For a change, fixed-income is where all of the excitement is. For more than a month (since March 5th, the S&P has closed no lower than 1540 and no higher than 1570, plus or minus a couple of nickels: a month-long range of less than 2%. What’s really amazing about that is that on seven of those twenty-three trading days, the range of the day was more than half of the month’s entire closing range. In two of the last four trading days, the intraday range was two-thirds of that for the entire month!

Meanwhile, the 10-year Treasury rate has gone from 1.90% to 2.06%, down to 1.71%, and ending today at 1.75%. The closing range in point terms of the current 10-year note was 99-16 to 102-19, or a bit more than 3% (and it was obviously more than that for the long bond). It has been a long time since bonds were more volatile than stocks over a period as long as a month.

Most of that volatility in nominal rates has been on the real interest rate side. The range in closing 10-year TIPS yields is -0.52% to -0.76%, or 24bps, compared to 35bps for the nominal yield. That’s more volatility than the real yield should be displaying at this level of rates, and it has moved TIPS from being slightly cheap a month ago to somewhat rich. Our Fisher yield decomposition model, which had been neutral on TIPS and breakevens since mid-February, is now modestly short TIPS (and still flat breakevens). Moreover, the leverage applied by our long-inflation-biased “smart beta” model is only 2/3 of the neutral leverage, so conservatism is the watchword at the moment.

The rally in TIPS and nominal yields owes much, I am sure, to the somewhat feeble data we have seen over the last week. The Employment data, in particular, were very disappointing, especially to that group of people who expected profligate monetary policy easing to create economic growth. It will surprise no regular reader of this column that I am not shocked to see a lack of growth response to aggressive monetary policy easing – as I take pains to remind readers, monetary policy is not supposed to affect growth, except in the presence of money illusion. It is therefore something less than a news flash that growth is responding more to tiny changes in government spending (albeit temporarily) than to massive changes in monetary aggregates.

To be sure, even monetary aggregates have been drooping lately…at least, the ones that matter. M2 has been lurching along in the mid-6% growth rate year-on-year, and flat over the last quarter (see chart, source Federal Reserve). That’s only slightly above the average growth rate in M2 since 1981 – although, to be fair, the average core inflation over the same time period has been about 3.1%, so core inflation is still well below where we would expect it to get to if this rate of monetary growth continues.


Growth in commercial bank credit growth, also, has retreated to only 4.1% year-over-year after spending most of the past year above 5%. It too is still right around the long-term average real growth in commercial bank credit (see chart, source Federal Reserve, Enduring Investments), but last year it had been edging towards the mid-2000s standard.


So these are positive developments from the standpoint of future inflation, but it is far too early to call victory on that front. I expect the rise in M2 to re-accelerate in fairly short order; but in any event it is important to remember that the Fed is not the only game in town and not the only central bank that is pursuing easy-money policies. Indeed, last week the biggest news was that the Bank of Japan pledged to double its monetary base, its holdings of JGBs, and its holdings of ETFs and JREITs over a period of only two years.

This policy will almost surely produce the result the Japanese policymakers have been shamelessly vocal about seeking: higher inflation, in a short period of time. At the end of the day, the inflation that Japan gets in the near-term will depend on what their domestic money velocities and multipliers do, but they will surely get higher inflation eventually just as the Fed’s policies have produced inflation even with declining multipliers and velocity. To my mind, the Japanese inflation swaps market – which according to Bloomberg is at 1.26% for 5 years and 1.01% for 10 years – seems to be cheap!

But the Japanese policy will certainly not stop at the water’s edge. Around 2/3 of our domestic inflation is sourced from global factors, and the monetary policy of a major trading partner is a significant global factor. The behavior of the Yen and industry response to changing competitive pressures from Japan will determine how much of the BOJ’s inflation remains domestic and how much is exported, but it would be surprising indeed if the result was entirely contained within the borders of Japan. The Yen has responded sharply to the policy changes at the BOJ (see chart, source Bloomberg), but in my opinion it has very much further to go. In fact, the only reason we may not get back to mid-1980s levels is that the Fed’s policy is similarly aggressive – the only difference at the moment is that the Fed is giving lip service to the notion that they intend to hold down inflation in the long run. (I don’t believe them.)


None of the above has much, if anything, to do with North Korea, or Cyprus, or Slovenia, or Portugal. All of those countries still are potential wild cards, and all of them (it needs hardly be said) constitute downside risk. The White House is seemingly satisfied to wait to see if North Korea really will launch a nuclear-tipped missile; this means that the entire distribution of potential outcomes is compressed so that there is a very high likelihood of nothing bad happening, and a very small chance of something really, really bad happening. How do you trade that? The answer is that you use options. Implied volatilities are under pressure again because the recent tight range makes it difficult to eat the time decay of long-vol positions. But as for me, I’m delighted to pay insurance premiums for insurance that turns out to be unnecessary, especially when that premium is low. I don’t have any long equity positions, but if I did then I’d be protecting them with cheap put options.

  1. Eric
    April 8, 2013 at 7:13 pm

    Two questions:

    1. How does printing yen create inflation in dollars. Shouldn’t the amount of yen inflation that the yen printing creates be offset by yen devaluation? Otherwise, it seems like a country could consume more of world-wide goods just by printing its own money. And in the long run, that doesn’t possible, does it? (Not an argument–just a naive question.)

    2. Is there a retail way to get exposure to Japanese inflation swaps or something approximating them? Something akin to INFL for the japanese market. (Does Japan have TIPS?)

    • April 8, 2013 at 9:35 pm

      Great questions, Eric. As for (2), which is the easy one, the answer is no…in fact, it’s not all that easy for institutional investors to get access to that market either, as the liquidity is fairly poor (the government a couple of years ago ceased, for a while, issuance of JGBi, which really hurt the market’s development).

      (1) is more difficult, and I’m struggling to make the answer concise and yet vaguely clear. In a world with perfectly responsive foreign exchange markets, in which each country produces a single good with static inputs, and consumes all of its GDP without savings…then yes, changing the supply of one currency should have no effect on the overall price level, but will change the foreign exchange rates. Then the ‘law of one price’ holds, and there is one global price for each good in different currencies. The inflating country has more domestic currency, but it buys less of all of the other currencies in precise measure so that it imports and exports and consumes exactly the same as it did before. There is no wealth effect because we’re assuming no wealth, and consumption patterns do not change because we’re assuming that GDP is equal to national income so that inflation is fully transmitted to all input as well as output costs.


      In reality, none of that stuff holds. If a country makes more than one good, with differing types of inputs, and consumers do not spent amounts equal to their wealth, then inflation even in one country changes the pattern of consumption within that very country even if the real prices haven’t changed (because the real value of savings has). And if the currency precisely adjusts to make good X, with inputs (a, b) in a certain proportion, have the same global price and the same global input costs no matter what currency it’s bought or sold in, there will be another good Y, with inputs (a, c)…some of them imported…in different proportions, and the currency move will cause consumers in one country to prefer more or less of that good than they did previously, and to save more or less in different currencies. And then the whole apple cart is upset.

      The really short answer I think is that there are market frictions, taxes, quotas, currency support regimes, sticky prices in some goods, different patterns of wealth endowment, and different degrees of money illusion that means the currency typically does not precisely adjust in real time to the different monetary policies. If the currency under-adjusts, then inflation is exported. If it over-adjusts, then inflation is imported.

      This isn’t as crazy an inefficiency as it may seem. Spot currency prices respond to a lot of things rather than the near-term supply of currency!

      I’m not sure I did a good job explaining that, but I think that’s because it’s not easy to explain!!


  2. Eric
    April 8, 2013 at 9:46 pm

    No, that was really good. And it makes basic sense. The basic truth that does a lot of the work seems to be this: “Spot currency prices respond to a lot of things rather than the near-term supply of currency!” And I guess that’s obviously true, since lots of currencies become “undervalued” and “overvalued” according to the Big Mac index, etc.

    As for 2: There are ETF’s that short Japanese nominal bonds. But there dont seem to be Japanese TIPS etf’s. I guess buying an international TIPS etf like ITP and a short Japanese etf like JGBS in the right proportion would have some substantial likelyhood of tracking japanese inflation swaps. But that would be adding a lot of risk no one probably wants.

  1. No trackbacks yet.

Leave a Reply