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The Answer is No

February 18, 2015 2 comments

What a shock! The Federal Reserve as currently constituted is dovish!

It has really amazed me in recent months to see the great confidence exuded by Wall Street economists who were predicting the Fed will begin tightening by mid-year. While a tightening of policy is desperately needed – and indeed, an actual tightening of policy rather than a rate-hike, which would do many bad things but not much good – I was surprised to see economists buying the line being put out by Fed speakers on this (and I took issue with it, just last week).

Yes, the Fed would like us to believe that they stand sentinel over the possibility of overstaying their welcome. Their speeches endeavor to give this impression. But it is easy to say such a thing, and to believe that it should be said, and a different thing altogether to actually do it. Given that the Fed’s “preferred” inflation measure is foundering; market-based measures of inflation expectations were in steady decline until mid-January; the dollar is very strong and global economic growth quite weak; and other central banks uniformly loose, in my view it seemed that it would have required a historically hawkish Federal Reserve to stay the course on a mid-year hiking of rates. Something on the order of a Volcker Fed.

Which this ain’t.

Today the minutes from the end-of-January FOMC meeting were released and they were decidedly unconvincing when it comes to steaming full-ahead towards tightening policy. There was a fairly lengthy discussion of the “sizable decline in market-based measures of inflation compensation that had been observed over the past year and continued over the intermeeting period.” The minutes noted that “Participants generally agreed that the behavior of market-based measures of inflation compensation needed to be monitored closely.”

This is a short-term issue. 10-year breakevens bottomed in mid-January, and are nearly 25bps off the lows (see chart, source Bloomberg).

10ybe

To be sure, much of this reflects the rebound in energy quotes; 5-year implied core inflation is still only 1.54%, which is far too low. But we are unlikely to see those lows in breakevens again. Within a couple of months, 10-year breakevens will be back above 2% (versus 1.72% now). But this isn’t really the point at the moment; the point is that we shouldn’t be surprised that a dovish FOMC takes note of sharp declines in inflation expectations and uses it as an excuse to walk back the tightening chatter.

The minutes also focused on core inflation:

“Several participants saw the continuing weakness of core inflation measures as a concern. In addition, a few participants suggested that the weakness of nominal wage growth indicated that core and headline inflation could take longer to return to 2 percent than the Committee anticipated.”

As I have pointed out on numerous occasions, core inflation is simply the wrong way to measure the central tendency of inflation right now. It isn’t that median inflation is just higher, it’s that it is better in that it marginalizes the outliers. As I pointed out in the article last Thursday, Dallas Fed President Fisher seemed to be humming this tune as well, by focusing on “trimmed-mean.” In short, ex-energy inflation hasn’t been experiencing “continuing weakness.” Median inflation is near the highs. Core has been dragged down by Apparel, Education and Communication, and New and used motor vehicles, and these (specifically the information processing part of Education and Communication, not the College Tuition part!) are among the categories most impacted by dollar strength. Unless you expect dramatic further dollar strengthening – and remember, one year ago there were still many people who were bracing for a dollar plunge – you can’t count on these categories continuing to drag down core CPI.

Again, this isn’t the current point. Whether or not core inflation heads higher from here to converge with median inflation (which I expect to head higher as well), and whether or not inflation expectations rise as I am fairly confident they will do over the next few months, the question was whether a Fed looking at this data was likely to be gung-ho to tighten policy in the near-term. The answer was no. The answer is no. And until that data changes in the direction I expect it to, the answer will be no.

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Pre-packaged Baloney

January 28, 2015 Leave a comment

Ten-year nominal rates continue to drift back towards the 2012 lows; the 10y Treasury yields only about 1.75% now. But 2015 is so very different than 2012 in terms of the cause of those low rates.

Nominal bonds are like the packaged sandwich you pick up at a gas station: no special orders. You get the meats in the proportions they were put on the sandwich; in the case of nominal bonds you get real yields plus inflation expectations and the nominal yield moves the same amount whether the cause is a change in real yields or a change in inflation expectations. If you buy nominal bonds because you think the economy is growing weak, and you’re right but at the same time inflation expectations rise, then you’re out of luck. You get what’s in the package.

If you look beyond the packaging, to what is making up that 10-year yield sandwich, then the difference between 2015 and 2012 is stark. When 10-year nominal yields were at 1.50% back in 2012, 10-year real yields were at -0.90% and 10-year inflation expectations were around 2.40%. The bond market was pricing in egregiously weak real growth for the next decade, coupled with fairly reasonable inflation expectations. TIPS were clearly expensive at the time, although I argued that they were less expensive than nominal bonds. (In fact, I may have said that they were expensive to everything except nominal bonds).

Today, on the other hand, nominal yields are low for a different reason. TIPS yields, while low, are positive (10-year real yields are 0.13% as I write this) but inflation expectations are very low. So, in contrast to the circumstance in 2012, we see TIPS as very cheap, rather than rich.

One way to look at this difference in circumstance is to study how the proportions of meats in the sandwich have changed over time. The chart below (source: Enduring Investments) shows the percentage of the nominal yield that is made up of real yields. The percentage which is made up of inflation expectations is approximately 100% minus this number, so one chart suffices. Back in “normal times,” real yields tended to make up 40-50% of nominal yields.

real10ratio

That 40-50% isn’t graven in stone; for example, we can say with some confidence that the ratio should be lower at very high nominal yields: if 10-year rates are at 20%, it isn’t because people expect real growth of 8%, but because inflation expectations are quite high. And another line of reasoning applies when nominal yields are very low, because inflation expectations tend to reach a floor. I mention this because I wouldn’t want someone to look at this chart and say “the ratio ought to get back to 40%, and it’s at 7% now, so TIPS are still very expensive.” In fact the relationship is considerably more complex, and as I said before we see TIPS as very cheap, not rich.

That being said, the point is that while nominal yields are similar now to what they were in 2012, the circumstances are quite different and your trading view of nominal bonds must take this into account. In 2012, to be bearish on nominal bonds you mainly had to be of the view that growth expectations were unlikely to get appreciably worse than the awful expectations which were embedded in the market. In 2015, to be bearish on nominal bonds you mainly have to be of the view that inflation expectations are unlikely to get appreciably lower.

Today the Federal Reserve acknowledged that they are concerned with the state of inflation expectations. In the statement following today’s meeting the FOMC noted that “Market-based measures of inflation compensation have declined substantially in recent months” and they repeatedly noted that they need not only inflation but also expectations to move back towards their long-term targets before they start to think about nudging interest rates higher.

It is certainly convenient since median CPI is at 2.2%, which is fairly consistent with where they perceive their target to be. But this is a dovish Fed and they’re not looking anxiously to tighten. Ergo, inflation expectations are now their focus. Beyond that, you can expect them to focus on the 5y forward expectations once spot expectations rise (see chart below, source Enduring Investments, showing 5y and 5y5y forward inflation from CPI swaps).

5y and 5y5y

This is all good for restraining velocity, since lower rates tend to keep money velocity low…except that velocity is already lower than it should be, for this level of rates! And so we come to the last chart of the day: corporate credit growth. To the extent that some part of the decline in money velocity was due to the impairment of banks’ ability to offer credit, this seems to no longer be an issue. Commercial bank credit is up at an 8.7% pace over the last year (11.1% annualized over the last 13 weeks), which looks to be back to normal…if not on the high side of normal.

corpcreditSo, as far as sandwich meats go, the Fed is focusing on a bunch of baloney. There are plenty of reasons to hike rates right now, if they wanted to. They don’t. (Moreover, as I have pointed out before: hiking rates will actually push inflation higher, unless they arrest money growth…which they have little ability to do right now).

Seasonal Allergies

October 14, 2014 8 comments

Come get your commodities and inflation swaps here! Big discount on inflation protection! Come get them while you can! These deals won’t last long!

Like the guy hawking hangover cures at a frat party, sometimes I feel like I am in the right place, but just a bit early. That entrepreneur knows that hangover cures are often needed after a party, and the people at the party also know that they’ll need hangover cures on the morrow, but sales of hangover cures are just not popular at frat parties.

The ‘disinflation party’ is in full swing, and it is being expressed in all the normal ways: beat-down of energy commodities, which today collectively lost 3.2% as front WTI Crude futures dropped to a 2-year low (see chart, source Bloomberg),

front_crude

…10-year breakevens dropped to a 3-year low (see chart, source Bloomberg),

10y_breaks

…and 1-year inflation swaps made their more-or-less annual foray into sub-1% territory.

1ycpiswaps

So it helps to remember that none of the recent thrashing is particularly new or different.

What is remarkable is that this sort of thing happens just about every year, with fair regularity. Take a look at the chart of 10-year breakevens again. See the spike down in late 2010, late 2011, and roughly mid-2013. It might help to compare it to the chart of front Crude, which has a similar pattern. What happens is that oil prices follow a regular seasonal pattern, and as a result inflation expectations follow the same pattern. What is incredible is that this pattern happens with 10-year breakevens, even though the effect of spot oil prices on 10-year inflation expectations ought to be approximately nil.

What I can tell you is that in 12 of the last 15 years, 10-year TIPS yields have fallen in the 30 days after October 15th, and in 11 of the past 15 years, 10-year breakevens were higher in the subsequent 30 days.

Now, a lot of that is simply a carry dynamic. If you own TIPS right now, inflation accretion is poor because of the low prints that are normal for this time of year. Over time, as new buyers have to endure less of that poor carry, TIPS prices rise naturally. But what happens in heading into the poor-carry period is that lots of investors dump TIPS because of the impending poor inflation accretion. And the poor accretion is due largely to the seasonal movement in energy prices. The following chart (source: Enduring Investments) shows the BLS assumed seasonality in correcting the CPI tendencies, and the actual realized seasonal pattern over the last decade. The tendency is pronounced, and it leads directly to the seasonality in real yields and breakevens.

seasonal

This year, as you can tell from some of the charts, the disinflation party is rocking harder than it has for a few years. Part of this is the weakening of inflation dynamics in Europe, part is the fear that some investors have that the end of QE will instantly collapse money supply growth and lead to deflation, and part of it this year is the weird (and frustrating) tendency for breakevens to have a high correlation with stocks when equities decline but a low correlation when they rally.

But in any event, it is a good time to stock up on the “cure” you know you will need later. According to our proprietary measure, 10-year real yields are about 47bps too high relative to nominal yields (and we feel that you express this trade through breakevens rather than outright TIPS ownership, although actual trade construction can be more nuanced). They haven’t been significantly more mispriced than that since the crisis, and besides the 2008 example they haven’t been cheaper since the early days (pre-2003) when TIPS were not yet widely owned in institutional portfolios. Absent a catastrophe, they will not get much cheaper. (Importantly, our valuation metric has generally “beaten the forwards” in that the snap-back when it happens is much faster than the carry dynamic fades).

So don’t get all excited about “declining inflation expectations.” There is not much going on here that is at all unusual for this time of year.

Why So Many Inflation Market Haters All of a Sudden?

September 25, 2014 6 comments

The inflation market offers such wonderful opportunities for profit since so few people understand the dynamics of inflation, much less of the inflation market.

One of the things which continually fascinates me is how the inflation trade has become sort of a “risk on” kind of trade, in that when the market is pricing in better growth expectations, reflected in rising equity prices, inflation expectations move with the same rhythm.[1] The chart below (source: Bloomberg) shows the 10-year inflation breakeven rate versus the S&P 500 index. Note how closely they ebb and flow together, at least until the latest swoon in inflation expectations.

beistocks

Your knee-jerk reaction might be that this is a spurious correlation caused by the fact that (a) bond yields tend to rise when growth expectations rise and (b) when bond yields rise, the components of bond yields – including both real rates and expected inflation – tend to rise. But look at the chart below (source: Bloomberg), covering the same period but this time charting stocks versus real yields.

realplusspx

If anything, real yields ought to be more correlated to movements in equities than inflation expectations, since presumably real economic growth is directly related to the real growth rates embedded in equity prices. But to my eyes at least, the correlation between real interest rates and equity prices, for which there is a plausible causal explanation, doesn’t look nearly as good as the relationship between stocks and inflation expectations.

It doesn’t make any sense that long-term inflation expectations should be so closely related to equity prices. I know I have mentioned before – in fact, regular readers are probably sick of me pointing it out – that there is no causal relationship between growth and inflation. Really, it is worse than that: one really needs to torture the data to find any connection at all, causal or not. The chart below (source: Bloomberg) shows quarterly real GDP in yellow against core inflation in white.

coreandgdptimeseries

I’ve pointed out before that the big recession in ’08-09 saw almost no deceleration in core inflation (and none at all if you remove housing from core inflation), but it’s hard to find a connection anywhere. The next chart (source: Bloomberg) makes the point a different way, simply plotting core inflation (y-axis) against real GDP (x-axis) quarterly back to 1980.

gdpcoreinflationregression

In case anyone out there is protesting that there should be a lagged relationship between growth and inflation, I am happy to report that I was able to get an r-squared as higher as 0.257 with a lag of 12 quarters. Unfortunately, the lag goes the wrong way: high inflation precedes high growth, not vice-versa. And I don’t know anyone who proffers a reasonable explanation of a causality running in that direction. Lags the other way fail to produce any r-squared over 0.1.

So, how to explain the fact that since the end of August we have seen 10-year real rates rise 29 basis points while 10-year breakevens were falling 12bps (producing a net rise in nominal rates of only 17bps)? The explanation is simple: the market is wrong to treat breakevens as a “risk on/risk off” sort of trade. Breakevens have cheapened far too much. I don’t know if that means that TIPS yields have risen too much, or nominal yields have risen too little (I rather expect the former), but the difference is too narrow. The short end of the US curve (1 year inflation swaps are at 1.44%) implies either that core inflation will decline markedly from its already-depressed level well below median inflation, or that energy prices will decline sharply and much further than implied by gasoline futures.

I think that one of the reasons US inflation has been under pressure is that it is currently at a very large spread versus European inflation, and earlier this month it was at the highest level in at least a decade (see chart, source Enduring Investments).

USCPIHICPxt

This may look like an appealing short, perhaps, but based on our internal analysis and some historical relationships we track we actually believe the spread is too low by about 50bps. And think about it this way: if Europe really is in the process of inheriting Japan’s lost decade, then 10-year expectations for the US ought to be much, much higher than in Europe. I don’t really think Europe will end up there, because the ECB seems to be trying to do the right thing, but it is not unreasonable to think that there should be a hefty premium to US inflation over Europe.

[1] Of course, the correlation of levels won’t be very good because stocks have an upward bias over time while inflation expectations do not. To run the correlation, you’d have to de-trend stocks but I’m trying to make a visceral point here rather than a quantitative one.

Imagining the Unimaginable

January 21, 2014 6 comments

Last week I met and spoke with some bright minds at a big reinsurance company, who were sampling some views on inflation. Among the questions, however, were ones concerning my views on nominal interest rates, to which they are more directly exposed.

Since I was a rates strategist long before I was an inflation specialist, I do have some opinions on the matter.

Early this month, I wrote an article asking “which consensuses are worth fading?” in which I noted that of all of the “consensus” views, I am most sanguine about the view that interest rates will rise over the course of this year. Now, there are lots of ways that this view can be derailed. For example, there are a lot of concerns about a slowdown in China and what that might mean for global growth. There are other land mines, such as the risk of a default of Puerto Rico, which could send investors scurrying for at least a short time into nominal bonds. And, of course, we are not out of the woods ourselves, and a dovish Chairman Yellen (if in fact she turns out to be as dovish as we all expect) could easily stop or reverse the taper even though that does not seem to be the plan at the moment according to the Wall Street Journal’s Jon Hilsenrath.

But abstracting from the chance that a metaphorical meteor might strike the earth and ruin all of our plans, what are the chances of somewhat higher rates, or drastically higher rates? In my mind, the chances of these different outcomes derive from the types of causes that could provoke them.

10-year rates at 4% by year end – To get 10-year rates to approach 4% (a level last touched in 2010 and not seen on a closing basis since before the crisis in 2008) doesn’t require a miracle. The Fed is in taper mode, and there reportedly remains a pocket of ‘negative convexity’ that could turn a mild selloff into a major selloff if interest rates rise towards 3.25%. It was the ‘convexity trade’ that helped fuel the move in 10-year notes to 3% last year (see my comment about that here) from 1.65% in May, and another convexity-triggered selloff could easily cause rates to reach 4% at some point this year. Of course, that would still be an interesting technical development, since it would be the largest deviation above the log-channel lower in rates that has been in force for more than thirty years (see chart, source Bloomberg).

channel

10-year rates at 5% by year end – Five percent 10-year rates seems outlandishly far away, and we haven’t seen them since 2007, but we should recognize that this is roughly a neutral nominal rate. If real growth is expected to be 2.75% on average over time, and inflation is expected to be around 2.25%, then r + i = 5%. If the Fed is normalizing policy, is it really that much of a reach to get normal market rates? I don’t see 5% as being outrageous. However, realistically I would have to say that there will be a lot of friction between here and there, by which I mean that as interest rates rise, investors will find them increasingly attractive and will rotate from equities to bonds. That will make a 200bp selloff somewhat difficult, in my view. But against this, we need to keep in the backs of our minds the possibility that the Federal Reserve could choose to start selling securities from its portfolio at some point; while the Fed professes to be relying on its reverse repo facility to be able to drain liquidity as needed, that’s only plausible if they need to drain relatively small amounts of liquidity (tens or scores of billions). As rates approach 5%, losses in the Fed’s SOMA portfolio will be large enough that it will be technically impossible for it to fully drain all of the reserves they have added – and will be a political football, no matter how the Fed chooses to account for a mark-to-market loss (see my article from a year ago on this topic here and a follow-up article with additional issues here). I am not making any predictions about what the Fed will do or not do when rates start to rise past 4%; I only point out that there will be a lot of zeroes involved and that tends to affect decision-making. A move to 5% isn’t, in short, completely crazy although I don’t think we’ll get there.

10-year rates at 8% by year end – How can you get really ugly outcomes, like 8% nominal rates (which we haven’t seen since 1991)? This is outside the realm of forecasting. A 500bp move in a year is roughly a 4-5 standard deviation event. In the post-WWII period we have never had a 500bp move on a year-end to year-end basis. In fact, we have never had 10-year rates move more than 400bps in a 12-month period. So, this is really outside of the range of outcomes one could reasonably expect in a normal world.

This is, of course, not a normal world. But it is non-normal because weird departures from normality happen stochastically and, when they do, the distribution we draw market outcomes from is unknown. Put another way: for rates to rise to 8% in a year would take something really crazy. So, we can’t make predictions, but we can play with entertaining suppositions and I will do that in a moment. But before I do, I just want to make very clear that guessing how rates would come unglued and get to 8% in 12 months is, since it relies on a chaotic break, probably unknowable in advance. We can, though, test the limits of imagination to see if we can come up with a plausible scenario in which such an outcome would not be impossible.

And here is where inflation, and specifically inflation expectations, come in. The dynamics of nominal interest rates imply that at low levels of nominal rates, movements are caused mostly by changes in real rates (thus the high beta of TIPS at low rates) while at high levels of nominal rates, movements are caused mostly by changes in inflation expectations.

Suppose that inflation expectations can be characterized as “multi-equilibrium,” meaning that they are mean-reverting within some ranges but then can jump to a new equilibrium when expectations become “unanchored.” I’m not particularly enamored of that notion, because it has been used to conceal of a lot of bad econometrics, but let’s just suppose it’s possible that inflation expectations can both anchor, and become unanchored. We could hypothesize, for example, that consumers (and investors) don’t encode “1.987% inflation” or “3.5093% inflation” or “6.421% inflation,” but rather “low inflation,” which means anything where inflation doesn’t enter into daily consideration, or “medium inflation” (which is where inflation considerations cannot be overlooked), or “high inflation” (which is where inflation considerations are the prime concern).

If that describes the way that inflation expectations behave – and I think it is fair to say that, at least, it is the way that financial journalists behave – then it’s plausible to say that inflation expectations might move very rapidly from a distribution centered around, say, 2% to one centered around 5%. And that, in turn, could trigger a very sharp move in nominal rates. If that happened, it could plausibly be worse than historical precedents if only because the system is far, far more leveraged now than it was in the late 1970s, when we last saw a sharp ramp-up in expectations.

Again, none of the foregoing is a forecast per se, but a statement of possibilities. I expect nominal rates will at some point this year (probably in late Q3) approach 4%, and I think there’s a measurable chance that things could get ugly enough, in an environment where Wall Street dealers are discouraged from providing liquidity by leaning against the flow, to push rates towards 5%. I don’t really think that’s very likely, though. And I think it’s quite unlikely that rates could approach 8% this year, or even next year. But if you’re thinking about tail risks – and you should be – it’s less important that it may happen than that it can happen. The point is not to try and look for the signals that this particular scenario is unfolding; by the very nature of such a chaotic move, it is very unlikely that we’ll correctly guess in advance what will actually cause it. But, if we can imagine a not-wickedly-outlandish scenario in which this outcome can be achieved, then it means the unimaginable is no longer unimaginable. It is possible, and the next question is whether it is worth hedging against that tail risk.

Is Inflation of 2% Enough for You?

October 28, 2013 2 comments

In one of those “what could possibly go wrong with that plan” moments – which are becoming all too frequent these days – the New York Times this weekend reported that there is “growing concern inside and outside the Fed that inflation is not rising fast enough.”

At some level, this is not exactly new thinking. For decades, economists have argued that “price stability” really means inflation of something just slightly over 0%, because it is assumed to be quite hard to get out of a deflationary spiral. in my view, that’s silly, because simply adding a zero to the currency in everyone’s pocket is a guaranteed way to get out of deflation. It may be that since nudging inflation higher is harder than kicking it higher, the costs of mild deflation are higher than the costs of mild inflation, but I think the jury is out on that question since it isn’t something we have ever experienced. But in any event, this is the reason that inflation in the neighborhood of 2%, rather than 0%, has been the Fed’s implicit or explicit target for a long time.

To the extent that discussion stays academic, it’s not worrisome. Navel-gazing is an occupational hazard of being a professional economist, after all. But now, there are louder and more frequent voices arguing that 2% is too low a target. To see how urgent a problem this is, I submit the following chart, which shows median CPI, along with a horizontal line at 2.25% (roughly equivalent to a 2% target on PCE). Wow, I can see the reason for panic. We are nearly 0.2% below that! And we got within 0.6% of deflation in 2010, in the aftermath of the worst credit crisis in almost 100 years.

clevcpiI am all for the idea that mild inflation serves to lubricate the gears of commerce, but we should remember that when the CFO of Costco says he likes rising inflation because in that circumstance “the retailer is generally able to expand its profit margins,” that’s good for the equity market perhaps but not as good for the consumer!

It always amazes me how sketchy is the understanding of inflation in a capital markets context by members of the Fed. In the aforementioned article, Chicago Fed President Evans is quoted saying “If inflation is lower than expected, then debt financing is more burdensome than borrowers expected. Problems of debt overhang become that much worse for the economy.” This is absolutely true, but almost completely irrelevant in the current context. Inflation has been lower than a priori expectations since about 1980, which is why a long-nominal-bond position has routinely outperformed inflation. But currently, as the chart below illustrates, 10-year inflation breakevens are at 2.19%. Fully 72% of all 10-year periods since 1914 have seen compounded inflation above that level.

10ybeisTen-year inflation swaps, a better measure of inflation expectations, are at 2.52%, which still doesn’t sound like a horrible bet for borrowers. If inflation comes in above 2.52%, the borrower of 10-year fixed-rate money wins; if it comes in below 2.52%, the borrower loses. This is one reason that it is so rare to see corporations issue inflation-indexed debt…they like that bet.

Finally, the article explains that higher inflation allows workers to get higher wages, and gives the example of teachers in Anchorage, Alaska, who just agreed to a contract giving them 1% pay increases for each of the next three years. Since inflation is likely to be above that, the article says, they will be probably receiving a pay cut in real terms. This is absolutely true. (It is also the exact opposite position of the debtor, in that the teachers will do better in real terms if deflation actually happened. Sometimes I just wish the authors of these articles would be consistent.) But this circumstance certainly isn’t helped by inflation; since wage increases tend to trail inflation, real wages tend to lag in inflationary upticks.

None of this represents deep insight from this author. It merely represents that I have at least a rudimentary understanding of how inflation works, and a respect for the damage which inflation can cause to economies, workers, and savers. The fact that this is increasingly rare these days is probably cyclical, and unfortunately is probably a minimum condition for setting up this next inflation debacle. In that context, and with more Federal Reserve economists openly musing about needing to target higher inflation, does 2.19% breakeven sound like a bad deal?

Objects In Mirror May Be Closer Than They Appear

December 12, 2012 2 comments

The Fed delivered QE4, as expected, on Wednesday as it pledged to continue buying longer-dated Treasuries even though it will no longer sell shorter-dated Treasuries in Operation Twist. In other words, they will accelerate the balance sheet expansion from $40bln (all mortgages) to $85bln (Treasuries and mortgages) per month, beginning next month.

What was unexpected was that the FOMC decided to parameterize the “soft Evans rule” that has been in place since the summer but which has grown gradually more specific since then. The relevant passage from the statement was this:

“In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”

The financial chatterverse immediately set about guessing how quickly the economy could reach 6.5% unemployment, and variously asserting that this was a hawkish or a dovish statement based on their assessment of the likelihood of reaching that level soon. (According to the Fed’s projections, released somewhat after the FOMC statement, they expect to reach that level sometime in 2015.)

But that isn’t the binding parameter. As I showed yesterday, longer-term inflation expectations are arguably not very well-contained; moreover, 1 year inflation, 1 year forward is currently around 2.15% in inflation swaps. Inflation swaps are based on CPI, not PCE, so this equates to roughly 1.90% in forward PCE versus a 2.50% barrier for the Fed. As the chart below shows, 1y inflation 1y forward hasn’t been above 2.75% in a while (equivalent to 2.50% on PCE), but it has gotten pretty close in recent years. It doesn’t seem like a bad level to target, but it’s much closer than the market seems to understand.

1y1yswaps

Here also is 5y, 5y forward, but from inflation swaps rather than breakevens (source: Bloomberg). The Fed prefers breakevens, because they imply a lower level of inflation; market participants know (at least, most of them know) that this is due to quantitative phenomena that distort Treasury yields low and that the inflation swaps market typically gives a better indication. Note that the upward trend I identified in yesterday’s column is still there, although somewhat less monotonic.

5y5yswaps

Street economists in the immediate aftermath of the FOMC announcement made lots of pronouncements but in generally were looking at the wrong thing. I saw economists look at the 10y spot BEI  at 2.4% when the 5y, 5y forward inflation swap – more relevant to examining  is around 3.20%. This is wrong. The right numbers to look at are now 1y, 1y forward and 5y, 5y forward.

The Fed in this statement is no less dovish than they had been. They are led by a super-dove and Lacker still dissented as the lone voting hawk. But the Committee is increasingly painting themselves into a corner as they have parameterized the Evans Rule. They’ve drawn a line in the sand now, and when inflation bursts higher and 1y1y is trading at 3.5%, it’s going to be hard for the Fed to keep forecasting 2% for next year with any credibility. In his press conference, Chairman Bernanke listed as indicators the Fed will look at on the inflation side: median and trimmed mean CPI, the views of outside forecasters, and econometric models of inflation. He didn’t mention market prices at all! So, we can expect that the Fed will try to ignore (as they are already ignoring) market indicators of inflation expectations…but at some point, this will become more or less untenable.

On the fiscal cliff front, there was again no progress. JPM Chairman Jamie Dimon said on CNBC that the economy will boom if the fiscal cliff is averted: the same unsubstantiated assertion that the President and members of Congress have been making recently.

Here is my question: isn’t it in a booming economy that we’re supposed to reduce the deficit? If the economy is really as strong as they say it is, then the fiscal cliff is timely. I mean, if we increase the deficit in recessions and don’t reduce it in booms…do you have to be able to do much math to see where that leads? Even a CEO who mistook a big punt for a hedge ought to be able to do THAT much math.

So all the good news is out, unless the fiscal cliff is averted. I suspect the stock market will slide from here, and interest rates will rise into year-end. With volumes this low, that’s a perilous call to be sure, but in my mind the risks outweigh the rewards of betting the Santa Claus rally will continue.

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