The Quintillion-Dollar Coin

January 25, 2023 Leave a comment

I was going to write a technical column today about how the sensitivity of bonds (and consequently, lots of other asset prices) to interest rates increases as interest rates decline, and discuss the implications for equity investors nowadays as interest rates head back up. That article will have to wait another week. Today, I want to just quickly dispense with a really silly idea that keeps making the rounds every time there is a standoff on the debt ceiling, pushed by the same guys who think Modern Monetary Theory (MMT) will work (even though we just tried it, and it didn’t).

The idea is that, thanks to a law passed back in the 1990s, the Treasury has the right to issue a platinum coin of any denomination. Ergo, it could produce a $1 Trillion coin, deposit it at the Federal Reserve (who does not have the option to not accept legal tender, Secretary Janet Yellen’s recently-voiced concerns notwithstanding), and continue to pay the government’s bills. Why? One well-traveled and entertaining simpleton started explaining the reasoning for doing this by saying “there’s this silly, anachronistic and ineffectual law on the books called the Debt Ceiling…”

If we started doing really really silly, not to mention stupid, things to get around every law that we thought was silly and anachronistic, legislators would be busy 24 hours a day, 7 days a week. (And, obviously, the law isn’t “ineffectual”; if it was then we wouldn’t need to get around it.)

I am continually amazed by how durable the really stupid ideas are. For instance, the notion that the government is lying about inflation to the tune of 6% per year is an idea that never seems to die even though you can show with basic math that it can’t possibly be the case. So, let’s dispense with this one even though I am sure I will have to keep slaying this dragon when it inevitably comes back from the dead.

A useful tool of logic that’s handy when you are trying to smoke out a dumb idea is to ask, “If that works, why don’t we do lots more of it?” Let’s not try to figure out why a $1 Trillion coin is a bad idea. Let’s try to figure out why a $1 Quintillion coin (a million trillions) is a bad idea.

After all, if we are going to mint a coin anyway, it doesn’t cost much more to stamp “Quinti” than it does to stamp “Tri”. And if the Treasury minted a Quintillion-dollar coin and deposited it at the Fed, it would be much more significant. With that balance, the Treasury could pay off all outstanding debt, fully fund Medicare and Social Security, and cancel all taxes basically forever while also dramatically increasing services! Why isn’t that a better idea? I spit on your Trillion-dollar coin.

Naturally, that would be a terrible idea and it’s now obvious why. I can think of several reasons, but I’ll leave most of them for other people to highlight in the comments. The immediate one is that by paying off all federal debt, increasing spending and decreasing taxes to zero, the money supply would increase immensely and immediately. As we saw quite recently, the result that rapidly follows is much higher inflation. Much much higher inflation. I will see your 8% and raise you 800%. Yes, to some extent that would depend on the Congress deciding to do that spending and cut those taxes – but do you doubt that would happen? And the Treasury offering to buy back all of the outstanding bonds wouldn’t need Congressional authorization. That’s trillions in money being suddenly returned to bondholders, which puts it back in circulation.

A trillion here, a trillion there, and pretty soon you’d be talking real money.

The Monetary Policy Revolution in Three Charts

January 18, 2023 Leave a comment

Over the last few years, I’ve pointed out exhaustively how the current operating approach at the Fed towards monetary policy is distinctly different from past tightening cycles. In fact, it is basically a humongous experiment, and if the Fed succeeds in bringing inflation gently back down to target it will be either a monumental accomplishment or, more likely, monumentally lucky. My goal in this blog post is to explain the difference, and illustrate the challenge, in just a few straightforward charts. There are doubtless other people who have a far more complex way of illustrating this, but these charts capture the essence of the dynamic.

Let me start first with the basic ‘free market’ interest rate chart. Here, I am showing the quantity of bank lending on the x-axis, and the ‘price’ of the loan – the interest rate – on the y-axis. If we assume for the moment that inflation is stable (don’t worry, the fact that it isn’t will come into play later) then whether the y-axis is in nominal or real terms is irrelevant. So we have a basic supply and demand chart. Demand for loans slopes downward: as the interest rate declines, borrowers want to borrow more. The supply curve slopes upward: banks want to lend more money as the interest rate increases.

An important realization here is that the supply curve at some point turns vertical. There is some quantity of loans, more than which banks cannot lend. There are two main limits on the quantity of bank lending: the quantity of reserves, since a bank needs to hold reserves against its lending, and the amount of capital. These are both particular to a bank and to the banking sector as a whole, especially reserves because they are easily traded. Anyway, once aggregate lending is high enough that there are no more reserves available for a bank to acquire to support the lending, then the bank (and banks in aggregate) cannot lend any more at any interest rate – at least, in principle, and ignoring the non-bank lenders / loan sharks. We’re talking about the Fed’s actions here and the Fed does not directly control the leverage available to loan sharks.

Now, traditionally when the Fed tightened policy, it did so by reducing the aggregate quantity of reserves in the system. This had the effect of making the supply curve go vertical further to the left than it had. In this chart, the tightening shows as a movement from S to S’. Note that the equilibrium point involves fewer total loans (we moved left on the x axis), which is the intent of the policy: reduce the supply of money (or, in the dynamic case, its growth) by restraining reserves. Purely as a byproduct, and not very important at that, the interest rate rises. How much it rises depends on the shape of the demand curve – how elastic demand for loans is.

As an aside, we are assuming here that the secondary constraint – bank capital – is not binding. That is, if reserves were plentiful, the S curve would go vertical much farther to the right. In the Global Financial Crisis, that is part of what happened and was the reason that vastly increase reserves did not lead to massive inflation, nor to a powerful recovery: banks were capital-constrained, so that the Fed’s addition of more reserves did not help. Banks were lending all that they could, given their capital.

Manipulating the aggregate quantity of reserves was the way the Fed used to conduct monetary policy. No longer. Now, the Fed merely moves interest rates. Let’s see what effect that would have. Let’s assume for now that the interest rate is a hard floor, and that banks cannot lend at less than the floor rate. This isn’t true, but for ease of illustration. If the Fed institutes a higher floor on interest rates then what happens to the quantity of loans?

This looks like we have achieved the same result, more simply! We merely define the quantity of loans we want, pick the interest rate that will generate the demand for those loans, and voila, we can add as many reserves as we want and still get the loan production we need. The arrows in this third chart show the same movements as the arrows in the prior chart. The quantity of loans is really determined entirely by the demand curve – at the prescribed interest rate, there is a demand for “X” loans, and since banks are not reserve-constrained they are able to supply those loans.

However, it’s really important to notice a few things. The prior statement is true if and only if we know what the demand curve looks like, and if the floor is enforced. Then, a given interest rate maps perfectly into Q. But:

  1. D is not known with precision. And it moves. What is more, it moves for reasons that have nothing to do with interest rates: for example, general expectations about business opportunities or the availability of work.
  2. Moreover, D is really mapped against real rates, while the Fed is setting nominal rates. So, for a given level of a nominal floor, in real space it bucks up and down based on the expected inflation rate.
  3. Also, the floor is not a hard floor. At any given interest rate where the floor would be binding, the desire of banks to lend (the location of the S curve) exceeds the demand for loans (by the amount of the ?? segment in the chart above). The short-term interest rate still affects the cost to banks of that lending, but we would still expect competition among lenders. This should manifest in more aggressive lending practices – tighter credit spreads, for example, or non-rate competition such as looser documentary requirements.

In the second chart I showed, the Fed directly controlled the quantity of reserves and therefore loans. So these little problems didn’t manifest.

Now, there is one advantage to setting interest rates rather than setting the available quantity of reserves as a way of reducing lending activity. Only the banking sector is reserve-constrained. If there is an adequate non-bank lending network, then the setting of interest rates to control the demand for loans will affect the non-bank lenders as well while reserve constraint would not. So this is somewhat “fairer” for banks. But this only means that non-bank lenders will also be competing to fill the reduced demand for loans, and the non-bank lending sector is less-vigorously regulated than the banking sector. More-aggressive lending practices from unregulated lenders is not, it seems to me, something we should be encouraging but what do I know? The banks aren’t lobbying me to help level the playing field against the unregulated.

Hopefully this helps illuminate what I have been saying. I think the final chart above would be a lovely final exam question for an economics class, but a bad way to run a central bank. Reality is not so easily charted.

Summary of My Post-CPI Tweets (December 2022)

January 12, 2023 1 comment

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy, but to get these tweets in real time on CPI morning you need to subscribe to @InflGuyPlus by going to the shop at https://inflationguy.blog/shop/ , where you can also subscribe to the Enduring Investments Quarterly Inflation Outlook. Sign up for email updates to my occasional articles here. Individual and institutional investors, issuers and risk managers with interests in this area be sure to stop by Enduring Investments! Check out the Inflation Guy podcast!

  • It’s #CPI Day – and this one finishes up the book for 2022.
  • I am doing the walk-up differently today. I’m doing it as a thread on the night before, which I’ll re-tweet in the morning. I’m usually doing the analysis in the evening…why wait?
  • Today’s number, or I guess really we can say starting with October or November, starts the interesting part of the inflation cycle.
  • When inflation was going up, excuses abounded but the real debate was WHEN the peak was going to be, and HOW HIGH only to a lesser extent. Now that inflation appears to be clearly decelerating, the much more important debate is: where is it decelerating to?
  • If inflation drops back to 2%, and becomes inert at that level again, then the Fed will deserve considerable laurels. If inflation instead drops to 4% and appears resistant to a drop below that, then a much more interesting debate will ensue.
  • I think it should be clear that I am in the latter camp.
  • The other interesting thing that we’re going to see, and are already seeing, is manifestation of the basic tricks of the trade of macro economists.
  • Trick 1 is to assume that everything returns to the mean. Most things do, eventually, return to the mean – so if you are wrong on the timing, you’ll probably eventually be right. Economists love to forecast returns to the mean.
  • Economists though are very bad at forecasting departures AWAY from the mean, which is why there were so many forecasts of “transitory” this cycle.
  • Since they didn’t see it coming, it must have been a random perturbation (because that’s how their models work). But it’ll all go back to the mean and all is right with the world. Or so goes the assumption.
  • Trick 2 is to assume that the mean doesn’t change, or changes pretty slowly. In econometrics terms, the distribution is ‘stationary.’ If you’re going to forecasts returns to the mean, it is fairly important that the ‘mean’ is known or knowable and doesn’t move a lot.
  • The problem in inflation is that the (unobservable) mean of the distribution never appeared to be very stable until the mid-1990s; the hypothesis is that this anchoring happened because of “anchored inflation expectations.”
  • (A member of the Fed’s own research staff tore apart that notion in a devastating article a couple of years ago, but the Fed promptly ignored him because if he was right it’s really bad for forecasting the way that they like to forecast: everything returns to the mean.)
  • Getting to Thursday’s CPI figure, we can see these tricks in play in the economist forecasts.
  • As an example, one of the forecasts I saw from a large bank had drags calculated from Used Cars (and New Cars), a deceleration in shelter costs, a drag from airfares due to lower jet fuel costs, and a drag from health insurance. But what about accelerations?
  • Do you really think that NOTHING will accelerate, or are all of those pre-defined as “one-offs”?
  • It reminds me a little of what Rob Arnott says about the S&P earnings “ex-items”: any one company it might make sense to ex- the unusual events. But in aggregate, some level of unusual events is usual. So it is with inflation.
  • There will be some ups. So my forecasts are a little higher than others’, because I anticipate there will be some surprises.
  • Where would those surprises come from? Wage growth is strong, and that pushes up on prices in hospitality, domestic manufacturing, food away from home, and even shelter.
  • I also don’t think that airfares will be the drag that’s implied by jet fuel. Here’s the regression that would make you think they WOULD.

  • But here’s the one that makes you think maybe not. Airlines tend to push prices higher when there are spikes in jet fuel costs, but they don’t necessarily lower them very fast when jet fuel prices decline. And did I mention wage pressures? Airlines feel them.
  • I do think that used car prices will drag again, although the CPI has been falling a little faster than the Black Book and Mannheim indices would suggest they should. But I don’t see a strong argument for New Car prices to decline.
  • New Cars are in black in this chart, while Used are in blue. New car prices are up 20%, while used are up 40%, since the end of 2019. And the money supply is up around 40%. That doesn’t mean new car prices won’t decline, but it doesn’t look like a slam dunk to me.
  • Finally, a point I’ve been making recently on a longer-term horizon viewpoint. Markets are fully priced for inflation to totally and almost immediately mean-revert. Large declines in breakevens, especially short BEI. Some of that is the gasoline slide. Not all of it.
  • The short end of the inflation swap curve has NSA inflation at -0.38% m/m in December, +0.37% in Jan, +0.33% in Feb, and 0.30% in March. And that’s the last 0.3% print we see. According to inflation swaps, y/y inflation will be at 2% in June.
  • Even if I am wrong about inflation staying around 4-5%, you have a 2% cushion to bet that way. (I think I used an unfortunate analogy a few days ago saying that if you give me 21 points I’ll take TCU over Georgia, but you get my point.)
  • Ergo, for choice I’d be long breakevens going into this number.
  • The response in the stock market will be interesting. If the number is as-expected or better, I would think stocks will try and scream higher on the theory that the Fed can back off. The problem is that folks are already long for that, I sense.
  • So I’d probably sell that pop, especially because earnings may be a hurdle in the near future, though you have to be cognizant of the 200-day moving average in the S&P. The mo-mo crowd will try to get some prints above that so I’d be cautious.
  • What about on a strong CPI? Few seem to be thinking/talking of that, which means to me that folks are a little naked there. Do I think it would change the Fed trajectory? Not from what the Fed is SAYING they’re doing, but from what the market is pricing – yes.
  • As I said, this is the interesting part of the inflation cycle. Buckle up.
  • At 8:30ET, I’ll be pulling the data in & will post charts and #s – then retweet some of those charts w/ comments plus other charts. Around 9:30ish, I will have a private conference call for subscribers where I’ll quickly summarize the numbers.
  • Pre-release, both stocks and bonds are loving this number! May be that some are reading into the fact Biden has a speech this morn including inflation as a topic, and perhaps he wouldn’t if the number was bad. But even if it is, he can focus on y/y so not sure that means much…
  • That’s all for now. Good luck!

  • m/m CPI: -0.0794% m/m Core CPI: 0.303%
  • Last 12 core CPI figures
  • Overall, highest core number in 3 months, but clearly in a down trend. I think lots of people would be DELIGHTED with 3.6% annualized compared with where we have been, but that’s closer to what I am expecting than what the market/Fed is looking for.
  • M/M, Y/Y, and prior Y/Y for 8 major subgroups
  • Interesting thing is apparel, up for the second month in a row. Apparel is an almost pure import, so if it’s up then either (a) the recent dollar weakness is already affecting prices or more likely (b) there is pricing power at retail, and the markdowns for Christmas were lower.
  • Core Goods: 2.15% y/y Core Services: 7.05% y/y
  • The story continues to be bifurcated and we will look further at the four-pieces. More important than the fact that services are trending and goods are deflating, is whether the services part was all rents.
  • Here is my early and automated guess at Median CPI for this month: 0.378%
  • Clearly good news! Lowest median m/m in quite some time. So core was higher, but median lower. THIS is positive. And as I said, this is the interesting part now: inflation is decelerating, but why and how fast and how far? Median clearly shows it is.
  • Primary Rents: 8.35% y/y OER: 7.53% y/y
  • Further: Primary Rents 0.79% M/M, 8.35% Y/Y (7.91% last) OER 0.78% M/M, 7.53% Y/Y (7.13% last) Lodging Away From Home 1.5% M/M, 3.2% Y/Y (3.2% last)
  • Although the rent data is clearly bad news, there has been a strong campaign against this data to weaken its importance by claiming it’s just really lagged. That’s partly true but the recent research on the subject has enormous error bars for short-term forecasts so…
  • Some ‘COVID’ Categories: Airfares -3.12% M/M (-3.02% Last) *** Lodging Away from Home 1.47% M/M (-0.71% Last) *** Used Cars/Trucks -2.55% M/M (-2.95% Last) *** New Cars/Trucks -0.06% M/M (0.04% Last)
  • So, I was ‘on’ core even though I was wrong on airfares (it was weak, despite the fact that every fare I saw in December was about 2x normal). Used cars was the predicted drag, and New cars was not…but I was low on rents. That’s the ‘away from mean surprise’.
  • Incidentally, Lodging Away from Home was quite strong – and is one of those core-services-ex-rents that is driven a lot by wages.
  • Piece 1: Food & Energy: 9.31% y/y
  • Piece 2: Core Commodities: 2.15% y/y
  • Piece 3: Core Services less Rent of Shelter: 6.34% y/y
  • …and here is the spoiler: it wasn’t all rents. Core services less rents still strong. I’ll drill down further in a bit.
  • Piece 4: Rent of Shelter: 7.59% y/y
  • So, the swap market gets closest-to-the-pin on headline (SA). -0.079% was the figure, a bit lower than consensus econs and a fair bit lower than me. On Core, econs and I were both pretty close as it was right around 0.3% (0.303%).
  • I had managed to talk myself into the idea that food and energy would be a bit less of a drag than my model said, but food wasn’t up as much as it has recently been. Ergo, right on core and off on headline.
  • Interesting story in Medical Care, which has been a drag recently because of the huge adjustment to insurance company margins (huge and unlikely, btw). Doctors’ Services is slowly reaccelerating a little. Hospital Services continues to have problems getting sufficient sample.
  • Overall, Medical Care was up 0.1% m/m, but that’s after the continuing ‘insurance’ drag. Y/Y it was at 3.96%, down from 4.15% but looking like it’s leveling out.
  • The median category in the Median CPI will be Food Away from Home, +4.63% annualized monthly number. And the y/y Median will decline very slightly again. Was 7.00% in Oct, 6.98% in Nov, 6.93% in Dec. But heading down.
  • Biggest upward m/m movements in core categories were in Jewelry/Watches (+48% annualized monthly), Mens/Boys Apparel (+22%), Lodging Away from Home (+20%), Motor Vehicle Maint/Repair (+13%), and South Urban OER.
  • • Biggest decliners were energy things, including Public Transportation, plus Used Cars (-27% annualized monthly figure), and Car/Truck Rental (-18%).
  • Core ex-shelter: this includes core goods decelerating rapidly and core services accelerating so perhaps isn’t as useful as sometimes: 4.48% y/y, down from 5.2% last month and the lowest since April 2021. But if it stayed there, then it’s hard to get core to 2%.
  • While I’m waiting for the diffusion stuff to calculate, a word on what this does to the Fed: nothing. The Fed is aiming for 5% and then will keep rates high for a while unless something breaks.
  • Do markets love this data today because it means they were worried about a more-hawkish Fed, with higher rates or higher-for-longer? Or do they think it means the Fed will in fact start easing this year as the curves impound?
  • In my view, the latter is really unlikely. I can see the Fed starting QE again if auctions start getting difficult, but in my view there’s no evidence here that we’re going right back to 2% inflation and the Fed has been loudly consistent about this.
  • To be sure, they can turn on a dime and they have previously, but…I just think market pricing is really optimistic.
  • This [chart below] is consistent with the good news from Median – for the first time, our diffusion index has declined smartly. It’s still above the highs of the last couple of inflation ‘spikes’ (which no longer look like spikes!), but moderating.
  • This chart is not quite as good. The mean CPI is falling more because some high outliers (cars e.g.) are coming back to the pack, and some are moving from low to the low tail, and less because the middle is shifting a lot. Look at how >5% is barely declining.
  • I mean, that’s not TERRIBLE news, but obviously we need to see the “<2%” get close to 50% if the Fed is going to be confident they’re back near their inflation target. • One more point and then I’ll prep for the call. A lot of the positive-news things are well along towards delivering what they’re going to deliver. Health ins won’t be a drag in 2024. Used cars won’t drop another 20%. And >>
  • >>the dollar has turned south so core goods won’t be in retreat forever. The case for inflation going back to 2% rests on rents turning, and on wages slackening. And while those are expected, there are scant signs of them yet. So hold off on the celebrations in the Eccles bldg.
  • OK, let’s wrap up and get to the call. Thanks for subscribing. at 9:35ET I’ll be on this call; join if you want to hear me say what I just tweeted. 🙂 [NUMBER REDACTED]

The CPI figure was broadly in line with expectations, which means it was a “something for everybody” kind of number. Disinflationists see continued broad progress towards the Fed’s 2% PCE target, while sticky-inflation folks see the rents and core-services numbers and shake their heads, tsking ominously.

Two broad observations:

First, the disinflation from core goods is ‘on schedule,’ with Used Cars and other core goods categories doing approximately what they are expected to do. But the problem is that core goods inflation is down to 2.1%. If you are looking for the whole number to go back to what it was pre-COVID, you need core goods in mild deflation and core services down to 3%. But both parts of that story are difficult. With the world de-globalizing and near-shoring, it is going to be difficult to see core goods back in an extended period of mild deflation. Probably 0-1% is the best we can really hope for. And that means that the core goods sponge has been mostly wrung out. And core services back to 3%, even if rents are actually peaking (and just not showing up in CPI yet)? Well, core services-ex-rents remain pretty buoyant. So how do we get that back to 3%?

Second. The interesting part of the story is coming up. Inflation is probably returning to “the mean,” but what is the mean inflation now? For a quarter-century it was stable at 2-2.5%, but prior to that it had never been very stable. There are feedback loops in inflation, and those appear visibly to be at work here: higher wages help support higher services inflation, and rents, which in turn support higher wages. Social Security and other wage agreements that are explicitly linked to inflation help this process along. But it means this: the mean is not stationary. The real question of 2023, and probably 2024, is this: what is the mean, now?

My guess? It’s 4%ish, or even slightly higher. It’s very unlikely to still be 2-2.5%. Ergo, it is going to be very hard for the Fed to end 2023 in a happy mood…which means that it is going to be hard for investors to end 2023 in a happy mood!

Season(al)’s Greetings

As we move into 2023, one of my New Year’s resolutions is to write more frequently on the blog and post podcasts more frequently. I have a list of topics that is certainly long enough. When I was writing commentary for Bankers Trust, and for Barclays, and for Natixis, I wrote every day and somehow I never ran out of words…

Sometimes, as with today’s article, I am going to refer to pictures and observations that I have previously made on the private/subscription Twitter channel. You can subscribe to the Private Twitter feed at https://inflationguy.blog/shop/ . Not only that, but as of January 2023 I have marked the price down from $99 to only $69, which is a 30% nominal decline in the subscription price – and a 35% or so real decline. (Those of you who subscribed at the $99 price unfortunately will have to cancel and re-subscribe to get the lower price because there’s no way for me to edit a recurring subscription’s price, which annoys me as much as it annoys you but I suppose it’s to keep unscrupulous sellers from raising the price without your permission).

Today I want to present some oldie-but-goodie charts that I developed years ago to look at the seasonality of inflation breakevens. In updating the charts, what was amazing is that…the seasonality hasn’t changed much. Fairly consistently, breakevens rise in the early part of the year, and then decline from May to October. It’s not a guarantee,[1] but it is a pretty consistent tendency. The chart below shows, in black, the percentage of the time (1999-2021, so 22 years of history) in which 10-year breakevens increased in the 60 days following that date. So, on January 3rd, the number was about 70% which means that in 70% of those years, breakevens were higher 60 days after January 3rd than on January 3rd. The average increase (including years in which it decreased) is in red, and shows about 10bps on average. That doesn’t sound like much, but it’s an average of over 22 years. Buying breakevens early in the year is typically a good idea.

The next chart steps back and shows the average for the full year, properly de-trending the data so that any drift over time falls out (since breakevens have gone basically nowhere for a quarter-century, this doesn’t do much but it’s the right way). So, breakevens start the year below the level that will subsequently be the average, and by May they’re well above that level. Ergo, it has historically been good to be long into the first part of May. And then I guess you sell in May and go away, to coin a phrase.

None of this is guaranteed, as I said, but seasonal patterns which are consistent are valuable tools. The way I look at seasonals is that I want to see a move of some decent economic value, but mainly I want to see the consistency. And personally I won’t do a trade just to take advantage of the seasonal trend, but if I want to sell and the market shows a strong tendency to rally then I might consider “flat” the same as selling in that environment. Conversely, a market which has a strong tendency to rally when I want to buy is likely to make me be more aggressive getting in rather than trying to steal a tick on the bid/offer by hanging out on the bid. If you’re bearish on breakevens, then I don’t think you should be a buyer just because it’s a good time of the year to buy. But between the low level of breakevens, and the seasonal trend itself…I would be cautious about being aggressively short.


[1] …and some of it is an artifact: in the early part of the year, a breakeven buyer often has negative carry from bad inflation prints in November and December; as that carry passes, breakevens rise. But this only explains part of the early-season seasonality, not the whole thing.

Categories: TIPS, Trading Tags: ,

2022 Year-End Thoughts About 2023

December 22, 2022 2 comments

Use: This article may only be reposted in its unedited entirety (including all links), including the title and author with linkbacks to the original. If you wish to repost in serial form, please contact me via the form at https://enduringinvestments.com to discuss.

When I was a Street strategist, and/or producing ‘sales and trading commentary’ as a trader, it was de rigueur to produce an annual outlook piece. Naturally, everyone does one of those; consequently, I stopped doing them. It seems to me like it would get lost in the shuffle (this is one of the reasons that Enduring’s “Quarterly Inflation Outlook,” which we distribute to customers and is also available by subscription here, is produced on the ‘refunding schedule’ of February, May, August, and November rather than at quarter-end). Having said that – it does seem that, given what inflation has done recently, there are more people asking for my outlook.

I do have to raise one point of order before I begin. As regular readers of this column know, in my writing, I generally try to propose the ‘right questions,’ and I don’t claim to have all the right answers. An outlook piece is often interpreted as being the analyst’s best guess at the answers. While it is that, for me the answers I suggest here are likely to be less valuable to the reader (I do not recommend that you blindly place trades based on my outlook for where markets will go!) than the thought process that is going into them. You may and probably will disagree with some of my answers. But hopefully, you’ll be able to identify where in my reasoning you have specific disagreements, which will either enhance your own view or cause you to thoughtfully reconsider it. That’s the whole point, and I don’t care at all if you disagree! That’s what makes markets.

Moreover…even if my guesses end up being “wrong,” or “right,” based on the actual outcomes in the future, that doesn’t mean they were wrong or right in terms of being a good approach/positioning. Investing is not really all about making the “right” bet in terms of whether you can call the next card off the deck, but about making the “right” bet with respect to the odds offered by the game, and betting the right amount given the odds and the edge. On this topic, I recommend “Thinking in Bets” by Annie Duke as excellent reading.

So, here goes.

MACROECONOMICS

For most of this year, I have been saying that we would get a recession by early 2023. In 2022Q1 and Q2, US GDP contracted. This produced the predictable shrill announcements of recession, coupled this year with sadly simple-minded declarations that the Biden Administration had “changed the definition of recession” by saying we weren’t in one. One television commentator I saw strongly profess the view that the two-quarters-of-negative-growth-is-a-recession definition is “in every economic textbook.” Having read my fair share of economic textbooks and having taught or tutored from a few, I can assure you that is not the case.

I was, and remain, sympathetic to the incoming fire that the Biden Administration took then, because they were basically right: whether we chose to call it a ‘recession’ or not, there was scant sign of any economic distress. Employment (which lags, of course) remained strong, corporate earnings were solid, confidence was reasonably high except for inflation, and citizens still had a substantial cash hoard left over from the COVID stimmy checks. However, while the critics were wrong on the timing they weren’t wrong about the eventuality of a recession. As I also said a bunch of times, there has never been a period where energy prices rose as rapidly as they did between early 2021 and mid-2022, combined with interest rates increasing as rapidly as they did thanks to Federal Reserve policy, that did not end in recession. But it takes Wile E. Coyote some time to figure out that there is nothing under his feet, before he falls, and recessions work similarly. We will have a recession in 2023.

We are already seeing the early signs of this recession. One indicator I like to look at is the Truck Tonnage index, which falls significantly in every recession (see chart, source Bloomberg). The last two months have seen a decline in this seasonally-adjusted index. It is early yet – we saw a similar-sized decline in 2016, for example, so there are false signals for small changes – but the fact that this decline happened heading into the Christmas season gives it more significance.

That’s the goods side. The services side shows up more in the labor market, which lags behind the overall cycle. Yet there too we have started to see some hints of weakness. Jobless claims are well off the post-COVID lows, although they are still roughly “normal” for the tight pre-COVID labor market. And the labor market is really hard to read right now, given the continuing crosswinds from the COVID-period volatility and the fact that so many services jobs now are at least partly virtual. Upward wage pressure is continuing, partly because virtual workers are less productive (shocker reveal there), so this recession in my view will probably not feel as bad as the last couple of recessions (GFC, Covid) have felt. However, we will have a recession in 2023.

The bad news, though is that a recession does not imply that inflation, ex-energy, will decline. Look at this chart, which captures the last three recessions. The post-GFC recession was the worst in 100 years, and while core inflation slowed that was almost entirely a function of the housing market collapse and not the general level of activity. The COVID recession was worse than that, and core inflation accelerated. And the post-tech-bubble recession wasn’t a slouch either; core inflation accelerated throughout 2001 until it started to decline, but only got down to 1.1%, in late 2003.

This chart shows y/y changes, but helpfully shows core-ex-shelter (Enduring Investments calculations). There isn’t a lot to see here in terms of the effect of these three huge recessions.

Lest you think I am just cherry-picking the 2000-2022 period, here is core CPI and GDP normalized as of December 1979. Again, you can see in the GDP line the recessions of the early 1980s, of the early 1990s, and that post-tech-bubble recession. I can’t see those, in the CPI line.[1]

And hey, as long as we are doing this…how about the 1970s malaise when the multiple recessions and flat growth led to … well, not disinflation.

I think the evidence is very clear: forecasters who are relying on the “recession” forecast (which I share) to make a “hard disinflation” forecast are simply ignoring the data. Those two concepts, outside of energy, are not related historically.

That being said, I expect core inflation and median inflation to decelerate in 2023. I just don’t think they will decelerate nearly as much as Wall Street economists think. Shelter inflation is already well above my model, and I expect will come back towards it, but my model otherwise doesn’t see a lot of downward pressure on rents yet. The strong dollar, and some healing of supply chains, will help core goods – but core goods inflation will remain positive next year and probably for a long time, thanks to secular deglobalization, instead of being in persistent slow deflation. And core services ex-rents will decelerate, but mainly because of the technical adjustment in health insurance. Until wages start to ebb, it’s hard to see a crash in core services ex-rents inflation. So that brings me to this forecast for core CPI:

Current2023 Fcast
Core Goods3.7%2.3%
Rent of Shelter7.2%4.8%
Core Services less ROS6.3%5.1%
Core CPI6.0%4.2%

Most of the Street is in the mid-2s for core inflation; the Conference Board forecast for Core PCE recently was raised to 2.8% which would put core CPI at 3% or 3.1%. They’re getting there, but frankly it’s hard to see how you can get to those levels. In my view, most of the risks to my forecast are to the upside.

MONETARY POLICY

An important disclosure should be made here: in 2022, I was utterly wrong about the path the Fed would take. Almost as wrong as it is possible to be. Ergo, take everything I say hereafter in this section with a grain of salt.

Coming into 2022, I thought the Fed would follow the same script they had used for more than a quarter-century with respect to tightening policy: slow, late, tentative, and quickly reversed. Although inflation was already plainly not transitory, I know that the Fed’s models assume a strong homeostasis especially with inflation, to the extent that the persistent part of inflation is essentially (albeit with a lot more math) modeled as a very slow moving average and overall inflation is assumed to pull back to that level. When the Fed talks about the “underlying inflation trend,” that is in simple terms what they are saying. But if you believe that, then there’s very little reason to pursue something similar to a Taylor Rule where policy is driven by simple deviations of growth and inflation from the target levels.

So, when the Fed started to move I expected them to tighten a few times and then to stop and ultimately reverse when financial markets started doing ugly illiquid things. One thing I didn’t anticipate: the markets never really did ugly illiquid things. Investors welcomed the tighter policy, and ran ahead of the Fed to give them room. Especially considering that, at the end of 2021, I think most sophisticated investors viewed the Fed as incompetent (at best) or counterproductive (at worse), the markets gave the Committee an amazing amount of latitude. The Fed, to its credit, saw the gap in the defense and sprinted through it. I did not see that coming.

After nearly 500bps of rate hikes, and a small decline in the Fed’s balance sheet, money supply growth has come to a screeching halt. That’s largely spurious, I think, since money supply growth is a function of bank lending and banks are neither capital-constrained nor reserve-constrained at the moment, and longer-term interest rates have risen but not very much (except in the mortgage market). I suspect that most of the decrease in loan demand that is evidently happening is not in response to the increase in short-term rates but rather to the increase in mortgage rates almost entirely. If that’s the case, then it’s a one-time effect on M2 growth: mortgage origination can only go to zero once. The chart below shows the connection between M2 growth (in blue) and the MBA Purchase index (black). The correlation is not as incredible as it looks, because one is a rate of change that is off-center by 6 months (it’s y/y) and one is a level of activity, but if I expressed both in rate of change you would still say they look suspiciously similar.

If I am right about that point, then the money supply will shortly resume its growth as the overall volume of lending continues to grow without the negative offset of declining mortgage origination. With money velocity on the upswing now, this will support the level of inflation at a previously-uncomfortable level. So what will the Fed do?

Importantly, the Fed won’t really know that inflation isn’t dropping straight to 2% until after the midpoint of the year. But they’ll make the decision to pause rate hikes sooner than that. I think a 5% Fed funds rate is a reasonable target given their assumptions, a key one of which is that if “underlying inflation” is really 2%-3% then a 5% nominal rate will be plenty restrictive.  

What is really amazing to me – which the ‘me’ of 2021 would never have anticipated – is that Fed watchers and market participants are starting to talk as if they believe the Fed might overdo the tightening, raising rates higher than needed to restrain the economy and inflation (yes, I know I said that a recession doesn’t cause lower inflation but it’s an article of faith at the Fed so we need to pretend as if we believe it). It’s incredible, when you think about it: the Fed hasn’t come close to ‘overdoing it’ in a tightening cycle in decades, if by ‘overdoing it’ we mean that they caused a deflationary crash. The Fed has caused plenty of recessions, but core inflation hasn’t been negative since the Great Depression. And we’re worried about them overdoing it?

Naturally, if you don’t think that raising rates causes inflation to come down then any rate hikes at all…actually, any active monetary policy at all…is too much. But in any event, it’s striking to me that the Fed has somehow restored some credibility as a hawkish central bank. Not that credibility per se matters, since expectations don’t cause inflation. But I digress. It’s still pretty amazing.

When Powell was first named Chairman, I was hopeful that a non-economist could help break the Fed out of its scholarly stupor. As time went on I lost that hope, as Powell trotted out various vacuous terms like “transitory” and leaned on discredited models (nevertheless still in vogue at the Fed) such as those which utilize the ‘anchored expectations’ hypothesis. But I have to say, my opinion of him has risen along with the Fed funds rate.

In my view, the biggest Fed error of the last forty years was Greenspan’s move to make the Fed transparent, which caused the pressures on the Fed to be entirely one-way. The second-biggest Fed error follows from that, and that is the tendency to move rates further and further away from neutral, holding rates at such a level by maintaining vastly higher levels of liquidity than were needed to run the banking system. The consequence of this has been a series of bubbles and asset markets at levels where the prospect of future real returns was abysmal. Plus, it led to the heyday of hedge funds where cheap money levered small returns into big returns.

The Powell Fed, for all of its flaws and awful forecasting, has succeeded in getting the yield curve to the vicinity of long-term fair value, which I define as sovereign real rates near the long-term growth rate of the economy (2.00-2.25% in the US – see chart below, source Enduring Investments before 1997 and Bloomberg after 1997). With a Fed inflation target at 2.25% or so in CPI terms, this means long-term nominal interest rates should be in the vicinity of 4%-4.5% over the long term in the context of a responsible central bank. We’re not there, but we’re getting close.

All of which means that I think the FOMC is just about done with hiking rates for this cycle. I believe they will get to 5%, pause, and stay paused for a long time. I do not expect them to lower interest rates, even if there is a recession, unless markets or banks start to have difficulties or Unemployment gets above 6%. That might happen in late 2023, but even if it does I think the Fed will be much more measured about cutting rates than they have in previous cycles. Credit to Powell for the change in attitude.

Those pieces, the Macro and the MonPol, along with my assessment of relative valuations, inform everything else.

RATES, BREAKEVENS, AND CURVES

The long, long, long downtrend in interest rates is decisively finished. As noted above, when inflation is under control and in the vicinity of the Fed’s 2% target, long-term interest rates should be in the vicinity of 4-4.5%. Over the last century, when rates have been away from the 3-5% range it has generally been either because inflation was unstuck on the high side (1970s, 1980s) or unstuck on the low side (1920s, 1930s, 2010s) (see chart, source Federal Reserve and Bloomberg). The long-term downtrend can be thought of as going from unstuck-high inflation, to normal, and overshooting to the downside in the last decade. But we have now definitively ended that low-rates period.

At a current level of roughly 3.5% nominal, 1.4% real, interest rates are ‘too low’ again, but this is normal for an economy headed into recession. Ordinarily, this configuration of events – a Fed nearing the end of a tightening cycle, a recession looming, and interest rates that have risen 320bps over two years – would make me bullish on bonds. And I do think that the first part of 2023 may see a decent rally as the Fed finishes their business and the stickiness of inflation is not yet apparent, but the recession is. Seasonally, you’d really prefer to be long the bond market/out of equities in the last quarter of the year and out of the bond market/long equities in the first quarter of the year, but I think the seasonal pattern will be reversed this year. So we will come in all happy as bond investors, and get unhappy later in the year.

The reason I think the first quarter of the year will be pretty decent for bonds is because of the timing of the recession and of the end of the Fed tightening cycle. But why the selloff as the year progresses? Well, investors will start to see that inflation is not falling as fast as they had expected, the Fed is showing no signs of easing…and the Federal deficit is blowing up.

In FY 2022, the US government had a $1.38 trillion deficit,[2] in an expansion during peacetime. But there are some inexorable effects pushing that higher next year. For example, interest on the debt: higher interest rates will affect only the part of the public debt that has rolled over, but that is an awful lot of it.

In December 2021, the rolling-12-month interest expense on US Debt Outstanding (see chart, source Bloomberg) was $584bln.[3] As of November 2022, the rolling-12-month expense was $766bln. It will be up another $100bln, at least, in 2023. Social Security benefits paid this year were roughly $1.2 trillion, and benefit payments are due to increase 8.7% next year – so, even neglecting the fact that there will be more recipients next year, Social Security should also be $100bln further in the red. That’s $200bln, on top of the approximately $1.4trillion deficit, and I haven’t even considered Medicare, the decline in tax receipts that will occur thanks to a decline in asset markets this year, or the decline in taxes on earned income when the economy enters a recession. A $2 trillion, peacetime deficit is easily in reach and will be much more if it’s a bad recession. The last time we had that big a deficit, the Fed happened to also be buying a couple trillion dollars’ worth of Treasuries. This time, though, the Fed is shrinking its balance sheet.

It is fairly easy to imagine that longer interest rates will have to rise some, in order to roll the maturing debt. As I said, higher interest rates don’t really bother me because I don’t run a highly-levered hedge fund. (But if the rise in rates were to get sloppy or rates were to rise enough to threaten a spiral in the deficit, then I can imagine the Fed stepping in to reverse its balance sheet reduction and being under even more pressure to guide rates lower. However, it’s not my base case.)

Also, as the year goes along the stickiness of inflation will become more apparent and investors will rightly start to put that assumption back into their required return for nominal bonds. One of the really crazy things that happened in 2022 was that inflation compensation in nominal bonds (aka ‘breakevens,’ the mathematical difference between yields on nominal bonds and yields on inflation-linked bonds that pay inflation on top) declined even as the overall level of inflation continued to climb. At the time of this writing, Median CPI has not yet even decisively peaked, although I think it will. But with Median CPI at 6.98%, it’s incredible that the market is demanding only 2.28% annual compensation for inflation over the next decade (see chart, source Bloomberg). That basically says investors are comfortable earning an increment that underpays them for inflation in the near term, and in the long term will only compensate them for what the Fed says they are trying to pin inflation at.

That’s not as easy a trade as it was when 10-year breakevens were at 0.94% in March 2020, but it still seems to me that most of the risk over that decade would be for inflation to miss too high, rather than too low. I understand that the FOMC wants inflation down around 2%. And as for me, I want a Maserati. Neither one of us is likely to get what he wants, just because we want it.

As the first quarter of the year passes and long-term interest rates decline, the curve may invert further from its current level. But I don’t think it can invert that much, which limits the value to being long, say, 10-year notes from this level. Given the current level of inversion, it is fairly easy to construct steepener trades that throw off positive carry. For that matter, a leveraged investor who is financing at 4.5% and earning 3.75% is more likely to want to go the other way! I think it’s going to be difficult to get a good bull market rally going in bonds, and if I was a leveraged hedge fund investor I’d be playing from the short side/steepener side even in the first quarter of the year (albeit cautiously). The chart below (source: Bloomberg) shows 2s/10s monthly going back to 1980. The only time the curve was more inverted was in the early 1980s, a couple of years after Volcker’s Saturday Night Special and with the hiking campaign solidly underway as it is now. I’m expecting 2s/10s to go positive in 2023, although the best shot at something like +50bps would come if the Fed actually did ease. Ergo, a steepening trade is also nice because it works in my favor more if I’m wrong about the Fed staying on hold for a while after they finish hiking to 5%.

Put those together and I see Fed funds at 5%, 2yr Treasuries at 4.25%, and 10s at 4.5%.

We obviously look deeper than that, though, on this channel. We can separate nominal yields into real yields (represented by TIPS) and inflation compensation (breakevens, or inflation swaps). Here are what the curves look like today (source: Enduring Investments).

From here, it looks fairly obvious that a good deal of the steepening should come from longer-term real rates rising. The 2y TIPS bond is at roughly 2%, so 2s-10s in reals is about the same as it is in nominals. The inflation curve is ridiculously flat. I do think that the inflation curve is more likely to shift higher in parallel than to steepen; a steepening inflation curve would imply accelerating inflation going forward and I don’t think investors really believe we’ll get acceleration. So I think that the movement in the shape of the TIPS curve will be very similar to the movement in the nominal curve, but with the level of the nominal curve being driven by an upward parallel-ish shift in the inflation curve.

2y10y
Current TIPS Yields1.96%1.42%
EOY TIPS Yields1.80%1.85%
Current Breakevens2.30%2.27%
EOY Breakevens2.45%2.65%

VOLATILITY

Generally speaking, a higher-inflation environment is a higher-volatility environment. The chart below (source: Bloomberg) shows core CPI in blue against the ICE BofA MOVE Index of fixed-income option volatility. True to form, the higher-inflation regime has correlated with higher levels of fixed-income volatility.

It isn’t terribly shocking that volatility is higher in bonds than it had been during the years when interest rates were fixed within a stone’s throw of zero. And it shouldn’t be terribly shocking that I expect volatility to stay somewhat higher than the 2017-2019 and 2020-early 2021 levels, even as core inflation recedes somewhat. What may be surprising is the observation that a sizeable gap has opened up in the behavior of fixed-income volatility and equity volatility, as the following chart comparing the VIX (equity vol) and MOVE (fixed-income vol) shows. Note that these are different axes, but you can clearly see the uptrend in the MOVE that has not been replicated by the VIX.

I mentioned earlier how regular and controlled the decline in the stock market has been, and how this has allowed the Fed to push rates further than anyone thought they would, a year ago. There have not been too many periods where option sellers have been punished for being short vol in equities. On the other hand, bond vol has been very different now from what it was a few years ago. In short, there has been a regime change in bond vol, but not in equity vol. At some level, this will continue, but the spread should narrow as the Fed gets to the end of the tightening regime. I think we will end 2023 with the VIX above 22 log vol – where it is today or slightly higher – but with the MOVE around 90 norm vol.

Both of those figures represent more-volatile conditions than we have seen for some years pre-COVID.

EQUITIES

It hurts to say, but equities are still far, far, far overvalued.

For many years, there has been a running tension between people who use the “Fed model” as a way to justify the current level of the stock market and the people who point out that the “Fed model” does not imply that the current level of the market is fair. The “Fed model” essentially says that when interest rates are very low, the present value of future cash flows is higher; ergo, the equilibrium value of the average equity (whose fair value is dependent on the present value of future earnings) and hence the overall stock market is higher, when interest rates are lower. This is analytically true. However, it does not mean that your expectation of future returns, when P/E multiples are at 40 but interest rates are low, should be the same as your expectation when P/E multiples are at 15 but interest rates are high. The level of interest rates explains higher equity prices, but it does not imply that those are now long-term fair value levels.

But this tension was almost always resolved in favor of the people who thought that rock-bottom interest rates meant that stocks should be at sky-high multiples, and value investors were left in the dust for more than a decade.

Unfortunately, this tension is being reduced because interest rates are going higher, and may never go back to those levels again. Consequently, equity price/earnings multiples need to re-rate for the new level of interest rates. The same logic that was used to justify the stock market at a 35 Shiller P/E, reconciles to lower prices now and going forward. The chart below (source: Robert J Shiller, updated with Enduring Investments calculations) shows the Shiller P/E (aka Cyclically-Adjusted P/E Ratio, or CAPE) versus 10-year interest rates in the post-WWII period. There is, ex-Internet bubble, a pretty clear relationship between interest rates and valuations. The red dot is where current multiples and interest rates are.

My forecast of 4.5% 10-year Treasuries implies something like a 23 Shiller P/E, down from 30 now. Without earnings growth, that 23% decline in the multiple implies a 23% decline in the stock market from these levels. I don’t think earnings themselves will increase or decrease very much unless the recession is much worse than I think it’s going to be, but the same lag between wages and product prices that flattered earnings when inflation was heading higher will detract when inflation decelerates. Moreover, if I’m right that Powell is intentionally steering interest rates to a level that is consistent with a long-term equilibrium around 4%-4.5% then this 23% adjustment in prices will not necessarily be followed by another massive bull market the likes of which we became accustomed to during the long bond bull market of the last 40 years. A Shiller P/E in the low-20s is still fairly generous historically but it may be sustainable.

So, my point forecast is for the S&P to get to 3,000 sometime in 2023. I don’t think the current bear market will last the entire year, and in fact I am sure there will be a rollicking rally when it is clear the Fed is done tightening. But sticky inflation will hurt here, too, and after that rollicking rally I think we’ll have another low, and from that low is where a modest bull market will begin.

However, I should also note that 1-year equity vol is around 25%, so my projection is within 1 standard deviation of unchanged!

COMMODITIES

From 1999 through 2008, commodities were in a bull market. After a brutal crash in the Global Financial Crisis, commodity indices had another mini-bull market from 2009-2011 before enduring a 9-year bear market. Since March 2020, the massive increase in the quantity of money has driven down the value of money relative to commodities or, to put it in the normal way, has driven up the price of commodities.

The Bloomberg Commodity Index (spot) rose from 59 in March 2020 to 124 in March 2022, and has come off the boil a bit since then. At the highs, though, the level of the index was only back to the levels of 2014. This is normal with spot commodities, which thanks to improved production and extraction technology over time tend to be perpetually deflating in real terms.[4] The good news is that an investor in commodities does not generally buy spot commodities but rather invests through collateralized futures contracts or invests in an index based on collateralized futures contracts. Over time, the collateral return happens to be a very important source of return (in addition to spot returns, the return from normal backwardation, and the volatility/rebalancing return), and this year there is terrific news in that collateral returns are ~4% higher than they were before the Fed started to hike. This means that, all else equal, commodities index returns should be expected to be 4% better (in nominal terms) this year than over the last couple of years. All else is not equal, but I expect gains in investible commodities indices in 2023.

That’s entirely separate from the question of whether we are in a commodity supercycle, due to chronic underinvestment in exploration and extraction technologies and more difficult geopolitical pressures that increase the costs of mining, growing (e.g. because of fertilizer costs/shortages), and transporting the raw commodities. I think the answer there appears to be ‘yes,’ which means that in general I want to play the commodity market from the long side more than from the short side. Of course there will be brutal moves in both directions, and bears will really want to sell commodities as the recession comes to the fore. But most of that is already in the price, with gasoline at levels much closer to the GFC lows than to anything approximating the highs. The chart below shows retail gasoline prices, adjusted for inflation (using 2012 dollars).

Energy prices of course could fall further, but considering that part of the reason prices have fallen this far is that the Strategic Petroleum Reserve has been flushing oil into the system (and that has ended, in theory) and China’s economy has been sputtering under Zero Covid (which has also ended, in theory), it is hard to think that is the better direction at the moment.

OTHER THINGS

I want to append one very important admonition for investors and investment advisors. I mention this frequently on podcasts, TV and radio appearances, at cocktail parties and to random strangers on mass transit:

The next decade will be very unlike the decades we have just experienced. Not only will inflation and interest rates be higher than we’ve become accustomed to, and markets more volatile, but some important drivers of portfolio construction will shift. The good news is that at least some of those shifts are systematic and predictable. The table below shows how 60/40 returns correlate with inflation, with inflation expectations, and with inflation surprise over two periods. The first period was the 30 years ending in 2004, when inflation averaged 4.89% and was three times as volatile as during the subsequent period. During that period, a 60-40 portfolio was significantly exposed to inflation. The more-recent period, during which inflation was low and stable, produced placid 60/40 returns and correlations with inflation that are mostly spurious because there was more noise than signal. Inflation didn’t move!

The first implication of this is that portfolios which have productively ignored inflation-fighting elements over the last two decades need them now, because the main asset classes used in portfolio construction are terribly inflation-exposed. All portfolios for investors who do not have sufficient ‘natural’ inflation hedges should include such assets as commodities and an allocation to inflation-linked bonds in lieu of some of the nominal bond allocation.

The second implication is related but less conspicuous. The entire correlation matrix is shifting away from what it has been over the last couple of decades, and back to something that incorporates the inflation factor that has been dormant. As the most obvious example, stocks and bonds which have been inversely correlated for a while, due to the fact that they respond differently to economic growth, are becoming correlated again. This is not an aberration but entirely normal for regimes in which inflation is not low and stable. The chart below illustrates this. When 3-year average inflation is above 3% (the red shaded area), then 3-year correlations of stocks and bonds tend to be positive (blue line). When inflation is below that level, correlations tend to be negative.

Negative correlations between stocks and bonds are great because they lower portfolio risk. But in the coming decade, 60/40 won’t be as low risk as it has been. But beyond that, the entire covariance matrix that an advisor relies on to simulate and optimize portfolios needs to be examined. The normal way is to use recent returns (say, the last 10 years) to generate this covariance matrix, which then is used to find the mean/variance-optimized portfolio for a given level of risk. That’s normally okay, but as inflation proves sticky that sort of covariance matrix will be wrong, and wrong in a systematic way. What I am doing for our customers is comparing portfolios optimized with a recent covariance matrix to portfolios optimized using a covariance matrix from the 1980s-1990s. It’s important to be aware of this potential problem in portfolio construction, and to get ahead of it.


Finally, let me take a moment to thank the readers of this blog for their interest in it. I write partly because the discipline of arguing my points out thoroughly makes me (I think) a better trader and investor, but I also garner a lot of value from the information and ideas I receive reciprocally from readers who agree or disagree with what I write. I appreciate this feedback very much, and I thank the readers who take the time to share their opinions with me.

Aside from the personally selfish reason I have for writing, there is also the corporate mission the blog is meant to accomplish, and that is to raise the profile of Enduring Investments and the Inflation Guy franchise with prospective clients, and to encourage them to do business with us. If prospective clients see value in these musings, then I hope they will choose to do business with us. Yes, that’s crassly commercial. But ‘tis the season! And if you read this far in this missive, please consider what that means about the value you’re getting, and how much more value you might get from a deeper relationship with Enduring Investments!

And if not, Merry Christmas anyway! Happy holidays and Happy New Year.    

– Mike ‘The Inflation Guy’ Ashton

DISCLOSURE – My company and/or funds and accounts we manage have positions in inflation-indexed bonds and various commodity and financial futures products and ETFs related to them that are discussed in this column.


[1] It bears noting, though, that until 1982 the shelter component of CPI was tied to mortgage rates and home prices and not rents, so that the early-80s rise in core CPI partly reflected the Volcker rate hikes. Fixing that problem was what released the conspiracy nuts who plague us to this day claiming that the BLS “manipulated” CPI downward.

[2] https://fiscaldata.treasury.gov/americas-finance-guide/national-deficit/

[3] Net interest was about $110bln less, since some of that interest is paid to other parts of the government, for example the Federal Reserve system. For now.

[4] I wrote a nice, short little piece called “Corn Prices – Has the Correction Run its Course?” that is worth reading if you are interested in commodities.

Summary of My Post-CPI Tweets (November 2022)

December 13, 2022 4 comments

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy, but to get these tweets in real time on CPI morning you need to subscribe to @InflGuyPlus by going to the shop at https://inflationguy.blog/shop/ , where you can also subscribe to the Enduring Investments Quarterly Inflation Outlook. Sign up for email updates to my occasional articles here. Investors, issuers and risk managers with interests in this area be sure to stop by Enduring Investments! Check out the Inflation Guy podcast!

  • It’s #CPI Day – the last one of 2022!
  • A reminder to subscribers of the path here: At 8:30ET, when the data drops, I’ll be pulling that in and will post a number of charts and numbers, in fairly rapid-fire succession. Then I will retweet some of those charts with comments attached. Then I’ll run some other charts.
  • Afterwards (recently it’s been 9:30ish) I will have a private conference call for subscribers where I’ll quickly summarize the numbers.
  • After my comments on the number, I will post a partial summary at https://inflationguy.blog and later will podcast a summary at inflationguy.podbean.com .
  • Thanks again for subscribing! And now for the walkup.
  • Last month, the CPI was significantly weaker than expected. Against expectations for 0.5% core, we got 0.3%. Apparel and Medical Care (specifically in Health Insurance but there was weakness in other parts of Medical Care) were the main culprits.
  • However, Used Cars CPI was also more negative than private surveys had led us to believe. A decline in Airfares rounded out the list of usual and unusual suspects.
  • But on the other hand…
  • Other than Health Insurance, no services were on the “largest decliners” list. While Used Cars was droopy, New Cars inflation remained solidly positive. Rents were lower than in the prior month, but still increased at annualized monthly rates of 8.7% (Primary) and 7.7% (OER).
  • Median inflation was still +0.53%, a 6.4% or so annualized rate of increase. The Enduring Inflation Diffusion Index and other measures showed that inflation pressures remained quite broad.
  • This month, economists are calling for a repeat of softer core inflation, although the forecasts have been drifting up slightly as more economists add their estimates. Since economists like to shade vs other economists, this is like sharp money coming in on the “over.”
  • …although come to think of it, calling economists “sharp money” is probably wayyyy more generous than they (as a group) deserve.
  • Those prints (the economists’ estimates) would take y/y to 6.1% on Core (and 7.3% on headline).
  • I think the consensus is giving too much signaling weight to the deceleration in goods. It’s real, it’s important…but it is completely divorced from what is happening in services. There, we have a feedback loop in full swing.
  • Inflation leads to higher wage demands and settlements, which leads to higher inflation. Or at least, it slows the deceleration of inflation. Next year, we get an 8.7% increase in Social Security payouts, and wages are rising rapidly.
  • Median wage growth is basically steady around 6.5%ish. That’s 0.5% below median CPI, when it’s usually ~1% over. Now, I don’t think Median is about to jump another 1.5%, but another interpretation is that wage settlements suggest workers feel like 5.5% is what they’re seeing.
  • That doesn’t seem terribly wrong, and I think Median is in the process of peaking, but the point is that people are getting wage increases that in the Fed’s words are “not compatible with 2% inflation.”
  • To reiterate something I’ve been saying recently: I think the peak is in, and will show in Median CPI soon, but the real question is whether core goes back to 2%. This is ASSUMED by many economists these days. Peak=”inflation is done.” I think that’s very unlikely.
  • We also have to recognize that rents in the CPI are not going to slow soon, and I think economists are getting ahead of themselves on that one as well.
  • Yes private rent indices are declining. So? They were also skyrocketing at +18% when the CPI was not (this chart is sourced from https://en.macromicro.me).
  • That’s because only a tiny proportion of rents were turning over at those increases  The CPI was designed to capture the broad trend of expenses to consumers, NOT to mark-to-market the whole rent market. So CPI goes up less, and down less.
  • To be sure, rents are higher than my model “expected” them to be, but it’s not really egregious and I don’t expect them to slow markedly and immediately. **I think some economists are mistaking timely data for quality data.**
  • Another effect, more minor, I discussed on the private blog a week or so ago: the possibility that Hospital Services has some catch-up this month after not being reported last month. See the tweet at https://twitter.com/InflGuyPlus/status/1600503515121680384 Worth a couple of bps max.
  • So, I’m on the ‘over’ for this report, but I can make a case for a higher-than-0.4% core more easily than I can make a case for a lower-than-0.3% number.
  • Now since last month’s surprise, breakevens have dropped and so have real yields. It helps that Powell and others have basically committed to decelerating Fed hikes this month, and the market clearly believes (as do I) that they’re nearly done.
  • I don’t think this number will change that trajectory unless it’s, say, 0.7% on core or something like that. Even then, it would be very hard for the Fed to produce 0.75% tomorrow with no time to leak the change…and a quarter point wouldn’t matter much anyway.
  • BUT, if we got a crazy number then the market would immediately price a higher peak rate and push the pivot out further in the future. And stocks would get shellacked.
  • We’d need a lot of messaging pretty quickly in that case, and liquidity is very thin at this point of the year. Fortunately I don’t think we get anything that outlandish. Knock wood!
  • Good luck! Done with the walkup a bit early this month since I started early. Auto charts will follow the print fairly quickly. I still curate the charts rather than totally auto-tweet them; one of these days I’ll trust the Machine but not yet.

  • Someone is pretty sure they know the number three minutes early! Equity futures just popped 20 points.
  • …looks like he did! Weak figure.
  • m/m CPI: 0.0963% m/m Core CPI: 0.199%
  • Last 12 core CPI figures
  • Just to be clear, core at 0.2% almost exactly was the best in years. Doesn’t really feel like that when you are out shopping, IMO.
  • M/M, Y/Y, and prior Y/Y for 8 major subgroups
  • Apparel back in positive territory, which is slightly surprising. In Medical Care, Medicinal Drugs were +0.08% m/m, and Doctors’ Services +0.04%. Pretty weak, but not negative. The negative is entirely from Health Insurance and I’ve said my piece there.
  • Here is my early and automated guess at Median CPI for this month: 0.477%
  • Always a caveat here when the median category is a regional housing index. Still, it would be the lowest in more than a year although 5.7% isn’t exactly great.
  • Actually, when I calculate this using my spreadsheets I get 0.456% m/m with Recreation the median category. That would put y/y still at 7%, but slightly (very slightly) lower than last month. Fairly easy comp next month, so high might not quite be in, but pretty close.
  • Core Goods: 3.68% y/y   Core Services: 6.82% y/y
  • story here is that core services reaccelerated a tiny bit. NOT that core goods plummeted. Core goods reverting lower is something we knew already.
  • the SIZE of the core goods adjustment is what was surprising. I wonder how much of this involves early Christmas discounting. There was certainly some fear among retailers that they’d over-ordered. I don’t have an easy way to measure that.
  • Suffice to say that I’d like this number better, if it was services which had decelerated.
  • Primary Rents: 7.91% y/y       OER: 7.13% y/y
  • Further:
    • Primary Rents 0.77% M/M, 7.91% Y/Y (7.52% last)        
    • OER 0.68% M/M, 7.13% Y/Y (6.89% last)        
    • Lodging Away From Home -0.7% M/M, 3.2% Y/Y (5.9% last)
  • So, rents were HIGHER than last month, 0.77 vs 0.69 on Primary rents and 0.68 vs 0.62 on OER. This is convenient since economists have convinced themselves that they can look past this. Again, the question isn’t whether it decelerates. It’s HOW MUCH, when it does.
  • Some ‘COVID’ Categories:
    • Airfares -3.02% M/M (-1.1% Last)
    • Lodging Away from Home -0.71% M/M (4.85% Last)
    • Used Cars/Trucks -2.95% M/M (-2.42% Last)
    • New Cars/Trucks 0.04% M/M (0.37% Last)
  • Just want to say that Christmas airfares are way above normal, but nationwide fares are about right for the level of jet fuel prices. Weak Lodging Away from Home too. Note that New Cars is still rising, though weakly this month.
  • Piece 1: Food & Energy: 11.5% y/y
  • The story here continues to be that it isn’t down more than it is. Food is staying buoyant.
  • Piece 2: Core Commodities: 3.68% y/y
  • Piece 3: Core Services less Rent of Shelter: 6.33% y/y
  • It is funny to me that all of a sudden, this is the category everyone is talking about. And…it’s really not showing anything super positive, especially when you consider that health insurance is a drag. This is actually pretty bad news.
  • Piece 4: Rent of Shelter: 7.19% y/y
  • OK, so let’s hold the phone here.
  • Today’s number is a core goods story. Core goods y/y went to 3.7% from 5.1%. But core services went UP to 6.8% from 6.7%. Used cars large decline (& CPI is now ahead of private surveys a fair amount). And that’s despite health insurance, a large fall in airfares and auto rental.
  • Overall Core ex-housing (which includes core goods) is down to 5.2% y/y. That’s the lowest since…well, September 2021. Going the right direction but unless core services start to decelerate, there’s a limit to how good this picture can be.
  • So here’s the distribution story. Here is the overall distribution. You can’t tell much from this unless you have the prior chart handy. But there was a shift in the middle.
  • In red is the weight of components above 6% y/y growth. In blue, the weight of components above 5% y/y growth. This doesn’t tell you much about the monthly figure exactly but it tells you the middle of the distribution is shifting left. Still pretty high though!
  • Let’s see. Biggest monthly decliners in core were Used Cars and Trucks (-30% annualized monthly ROC), Car/Truck Rental (-26%), and Public Transport (-22%). Nothing else in the Median set declined faster than 10% at an annualized rate (Health Insurance is one level lower).
  • There were actually a lot of big gainers: Misc Personal Goods (+27%), Infants/Toddlers Apparel (+21%), Personal Care Services (+18%), Vehicle Maintenance/Repair (+17%), Communication (+13%), Jewelry/Watches (+11%), Vehicle Insurance (+11%), and the South Regional OER (+11%).
  • Lots of decliners in Recreation/Goods: TVs (-3.8% m/m), Other Video Equipment (-4.1%), Audio Equipment (-1%), Sports Equipment (-0.9%), Photographic Equipment/supplies (-1.6%), Toys (-1.8%)…see any common theme there? That looks like XMas.
  • Now, those are NSA, so some of that is the natural seasonal discounting of Christmas. But that is usually bigger in December.
  • First real pullback in the Enduring Investments Inflation Diffusion Index. So that’s also supportive of the notion that the peak is in.
  • Let me sum up. This supports the idea of a Fed taper, but I didn’t think there was much chance of derailing that unless we got a BIG number. But it’s not all it’s cracked up to be. I suspect early seasonal discounting had a lot to do with this.
  • Core services ex-rents is the fly in the ointment and will continue to be so until wages start to decelerate. No sign of that yet. I think next month we are unlikely to see another 0.2% on core.
  • But that’s not the market story. The market is celebrating because the Fed is nearly done.  Now, they are not going to start easing unless there’s a market crack-up and there’s no sign of that happening while people are happy about rates peaking.
  • The story is intact, despite the fact I was surprised by the overall figure: inflation is peaking, the Fed is nearly done…but inflation isn’t going back to 2% any time soon. *Nothing in this number suggests it is.* The sticky stuff is all still ugly.
  • To me…that’s a story of a steepening curve next year. Short rates aren’t going to go up when the Fed is sidelined but long rates will eventually have to adjust to a higher-inflation reality (and increasing deficits along with a balance sheet taper).
  • I’m going to give this summary verbally if anyone wants to listen! Call the conference number at <<REDACTED>>  Access Code <<REDACTED>>. We will start at 9:40ET (9 minutes).

This CPI print was definitely a surprise, but let’s just tap the breaks a touch. It was a one-tenth surprise on core CPI – certainly welcome, but it hardly changes the overall narrative. Let’s review the points of the overall narrative:

  1. Inflation is in the process of peaking, or has already peaked.
  2. Goods price inflation is decelerating markedly, for both demand- and supply-side reasons.
  3. Rents will eventually decelerate, of course, but private surveys seriously overestimate the degree of the deceleration and the timing.
  4. Core services ex-rents, where wage inflation lives, is going to prove sticky.
  5. All of this means that after the peak, median and core inflation will drop…but not to 2%. More like 4%-5%, where they will be disagreeably stubborn about declining further.

In today’s number, nothing in that list really changed. The deceleration in goods price inflation was sharper than I expected, but a lot of that was used cars and a lot of it were in categories that smell a lot like early Christmas discounting. Notably, rents reaccelerated from last month and core services ex-rents showed no signs of weakness.

What does this mean for the Fed? 50bps tomorrow, probably 25bps at the next meeting and possibly one more 25bps hike after that. And then the Committee stays on hold for most of the rest of 2023, unless something breaks. The bond market is pricing the former, but not the latter. The Fed is very unlikely to overreact to an 0.1% miss in core CPI, especially when their expectation is that inflation is decelerating.

So nothing really changes about the story on the basis of today’s number. I will add a few final thoughts, though. (a) part of the miss today came from Used Cars being down more than it “should” have given private surveys. That’s likely going to be a give-back in the future. (b) if part of the miss was due to early Christmas discounting, then that will come back in December or January. (c) someone really needs to look into the huge trades right before the number was released. This wasn’t an accidental post on the website. And you don’t put that much money into an illiquid market on a guess. Someone knew something. Do I expect anyone to investigate? Not really.

Oil Be Home For Christmas

November 23, 2022 Leave a comment

As a general rule, don’t trade on pre-holiday thin-liquidity sessions. There can be amazing-seeming opportunities, but price can still get shoved in your face by whoever it is who feels like pushing markets around.

A prime example today is the energy market, where front-month oil prices are down nearly 4% at this writing. Recently, energy futures have been regularly jammed lower overnight in low-liquidity conditions and then have recovered during the day. There is a structural shortage of energy globally at the moment, and inventories are low…but sentiment is also very poor and as I’ve shown before, open interest has been in a downtrend for years – aggregate open interest in NYMEX Crude hasn’t been lower since 2012.

So, it’s a market ripe for pushing around and the day before Thanksgiving is probably not the day to take a stand by getting long even when the reasons given for the selloff are nonsense. Today, the story is again about the price cap on Russian oil that is being implemented soon by the US and EU. Market participants seem to struggle with Econ 101 here. A price cap has one of two effects in the market under consideration: if the price cap is set above the market-clearing price, it has no effect. If the price cap is set below the market-clearing price, it leads to shortages as suppliers – in this case, Russia – won’t supply as much oil (if any) to the capped market when there are other uncapped markets (say, China and India). There is probably an area near the price cap where the cost of switching to delivering oil in other markets is higher than the gain from switching deliveries, but that’s only in round 1 of the game theoretic outcome.[1]

In this case, since only the price from one supplier is capped, the result should be higher prices in the markets than otherwise since once price exceeds the cap, one supplier is lost. The chart below shows the classic outcome. Below the cap, the supply curve is normal. Above the cap, the supply curve is left-shifted.

This leads, at least in a frictionless market (which this isn’t), to prices being discontinuous around the cap. As demand shifts from left to right, prices behave normally and rise as they normally would, until abruptly jumping higher once the capped producer is removed. In any case, price is more volatile than it would otherwise be…but, and this is important, it is never lower in a market where some or all of the suppliers are capped, than it is in an uncapped market. At best, prices are the same if the caps aren’t in play. At worst, a combination of shortages and higher prices obtain.

Speaking of shortages…it seems that people are growing calmer about the chances of a bad energy outcome over the winter in Europe. This seems, to me, to be related to the fact that inventories of gas are reasonably flush thanks to conservation efforts and vigorous efforts to replace lost Russian pipeline supply (see Chart, source Gas Infrastructure Europe via Bloomberg).

That’s great, but the problem is that since the pipelines are not flowing Europe needs more gas going into the winter than they otherwise would have – because it’s not being replenished by pipeline during the winter, either. We certainly hope that Europe doesn’t run out of heat this winter, but the level of gas inventories is not exciting.

Putting downward pressure on both of these markets, but especially Crude, is the idea that the world will enter a global recession in 2023. As I’ve been saying since early this year, that’s virtually a sure thing: we’ve never seen interest rates and energy prices rise this much and not had a recession. But I have thought that the recession would be relatively mild, a ‘garden variety’ recession compared to the last three we’ve had (the tech bubble implosion, the global financial crisis, and the COVID recession). What worries me a bit is that the consensus is now moving to that conclusion. It seems that most forecasts are for a mild recession (although predictably, economists are all over the map on inflation depending on the degree to which they understand that inflation is a monetary phenomenon and not a growth phenomenon). I’m still in that camp, but that concerns me, because the consensus is usually wrong.


[1] In round 2, after oil delivery from Russia is switched to the uncapped markets, the available price in the capped market will need to be appreciably above the market clearing price in the uncapped market in order to cause the switch back.

Summary of My Post-CPI Tweets (October 2022)

November 10, 2022 Leave a comment

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy, but to get these tweets in real time on CPI morning you need to subscribe to @InflGuyPlus by going to the shop at https://inflationguy.blog/shop/ , where you can also subscribe to the Enduring Investments Quarterly Inflation Outlook. Sign up for email updates to my occasional articles here. Investors, issuers and risk managers with interests in this area be sure to stop by Enduring Investments! Check out the Inflation Guy podcast! Note that this month and going forward, I will be delaying the drop of this tweet summary and the podcast until the afternoon rather than dropping it late morning. So subscribe if you want it live!

  • It’s CPI Day – and here we go again!         
  • A reminder to subscribers of the path here: At 8:30ET, when the data drops, I’ll be pulling that in and will post a number of charts and numbers, in fairly rapid-fire succession. Then I will retweet some of those charts with comments attached. Then I’ll run some other charts.      
  • Afterwards (hopefully 9:15ish) I will have a private conference call for subscribers where I’ll quickly summarize the numbers.    
  • Thanks again for subscribing! And now for the walkup.  
  • The chance of more-lasting inflation just went up a lot. With the much-narrower-than-expected margins for the Republicans in the House – and perhaps no margin at all in the Senate – this is “divided government” IN NAME ONLY.     
  • Republicans are notoriously bad at whipping their vote, and with a narrow margin it will be very easy to pick off a couple of votes with well-chosen pork to pass large stimulus measures if the Democrats want it. And they probably want it.             
  • And why shouldn’t they want it? The Republican message in the midterms was “Biden caused this inflation and we voted against the Inflation Redution Act.” The Democrat message was “Putin caused this inflation and we PASSED the Inflation Reduction Act.” Evidently, that resonated.          
  • Politicians will keep pushing MMT as long as the populace allows them to get away with it. And with such a narrow majority, Republicans can probably not ‘hold the line.’ Ergo, there will be more stimulus ahead.  
  • To say nothing of other continuing pressures, on resources & a need to shorten supply chains as the world fractures the post-Berlin-wall detente. To say nothing of demographic challenges. To say nothing of the fact that prices still have far to go to catch aggregate M2 growth.      
  • Those are not stories for the October CPI, but they are the backdrop.      
  • I was at a conference the last 2 days and several mainstream economists stated (it was barely phrased as an opinion) that core inflation will definitely be around 3% by middle of next year and low 2s by end of 2023.               
  • This seems ignorant of the composition of the CPI. EVEN IF you think inflation pressures in a macro sense are ebbing, we haven’t yet seen any signs of that in the data. Y/Y median CPI has accelerated 14 months in a row. Rents remain buoyant. 
  • Rents will eventually slow, but it will be a while before they slow very much. So far they are still accelerating! And core-services ex-rents is my recent focus. As a reminder, that’s where you find the wage-price feedback loops. And it has recently started spiking higher.
  • But there is a potential fly in the ointment in that group this month, and that’s the question about the CPI for health insurance. Here is the issue that some people are worried about.
  • Medical care is paid for by consumers directly, and indirectly for consumers by insurance companies. It is straightforward (if complex) to measure the part of medical care paid directly to providers – just ask doctors and hospitals.
  • The problem is that there is a difference between what insurance companies receive from consumers (which is part of consumers’ cost) and what they pay to doctors. That is, profit.
  • That’s still a cost to consumers but not captured if you just ask doctors. It shows up in the “Health Insurance” part of Medical Care CPI. So, periodically (because it’s not at all straightforward) the BLS tries to figure out this difference and adjust for it.
  • It tends to happen roughly this time of year, which is why people were looking for it last month and still looking for it this month. Here’s the problem – it isn’t always important.
  • You can see in the m/m changes in Health Insurance that sometimes there’s a discontinuity in the monthly figures, and sometimes not. Here’s the salient point, though – the adjustment doesn’t really matter.
  • If it’s done right, then the overall inflation in Medical Care will be about right. Could be seasonal issues, so any given month it could be wacky, but the REAL question is: is inflation in Medical Care overall accelerating/decelerating? Sure looks to me like it’s accelerating.
  • So I don’t pay a lot of attention to this nuance but be aware that it COULD have an impact potentially today.
  • Last month, big drivers were Rents again (primary=0.74%, OER=0.71%), Medical Care (0.68%, with Hospital Services 0.78% m/m and y/y Prescription Drugs at 3.2%, highest since 2018). Oh, and “Other” at +0.73%.
  • Inflation is of course very broad, and that means it is going to keep being pretty resilient. Until one day it starts narrowing and being less resilient. There’s no good way to say when rents will roll over. They will eventually. Probably not today.
  • But breakeven market is being very optimistic generally about this eventual occurrence! There’s almost no penalty to betting inflation will NOT go back to its old level. Or at least, a pretty small one.           
  • Used cars this month will again be heavy, but probably not as heavy as last month’s -1.1%. Used car prices have retreated (in the Black Book survey) about 12% from the highs but remain up about 35% since end of 2020. That’s about the same as M2, so it’s roughly “right”.       
  • Of course not everything will be up the same amount as the general price level, but that’s a decent touchstone. On average, once velocity finishes correcting back, the aggregate price level should be +30%-+35% (based on current M2) from 2020. Currently +15%. Long way to go.
  • Markets since last month: breakevens are up a bit, but real yields close to unchanged. Reals are pretty close to a long-term fair level. They’ll go higher if nominals go higher but they’re a pretty decent deal esp relative to nominals given the long term breakevens.
  • …and the nominal auction yesterday was pretty ugly, so I don’t know that the fixed-income bears are done. I suspect the Fed is getting close, though. My guess for terminal rate is currently 5%.          
  • Econ consensus for today’s CPI is 0.62% m/m on the headline and 0.47% m/m on core, bringing y/y core to 6.52%. With the medical insurance issue I’m reluctant to hazard a guess but 0.47% seems optimistic. Avg for last 6 months has been 0.56%. But interbank is LOWER than 0.47%.         
  • In any event, good luck! Auto charts will follow the print fairly quickly. I don’t know how many months I will be doing this before I stop being nervous about the automation. But I throttle those charts still to make sure that if something looks wrong it isn’t followed by 9 more.

  • m/m CPI: 0.438% m/m Core CPI: 0.272%       
  • OK now let’s look at these. Obviously the core figure was a disappointment but I can already see it’s not something I’m terribly worried about and not likely to signal that we’re done. That said, it should be a nice rally number.     
  • Last 12 core CPI figures        
  • Primary Rents: 7.52% y/y OER: 6.89% y/y     
  • Further: Primary Rents 0.69% M/M, 7.52% Y/Y (7.21% last) OER 0.62% M/M, 6.89% Y/Y (6.68% last) Lodging Away From Home 4.9% M/M, 5.9% Y/Y (2.9% last)
  • Well, 0.69% m/m is better than last month’s 0.84% on primary rents, but not exactly the deflation that people are expecting to happen ‘soon.’ Soon, it seems, is still a bit far away.
  • M/M, Y/Y, and prior Y/Y for 8 major subgroups          
  • Immediate observation – huge decline in Apparel (yes, a small weight) and in Medical Care (which I suspect is the technical adjustment). Housing, Food, Other, Recreation, all high.
  • Here is my early and automated guess at Median CPI for this month: 0.613%
  • Median: definitely better than recently! but a 7.6% compounded annual median rate isn’t GOOD news. And it suggests that most of the miss was in a few categories, not the main body of the distribution.
  • By the way, a little asterisk on my median calculation – I have the median category as West Urban OER. Since the individual components of OER are seasonally-adjusted (but we don’t know the seasonals), my estimate will be slightly off.
  • Core Goods: 5.08% y/y Core Services: 6.74% y/y        
  • And you can see the effect of Apparel (and Used Cars, which was down more than I expected it would be and more than Black Book suggested it would be) on core goods. This is partly a delayed dollar effect, and some supply-side relaxation, and not surprising in a macro sense.
  • Some ‘COVID’ Categories: Airfares -1.1% M/M (0.84% Last) Lodging Away from Home 4.85% M/M (-1.04% Last) Used Cars/Trucks -2.42% M/M (-1.07% Last) New Cars/Trucks 0.37% M/M (0.67% Last)           
  • So Used Car prices are coming down, and New Cars still going up. Remember in mid-2021 Used Car prices in some cases exceeded New Car prices b/c New weren’t available. They are now, so this is the convergence. Used is correcting, New is trending.
  • Used cars on top, New Cars on bottom, since day 1 of COVID. New have another 10% to go higher, Used another 15% lower, is my guess.
  • Piece 1: Food & Energy: 13.3% y/y   
  • Piece 2: Core Commodities: 5.08% y/y          
  • Piece 3: Core Services less Rent of Shelter: 6.42% y/y              
  • The y/y for health insurance went from 28.1% to 20.6%. Obviously, those numbers are way too high. But it caused the y/y for Medical Care to drop from 6% y/y to 5% y/y. This seems exaggerated.
  • Now, to be sure Medicare is dropping the amount that it is reimbursing health care providers. But Medicare is not in CPI and a squeeze on Medicare reimbursements may make the consumer part of health care more resilient. Got to pay health care providers somehow.
  • Piece 4: Rent of Shelter: 6.99% y/y  
  • No sign of any slowdown in rents yet. And without that, we’re not getting 2% inflation next year, period.
  • That really was an amazing adjustment to health insurance. I applaud those who decided it was going to be huge. Again, though, it’s just a question of how Medical Care inflation gets allocated. And it’s a one-off thing.          
  • Outside of food and energy, the biggest monthly decliners were Infants and Toddler’s Apparel (-32% annualized), Jewelry and Watches (-30%), Used Cars and Trucks (-25%), and Footwear (-13%). No services. OTOH…             
  • Biggest gainers were Lodging Away from Home (+77% annualized), Misc Personal Goods (+26%), Vehicle Insurance (+23%), and Food Away from Home (+11.8%). That last one is obviously Food & Energy but it’s also a wages indicator.
  • Looking at Median some more, probably the lowest it could be (if my West Urban OER seasonal is way off) is 0.55%. And could also be higher than my estimate. 
  • Core inflation ex-housing fell to 5.9% from 6.7%. That’s the lowest it has been since 11/2021. And it’s a good sign. A lot of that is goods.            
  • The deceleration in goods inflation is completely real. But that doesn’t mean goods prices are going to go DOWN, which is what consumers are expecting. Some places where there were overshoots like in Used Cars will go down, but in most cases we’re talking small.             
  • Here’s the challenge on the Fed question. I wouldn’t take a victory lap even though this is the lowest core m/m in more than a year. Median has still not obviously peaked! Next core comps are 0.52%, 0.56%, 0.58%, 0.50% before 0.32% in March.       
  • That means we are probably looking at core which will be steady to declining slowly, but not coming down rapidly. There aren’t 0.6s or 0.7s to roll off until May. So it will look like a peak but not a rapid drop. Unless of course rents roll over and drop like a stone.
  • OR, suddenly workers start getting wage cuts. Keep in mind that the Social Security adjustment for next year will flush a lot more money into the system. There’s just a lot of bad feedback loops that are in play.
  • By the way, Lodging Away from Home was high (+4.9% m/m) this month. That’s a volatile category but surprised me. Hospitality is having difficulty with finding workers though and so this is another one of those pass-throughs I suspect.      
  • Here’s the distribution of lower-level price changes y/y. It’s an interesting tale. The lower tail are mostly goods (insurance won’t be there for a long while), upper tail has some foods and some services. The middle part is still 7-9%.
  • Having said that, this is starting to look more like a disinflationary distribution where the mean is below the median because long tails start showing up to the lower side. I think we’ve likely seen the peak, although Median will take a bit yet.
  • I mean we still have 65% of the distribution above 6%…        
  • That health care insurance adjustment is odd. Normally the BLS smears the adjustment over 12 months roughly equally. I can’t imagine this is going to be 4% PER MONTH for a year. That would be really weird. Something to dive deeper on. For now I’m treating it as one-off.   
  • Last chart. I didn’t run this last month because of tech issues. The EI Inflation Diffusion Index remains high but dropped to 41. It’s not yet really signaling a peak in pressures but if we get down to 30 or 35 I’ll feel better that the peak is real.       
  • OK, let’s try the conference call for anyone who wants to hear this verbally. 🙂 [REDACTED] Access Code [REDACTED] Let’s say 9:35, 5 minutes from now.       

The number today made a lot of folks very happy, but it is a trifle early to declare victory over inflation yet. Core goods remains in deceleration mode. This is no surprise; the extended strength of the dollar helps depress core goods prices with a lag. The sharp drop in apparel prices is sort of the poster child for this effect. But the dollar will not be strong forever, and when it goes back to something like fair value – when the Fed stops hiking aggressively relative to the rest of the world – then there will be a little payback in this category. That doesn’t mean 10% core goods inflation but neither does it mean that we’re going back to the old normal of -1% inflation in core goods year after year. Given the re-onshoring trend and the general unsettled nature of geopolitics, I suspect core goods will end up oscillating around low-positive numbers. Think 1-2%, not -1% to -2%.

Rents remain strong, and there is no sign that they’ve rolled over yet. They will eventually, but it takes a long time for rents to reflect changes in home prices and even longer for asking rents to be fully reflected in rent CPI and OER. Rents will decelerate from here, but not for a while. And they’re also not going back to 2%.

Core services ex-rents is in a continued uptrend. There was a small correction this month, but the feedback loop has been triggered. Next year’s Social Security adjustment will throw more fuel on the fire, and even if unemployment rises so that real median wages decelerate nominal wages are going to keep climbing faster than they have historically. Core services ex-rents…and we saw similar effects in Lodging Away from Home and Food Away from Home, both of which have a big wage component…is going to stay strong for a while.

By the way, on Medical Insurance…that 4% per month drag over the next year is going to add up to 0.3% on headline and a bit more than that on core. But only if this isn’t offset elsewhere in the medical care category. This is bean-counting: insurance in the CPI doesn’t really measure the cost of insurance premiums but insurance company profits. If our estimate of profits declines it’s either because people are paying less for insurance (not likely) or because insurance companies are paying more out to doctors, which means the inflation should just show up there instead. So it will be a consistent drag that is mostly irrelevant in a practical sense.

All of which is to say that while core CPI has likely peaked, and median inflation will probably peak in a few months, the folks who are looking for it to drop to 2% next year are going to be terribly disappointed. I’m sticking with my view that we will be at high-4%, low-5% for 2023.

The Fed, though, will take the peak in Core as a reason to step down to 50bps at the next meeting, then probably 25bps, and ending at around 5%. If rates are at 5% and median inflation is around the same level late next year, it isn’t clear that much higher rates would be called for especially in a recession. But neither will much lower rates. So I think overnight rates get to 5% and then stay stuck there for a while. If you found this useful, and would like to get it in real time during next month’s CPI report, go to https://inflationguy.blog/shop/ and subscribe to my private Twitter feed. You can also subscribe to my quarterly, or purchase a single issue of the Quarterly Inflation Outlook (either current or historical). Thanks a lot for your support.

Summary of My Post-CPI Tweets (September 2022)

October 13, 2022 8 comments

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy, but to get these tweets in real time on CPI morning you need to subscribe to @InflGuyPlus by going to the shop at https://inflationguy.blog/shop/ , where you can also subscribe to the Enduring Investments Quarterly Inflation Outlook. Sign up for email updates to my occasional articles here. Investors, issuers and risk managers with interests in this area be sure to stop by Enduring Investments! Check out the Inflation Guy podcast!

The tweets below may have some deletions and redactions from what actually appeared on the private feed. Also, I’ve rearranged the comments on the charts to be right below the charts themselves, for readability without repeating charts, although in real time they appeared in comments associated with a retweeted chart.

  • It’s CPI Day – and here we go again!
  • A reminder to subscribers of the path here: At 8:30ET, when the data drops, I’ll be pulling that in and will post a number of charts and numbers, in fairly rapid-fire succession. Then I will retweet some of those charts with comments attached. Then I’ll run some other charts.
  • Afterwards (hopefully 9:15ish) I will have a private conference call for subscribers where I’ll quickly summarize the numbers.
  • After my comments on the number, I will post a partial summary at https://inflationguy.blog and later will podcast a summary at inflationguy.podbean.com . Busy day for the IG.
  • Thanks again for subscribing! And now for the walkup.
  • Last month, we again had a large upward surprise. Median CPI actually had its highest m/m print of the entire debacle-to-date. While y/y numbers are the big focus in the media, until we have a convincing peak in Median CPI we can’t really say the inflation pressures are receding!
  • Median CPI has moved back above core; this means that for the first time since April 2021 the longer tails are to the downside (the distribution skews lower, so the average is lower than the median).
  • If this is still true once inflation levels out a little bit, it will be encouraging. In inflationary cycles, the outliers show up on the high side and core moves above median. In disinflationary cycles, the opposite is true. Let’s give it some time and see what happens.
  • Rents in last month’s report were big, and though Used Cars set back a little bit New Cars had a big up. But the BIG eye-opener was the rise in core services less rents.
  • I wrote last month: “If core services ex-shelter is really taking the baton from core goods, that’s really bad news. Because core services ex-shelter is where wage pressure really lives. If you want a wage-price spiral, look in core services ex-shelter to see if it’s happening.”
  • So that is my main focus in this report. More later but let’s look at the consensus figures going in. Consensus for headline CPI is 0.21%/8.09%, while consensus for core CPI is 0.43%/6.52%. That will be a small acceleration in core (again).
  • For my money, the implied drag for food and energy (0.22%) looks slightly too large, and the interbank market seems to agree with an implied headline number of about 0.26% m/m. But I also think the core might come in a teensy bit lower than 0.4%.
  • I don’t know if what I am looking at would be enough to round it lower, but an 0.3% core print would make the markets very excited and COULD make the Fed favor a smaller move at this meeting. Not only because of 0.3%, but because things are starting to break.
  • …and the Fed’s models say that inflation should be slowing, so…why not taper the tightening? I think we MIGHT be having that discussion later this morning.
  • Certainly, the mkts have let the Fed go pretty far without throwing up a stop sign. 2y rates +72bps in the last month and 10y rates +54bps? Tens at 3.90% are pretty close to a long-term fair number (still a trifle low) after YEARS of being too low. Naturally, we could overshoot!
  • The decline in forward breakevens is very curious – I don’t see any sign that 2.25%-2.5% as a long-term equilibrium is still the attractor we will drift back to. The fun house mirror is broken for good I think.
  • So where do I see some potential softness? Our models have rents leveling off – not peaking per se, but leveling off – and that means that a trend projection of last month’s number might be overdone. Of course, those are just models.
  • More important (and obvious to many) is the decline in Used Cars prices. Last month, Used were a small drag but New cars added a bunch. We could still get the bump in New, but Used ought to be a decent drag based on the Blackbook figures.
  • But as an aside, this goes back to the error being made by a whole lot of people and politicians especially. See that last chart? Does it say “used car prices are coming back down and reverting, now that supply chain issues have cleared up? NO.
  • It’s a mistake, the same one people are making in rents & home prices. Rates of change could mean-revert. Prices will not. Prices are permanently higher, b/c the amount of money in the system is permanently higher. This chart shows the price level. Not going back to the old days.
  • Politicians saying inflation should ebb soon SEEM to be telling constituents that prices are going back down. At least, that’s what the constituents hear. They will be mad when the politicians say “see?” and they see all prices 30% higher than pre-COVID.
  • (I actually think something similar may be the root of a lot of conspiracy theories about how the government ‘cooks’ the numbers. They’re just talking past each other, with one talking price level and one talking rate of change.)
  • And speaking of money in the system – money supply growth has come to a screeching halt over the last few months, which is great news. Unfortunately, we are still catching up to the prior increase in money, which is why it will take a while for inflation rates to come back down.
  • There’s still work to do. Anyway, a lot of that is wayyyy beyond the trading implications for today’s figure. The key for me is to look past used cars and rents, and look at CORE SERVICES EX RENTS. That’s one of our “four pieces” that you’ll see in a few minutes.
  • If there’s softness in core, it will be taken well by both stocks and bonds and while I might fade stocks in a day or two, I’m not sure I’d fade a rate rally at least at the short end. If I’m wrong, and the core number is HIGHER…it could get pretty ugly. Liquidity is bad.
  • That’s all for the walk-up. Ten minutes until kickoff. Good luck today and thanks again for subscribing! Charts will launch a minute or two after 8:30, assuming data drops on time at the BLS.

  • welllllp. Not soft!
  • m/m CPI: 0.386% m/m Core CPI: 0.576%
  • Further: Primary Rents 0.84% M/M, 7.21% Y/Y (6.74% last) OER 0.81% M/M, 6.68% Y/Y (6.29% last) Lodging Away From Home -1% M/M, 2.9% Y/Y (4% last)
  • Last 12 core figures. About the same as last month. And if you exclude the two little dips, the other 12 are all pretty much 0.58% ish. That’s uncomfortable stability! Don’t want to see that. Comps get tougher going forward so core might not go up much more…but no sign of down.
  • Here is my early and automated guess at Median CPI for this month: 0.667%
  • Now, Median stepped down so that’s good news…but 0.667% m/m is not terrific. This is still the third-highest m/m in the last 40 years or so!
  • M/M, Y/Y, and prior Y/Y for 8 major subgroups
  • In the major subgroups, the drop in apparel stands out. The dollar’s strength is definitely affecting goods prices, and Apparel is one place where we see that most clearly.
  • Core Goods: 6.63% y/y Core Services: 6.65% y/y
  • It’s cute to see Core Goods and Core Services kissing. We know that goods are eventually going to go back down to 0-3%…especially if the dollar remains strong.
  • Primary Rents: 7.21% y/y OER: 6.68% y/y
  • This is a surprise – a further acceleration in rents. Economists might look past this, because with home prices leveling off rents won’t keep shooting higher and higher. Will they? Our model has a peak happening but if wages keep rising then rents need not decline, just slow.
  • Some ‘COVID’ Categories: Airfares 0.84% M/M (-4.62% Last) Lodging Away from Home -1.04% M/M (0.08% Last) Used Cars/Trucks -1.07% M/M (-0.1% Last) New Cars/Trucks 0.67% M/M (0.84% Last)
  • In the covid categories, Used Cars was in fact a drag. And New Cars was in fact a bump higher. There have been some big stories recently about markups for new trucks etc so this isn’t a surprise. But again, core goods will eventually decelerate.
  • Piece 1: Food & Energy: 14.2% y/y
  • Again Food & Energy is decelerating, but again it’s not as much as expected BECAUSE food, which we ordinarily mostly ignore, keeps rising. 10.8% y/y on Food & Beverages!
  • Piece 2: Core Commodities: 6.63% y/y
  • Piece 3: Core Services less Rent of Shelter: 6.62% y/y
  • Soooo…this is the piece that’s sort of ugly and I was worried about this. Core services less rent-of-shelter continues to accelerate. Medical Care was another 0.77% m/m, with Hospital Services 0.66% m/m. I’ll look at some of the other categories in a bit.
  • Piece 4: Rent of Shelter: 6.68% y/y
  • Core ex-housing (not just core services ex-housing) rose to 6.7% y/y. It had gotten as low as 6.04% two months ago but is reaccelerating. We know core goods is decelerating so the upward lift is core services ex-housing. And as I noted, that’s bad.
  • I forgot to mention that the median category was New Vehicles. As always with my Median CPI estimate, I caution that I have to estimate the seasonals on the OER subindices and if I’m off, and an OER category is near the median, then my Median guess might be off too.
  • Food AT HOME was 0.6% m/m (SA), 12.98% y/y. That’s slightly lower than it has been. Food AWAY FROM HOME, though, was +0.94% m/m, 8.48% y/y. This is bad – food commodities are leveling off a little, but wages show up in food away from home.
  • This number could have been worse. Airfares being -4.62% m/m helped. Airfares are largely driven indirectly by jet fuel, but had been positive last month so this is a catch-up. However, jet fuel is probably not going to go down much futher.
  • Conclusions: (a) this number is worse than expected. And not from little ‘I don’t care’ one-off things. (b) Where wages show up in the economy, we are seeing more inflation pressure show up in CPI. That’s not evidence a wage-price spiral has begun, but it is suggestive.
  • (c) since in yesterday’s FOMC minutes, participants had been musing about the risk of a wage-price spiral, this is especially salient right now. (d) This seals 75bps. They won’t do 100bps, and this report doesn’t let them do 50bps.
  • (e) This MAY raise the terminal rate. We will get more inflation data, but median CPI isn’t showing a deceleration and the m/m core is pretty solid at a 7%-ish rate (0.58%/mo) with occasional dips. Need at least 2 dip months.
  • (f) The deceleration in core goods is already happening. It has been happening. The dollar’s strength will help it to continue. But the acceleration in core services is more durable and not dollar-sensitive.
  • (g) it’s also not particularly rate-sensitive. (h) Higher wages also support higher rent growth. I am surprised at the extent of the strength in rents but put that (somewhat) in the wage-price spiral camp.
  • And finally (i) inflation markets are ridiculously mispriced. There is no reason to think that 2.25%-2.5% is the fair bet for 10-year inflation, especially when it’s going to be at 5% or above for the first 2 years of that 10 years. This is going to take a while.
  • I’m going to do a quick call right now and present my thoughts. Dial-in is <<redacted>> and Access Code <<redacted>>.
  • I will throw another housing-related chart here. Here is OER in red, against two home-price indices that are often used to model rents as a lagged function of home prices. The leveling-off should happen soon. BUT>>
  • …BUT the betas have changed and OER is higher than we would have expected based on the prior relationship. Those regressions were all based on nominal changes, not real…part of home price increase should be pass-through of value of real property, greater when infl is higher.
  • Either way, the timing suggests we should level off, and if you believe this model then in 6-12 months rents should be in sharp retreat. Maybe. But like I say, things have changed from the 2001-2020 baseline!

We keep waiting for a clear turn in inflation, and it hasn’t happened yet. Moreover, the longer it lasts then the more likely that it feeds back into wages, since workers have more and more evidence to take to the bargaining table when it’s time to discuss increases. Some of the feedback loops are purely automatic: For example, on the basis of today’s figure Social Security benefits next year will jump 8.7%, giving retirees an additional slug of cash to spend next year. That automatic adjustment also creates a feedback loop in deficits, of course – that big increase in benefits will also increase federal outlays! So, if you were hoping to balance the budget rather than pour more fuel on the fire…it just gets harder and harder.

The slight drop in m/m median CPI is nice, but not sufficient to signal that inflation pressures have turned. For a very long time, everyone else was surprised with the resilience in inflation and I was not – but now I’ve joined the ranks of those who are surprised. I haven’t thought, and do not think, that inflation will fall back to 2% any time soon, but I also didn’t think it would keep accelerating into year-end. I still don’t think that. But…it’s also hard to see where the deceleration is going to come from. Our models (and the final chart above) give reason to think that rents might level off from here, but not decelerate much; core goods will continue to retreat but core services seem to have a feedback loop going. The fact that food away from home is accelerating while food at home is correcting slightly is emblematic of the passing of the torch from raw materials pressures to wage pressures. This is not good.

That being said, and while 75bps is pretty much cemented now at the next Fed meeting, I still think that the FOMC is looking for reasons to slow the pace of hikes. Things are starting to break around the world, and there’s no appetite (I don’t think) to test the limits of the system’s fragility right now. But the balance sheet is going to continue to shrink slowly, and that’s a big part of the decline in market liquidity. Certainly, the market has been generous with the Fed so far and hasn’t offered them the Hobson’s choice of saving the markets or pushing inflation lower…but that choice is going to come sooner or later especially as inflation has not yet shown any real signs of slowing down.

And yet, as I write this the stock market has closed the gap by rallying up to yesterday’s closing level, and is spiking higher. That’s remarkable, and I think it’s fadeable!

Fair is Fair, and TIPS are There (Almost)

September 30, 2022 6 comments

For a very long time, I have been writing in our Quarterly Inflation Outlook that TIPS were “relatively cheap, but absolutely expensive.” By that I meant that TIPS real yields at -1%, -2%, etc were not exciting (implying as they did that a buyer would have long-term real wealth destruction), but that compared with nominal Treasury yields of 1%, 1.5%, or 2% any investor in fixed income should have vastly preferred TIPS.

I have repeatedly said – as far back as 2016 – that with breakevens below 1.5% there wasn’t even a decent strategic case to own nominal bonds rather than inflation-linked bonds (ILBs) except to defease specific nominal liabilities and that at times those low breakevens meant that owning nominals instead of ILB amounted to a really big bet (as I said in this article from March 2020). Those are relative concepts.

But 10-year real yields were below zero, and as low as -1.2%, for most of 2020, 2021, and the first half of 2022. And 10-year real yields have been below +1% almost continuously since 2011. When real yields were below zero or just fractionally positive, it meant that TIPS were absolutely expensive. That wasn’t just a TIPS problem of course: low real yields were the most obvious in TIPS, but you couldn’t avoid them by trafficking in other asset classes because they were a characteristic of the environment we were in. Everything was absolutely expensive, but TIPS were at least relatively cheap.

More recently, our models indicated TIPS getting quantitatively fair on a relative basis, which is historically unusual (see chart, source Enduring Investments); they even got somewhat rich a couple of months ago and that’s historically unheard of.[1] Real and nominal yields were still low, but at least it was a fair horse race between which ones to hold. And if you’d bought TIPS when I said there was “a big bet” being made against them, and sold them when we said they were fair, you crushed a nominal portfolio’s return. (As an aside, the rich/cheap chart and value is available every day on my private Twitter feed. Sign up for that private feed here: https://inflationguy.blog/shop/ I keep adding more charts etc, in addition to the main event, my live CPI report coverage each month).

As of today, 10-year TIPS yields are all the way up to 1.67%, the highest they’ve been since 2010. I explained back in June why the equilibrium risk-free real interest rate is approximately 2.25%, so TIPS are getting to the neighborhood of long-term fair values in an absolute sense. TIPS have no risk in real space, when held to maturity, so if you can get an annual 2%ish real increase in wealth with no risk, that’s a good deal. And inflation-linked bond yields in developed markets basically never yield more than 4% or 4.5%, so the higher the yield goes the less your potential mark-to-market downside. A 5-yr or 10-yr TIPS yield of 4% is back-up-the-truck stuff if you see it. At those real yields, with no risk, other asset classes simply can’t compete. At 1% breakevens there was no reason to own nominal bonds rather than TIPS; at 4% real yield there would be no reason to own stocks rather than TIPS.

But that sort of yield is of course very rare and we won’t see it unless nominal yields get up to double-digit land. At the current level, with TIPS at fair or slightly-cheap relative value and approaching fair absolute value, it is worth accumulating TIPS as a long-term hold.

It has been an astonishingly long time since I could make that statement. And TIPS may well get cheaper from here. I hope they do! But in the meantime, you can do a lot worse than guarantee yourself that your wealth will increase 18% more over the next decade than the price level rises.[2]


[1] I have written previously though about the value of long inflation tails, and how that value is NOT reflected in TIPS so that even when our model says TIPS are fair, they’re still very cheap if that tail option is reasonably valued. But that isn’t included here.

[2] (1+1.67%)^10 – 1 = 18%.

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