 0.20%, that plus the fees make the cost around 0.95% per annum. When T-Bills are at 1% and LIBOR at 1.30%, the net cost is essentially zero (1% + 1% – 1.30% – 0.75%). When T-Bills are at 2%, INFL should appreciate over time although that should be considered against your opportunity cost.[6]

Does Deutsche make money on the structure? Of course. But they make less they would with many structured notes, and these ETNs are, in my opinion, actually a useful way that retail investors can achieve a particular exposure. I don’t expect to hold this position until the ETNs mature, but with breakevens near 2% it is in my opinion a good way to bet on expectations rising over the next few months or years.


I appreciate that many of you have suggested to friends and colleagues that they follow this author – thank you very much! I also suspect that people you know may have concerns about inflation or be interested in learning more about inflation and hedging inflation, and that you can help them by introducing them to people who have something to say on the topic. I would appreciate your generous referral of these contacts of yours to our website, and would like to express my appreciation by sending a copy of my book, Maestro, My Ass!, to those of you who point people our way. (Please let your friends know that they should mention you when they fill out the contact form, so that I can know where to send my gift of thanks.) And thanks again.

[1] I say “probably” because although Fisher included the inflation risk premium in his work, it has never been clear to me why the provider of money would demand protection for the uncertainty of his real return while the user of money would not demand protection for the uncertainty of his real cost. To me, it isn’t clear which effect will dominate, and so I suspect it is entirely possible that the “inflation risk premium” can even be negative. We certainly see this phenomenon in some commodities futures curves. Anyway, since we can’t directly observe and separately trade the risk premium, it’s usually folded in with the breakeven.

[2] …unless there is sufficient deflation that the floor on the principal kicks in. This has never happened, but it adds a complexity to TIPS and requires that many statements about TIPS include the phrase “except if…”

[3] This fact leads some managers to make the false claim that “TIPS don’t hedge against inflation.” Of course they do. They hedge almost perfectly against inflation over the horizon from purchase to maturity. However, they do not hedge month-to-month or year-to-year inflation very well if they have a long time to maturity, because the short-term price change of the bond swamps the inflation accretion.

[4] Of course, past results are no guarantee of future returns. Anything can happen. 10-year inflation could go to -10%, or perhaps worse expectations could go to -10% even while inflation was rising, leading to a loss on the trade I’m about to mention. Consult your financial advisor.

[5] However, note that since the ETNs can be delivered in blocks to Deutsche on short notice, it is best thought of as short-term credit even though the notes themselves have a long maturity.

[6] I’m cuffing all of these relationships for the purposes of this column. The point is that right now the structure is about as expensive as it is going to be, and as rates rise INFL should have some positive net carry over time.

New Year’s Revolutions

If it’s January 3rd, it must be time to buy with both hands, right?

Markets leapt higher today, led by commodities. In December, managers evidently pursued a policy of buying what had worked (bonds, inflation-linked bonds) and selling what had not worked (commodities), but with a new year and a new P&L statement the money is springing back to where the opportunities are. And, while equities are not completely unattractive – they rallied today probably because that’s just what they do on Jan 3rd – in my view commodity indices are the most attractive, as I pointed out in my article “Long-Term Portfolio Projections Update” late in December.

To be sure, the increasing volume of saber-rattling in Iran helped put a bid in energy products. The Iranian regime warned U.S. warships to stay away from the Straits of Hormuz while Iran was conducting exercises, saying that they “will not repeat its warning,”while the U.S. responded that “deployment of U.S. military assets in the Persian Gulf region will continue as it has for decades.” Oil prices leapt more than $4/bbl to the highest WTI closing level since May of last year. But it would be a mistake to think that the movement in commodity indices was all about Hormuz. Agriculture was up more than 2%, Energy up 3%, Precious Metals up 4%, and Industrials and Livestock up more than 0.7%. No commodity in the DJ-UBS index declined.

Manufacturing data was decent, both the ISM (which rose to 53.9 from 52.7) as well as purchasing managers’ indices from Italy, France, Germany, and the UK, which all exceeded – albeit slightly – expectations.

Let us not forget that all of these PMIs, with the exception of the US, are also below 50. And let us also not be tricked into thinking that strong equity markets indicate that all is well with the world. This morning, a spokesman for Greece went on television to say that if Greece and the Euro Zone don’t reach an agreement on the second tranche of the bailout (some €130bln, due in March) quickly, the country will fail. Specifically, Greece would leave the Euro:

“The bailout agreement needs to be signed,” he said. “Otherwise, we will be out of the markets, out of the euro. The situation will be much worse.”

Strikingly, investors ignored this suicide threat today, but I wonder if they can continue to ignore it interminably. If everyone truly believes what the banks are saying, that a Euro breakup would be the end of organized cellular life on this planet, then Greece basically can get whatever it wants. Frankly, right now Greece and Iran share strikingly similar positions. Both can probably do what they are threatening, and so there are three questions for economic or military policymakers. (1) Do we really think the consequences are so devastating as they say? (2) Will Greece/Iran be willing to accept the consequences of their own actions, if they choose that path? And (3) given the answers to those two questions, can we bear the risk of finding out? With Iran, the answers are probably ‘no,’ ‘maybe,’ and ‘yes,’ but I am not as sure of the answers to the same three questions with Greece. Moreover, my answers would very likely be different from those of economic policymakers in Europe!

And, speaking of policymakers, the main economic event for Tuesday was the release of the FOMC minutes from the December meeting. There were some interesting tidbits in these minutes, which isn’t always true. Bond investors blanched at this phrase:

With regard to the forward guidance to be included in the statement to be released following the meeting, several members noted that the reference to mid-2013 might need to be adjusted before long.

However, it isn’t clear from the minutes exactly what that means. It may mean that, as bond investors feared, the Fed will ‘adjust’ the reference by shortening it, but this seems unlikely in the context (and because it would weaken the credibility of Fed communications if ‘at least’ turned out to mean ‘at least, maybe’). It probably means that the FOMC figures they need to eventually change to a more-vague goal, or roll the guarantee forward in some way, lest they converge on mid-2013 and be confronted with the same decision at a period of much more significance. This is one of the reasons it was dumb to make the guarantee in the first place, but policymakers apparently didn’t fully think through the ‘exit’ step.

The Fed in early December remained quite cheerful about inflation:

Inflation continued to decrease relative to earlier in the year. Indeed, the PCE price index edged down in October… Consumer prices excluding food and energy also continued to rise at a more modest pace in October than earlier in the year.

Recall that October’s figure on inflation, which the FOMC had at the time, had been a downside surprise. This may have contributed to the Committee’s optimism. But subsequent data on November prices, after the FOMC meeting was completed, showed an upside surprise in core inflation. (I discuss the release in “The Inflation Trend Is Not Yet ‘Tamed’”.)

The FOMC was more than happy to extrapolate the stabilizing and decline in headline inflation, and the brief stabilization in core. This is bad science even though it passes for okay economics in some schools: since new data can only cause a rejecting of existing hypotheses, there is no reasonable way that a one- or two-month slowing in core inflation should have caused the FOMC such elation:

Most participants anticipated that inflation would continue to moderate…Indeed, some expressed the concern that, with the persistence of considerable resource slack, inflation might run below mandate-consistent levels for some time.

Fortunately, some intelligent people were in the room too, and pointed out the incongruity of expecting resource slack to lower inflation when it clearly hasn’t done that in the last couple of years:

However, a couple of participants noted that the rate of inflation over the past year had not fallen as much as would be expected if the gap in resource utilization were large, suggesting that the level of potential output was lower than some current estimates.

Policymakers saw a lot of risk from global financial strains, and “a number” of them saw that there may be a need to ease further. Again, all of this happened before the ‘surprising’ continuation in the core inflation uptrend was made evident, so the doves may be more hawkish now. Somehow, I doubt it though.

There was also much-anticipated development in the Fed’s “communication strategy” (I can remember when they didn’t really feel they needed communication, much less a strategy). The plan at present seems to be for Members of the FOMC to publish their projections of the Fed Funds rate along with their projections of growth and inflation in the four-times-annually “Summary of Economic Projections” (SEP). This is also a bad idea, but it’s going to happen despite the adroit observation of some participants:

Some participants expressed concern that publishing information about participants’ individual policy projections could confuse the public; for example, they saw an appreciable risk that the public could mistakenly interpret participants’ projections of the target federal funds rate as signaling the Committee’s intention to follow a specific policy path rather than as indicating members’ conditional projections for the federal funds rate given their expectations regarding future economic developments.

Yes, that’s just one way in which giving this additional information has more downside than upside, but it continues a long-standing trend at the Fed towards “openness,” which is perceived to be a good but no one ever seems to actually analyze the costs and benefits. (As an aside, it illustrates the power of words. If instead of saying ‘the Fed increased its commitment to openness’ I said ‘the Fed decided to show how well or poorly it forecasts by leaking those forecasts’, we wouldn’t automatically agree that is a good thing. But the current policy is only different in that a ‘leak’ is awkward and potentially damaging information that was not supposed to be released, and this is awkward and potentially damaging information that is supposed to be released.)

On Wednesday, there is only light data being released as the ADP report has been moved to Thursday. For all the fury of today’s 1.6% rally in stocks, it was the worst NYSE composite volume for the first trading day of the year in at least a decade. Last year, 166 trading days saw less than 1bln shares traded on the NYSE. The year before, there had been 113 such trading days; in 2009 only 35. In 2011, it wasn’t until February 14th that we had a day with volume as light as it was today. That probably means that volume will grow over the next few days. But it’s just not a great way to start off a year reaching to higher prices. Now, in 2011 stocks rallied for the first six weeks of the year, hitting a high for the first quarter in … hey, look at that!…the week of February 14th.

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