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Don’t Count Bill Gross Out Yet

This is why I am hesitant to fade Bill Gross (aside from the statistical likelihood of doing so successfully). Days like today, in which bonds sell off 11bps (¾ point in the 10y futures contract) on essentially nothing more than the failure to appreciably bust through 3%, seem to me to be foreshadowing the day when the 11bps is just the start of something.

The catalyst couldn’t have been Retail Sales. Retail Sales was right on the estimates when the revisions to the prior month are included, and frankly this isn’t a data point that demands pinpoint accuracy since the misses can be quite large. Retail Sales ex-autos rose 0.3%, which was still the worst performance since last July. And yet the rains came in bonds.

Now, some people might be excited about the good news implied by the recent bounce in the Citi Economic Surprise index, which I mentioned here and which subsequently fell to -117.2, the lowest ever realized except for in the immediate aftermath of the Lehman crisis. The bounce to -95.4, however, is entirely a product of old data falling out of the 3-month window of the data (it’s not a smoothed average). In mid-March, bad surprises on Claims and on Michigan, as well as Trade, really started the downward surprises. In the next couple of days, a rotten Housing Starts figure will roll off. In short, it is going to be difficult for the index to not bounce a fair amount, especially since economists by now are surely compensating for the trajectory they now realize is in place.

Maybe bond guys just realize that if all of this bad news is in place, and not many folks are expecting a cheerful resolution from the Greek crisis, there are few reasons for Treasuries to rally further. I also wonder if it is time to be short TIPS. While inflation is going to continue to gradually accelerate (tomorrow’ CPI data is expected to bring the year-on-year core rate to 1.4%, reasonably close to the lower end of the 1.6%-1.8% range I expect it to inhabit at year-end), TIPS have benefitted more than Treasuries from a scarcity effect while the Fed was buying all of the net supply over the last six months at the same time that such a policy ignited a desire among investors to buy inflation protection. The 10y TIPS yield at 0.77% is very low, both on an outright basis and even as a proportion. Ten-year real yields are 25% of 10-year nominal yields; the more-normal proportion is 35-50% in non-crisis times. That suggests 10-year TIPS might be 30bps or more rich, only nine days away from a 30-year TIPS auction that will be held without the agreeable background of Fed buying.

To be sure, there are plenty of buyers of inflation protection and not much worth buying as all forms of direct protection are expensive. I first wrote about the exchange-traded inflation-linked bond issued by Sallie Mae, symbol OSM, in May 2010 when it was trading at 16 and priced to yield CPI+10%. Now it’s around 23, priced to yield CPI+4%, and that means it is approximately fair given the credit spread of Sallie Mae. I am entirely out of my position, because now the possible credit exposure in a period of tight spreads outweighs (for me) the marginally higher coupon. It’s fair relative to TIPS, that is, and TIPS are expensive so…

There are also signs of ebbing inflation concerns at the margin. Five-year inflation swaps are 35bps cheaper, even after widening about 5bps today, than they were at the beginning of May. If core CPI is soft tomorrow, it might not be safe to be around TIPS.

So what are the prospects for that outcome? Well, last month’s unrounded rise in core CPI was +0.185%, with the market consensus looking for another 0.2% this month. The good news was that shelter inflation did slow its rise (as I’d thought it would, given the housing overhang); the bad news was that Medical Care, Other, and Apparel all rose when they had previously been quiescent. If those were one-off wiggles, then tomorrow could surprise on the low side. I think it will be difficult for it to surprise us with an 0.3%; that’s a big rise and would constitute a shocking number as well as probably near-instant vindication for one Bill Gross. And in that case, you might still win being short TIPS.

This sounds rather strange, but it is because of different time-frames involved. A small miss lower on CPI will not change the fact that the overall trend is upward, but it would serve to reduce the fear premium currently embedded in TIPS. A miss higher would keep that fear premium stable or even increase it a little bit, but that would probably be in the context of rapidly rising rates overall. Your overall short position does better in the latter case, probably, because the whole yield structure would be moving to higher yields rather than just the incremental spread between TIPS and nominals. I think you’re risking 5-10bps to make 25-30bps.

Investors will also see Empire Manufacturing (Consensus: 12.00 from 11.88) and Industrial Production/Capacity Utilization (Consensus: +0.2%/77.0%). The data mill is finally grinding again.

Disclosure: I do not have a position, either long or short, in TIPS but our main long-only quantitative strategy has a significant underweight in inflation-linked bonds.

Categories: CPI, TIPS, Trading
    June 15, 2011 at 1:33 am

    Michael, just a technical question, I guess. How well do TIPS correlate with the real interest rates in the economy?

    • June 15, 2011 at 6:47 am

      Really tough question to answer, because we can’t observe the real interest rate faced by investors and savers. That’s because the real interest rate would combine the forward looking nominal interest rate with forward looking inflation expectations, and the only way we have to measure those is … using the inflation-linked bond markets (or swaps, which are connected).

      In the past (pre-TIPS), theorists (e.g., Fama/French) have used the backward-looking inflation rate actually realized matched up up with forward-looking interest rates, reasoning that would work if economic actors are naive and just extrapolate last year’s inflation. We now know that isn’t how it works, so that’s wrong.

      Moreover, each person faces a different real interest rate that depends on his/her consumption basket.

      Soooo, in my opinion it is best to assume that the deep, liquid market for TIPS reflects the real risk-free interest rate. But it’s a hypothesis we can’t easily test.

  2. Lee
    June 15, 2011 at 12:12 pm

    Thanks for the heads up on OSM. It seems poised to fall in response to QE2 ending perhaps and so seems interesting as a place to watch the battle unfold.

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