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Quick Notes on the Week

I have been quasi-vacationing this week on the Continent, and trying to follow the news and the markets. This will be a brief comment but I wanted to make a couple of quick notes:

1. I did not, and I still do not, understand why there was such a violent (and negative) reaction to the Fed’s statement and Bernanke’s suggestion that the “taper” may start later this year and end in mid-2014. There are all kinds of reasons not to freak out about that. First, it was approximately what was expected (although two weeks ago there were many who thought absurdly that the Fed would begin a taper at this meeting). Second, the taper is contingent on growth continuing to strengthen, and there are scant signs of that. Third, as Bullard showed today there is far from a consensus on whether Bernanke’s time frame is going to work out – and, while ordinarily the Fed Chairman’s vote is the only one that matters, in this case he is not going to be present for the end of the taper so what really matters is who is selected to replace him. Fourth, QE isn’t doing anything right now, except artificially depressing long Treasury yields. It is probably pressuring money supply growth, but not very much. The only thing that further QE will do is make the exit that much more difficult.

That said, the violent reactions to the Fed statement are prima facie evidence of what critics of the QE policy (me, for one) have always said: we have no idea how rates and markets will react when the Fed finishes and unwinds this policy, regardless of Bernanke’s assurances. The harsh reaction (quite a bit more than I expected, especially with such a tepid adjustment to the expected trajectory) is great evidence of how over-dependent the market is on the view that the Fed’s support makes losses extremely difficult. And, I will say again, this would be so much easier if the Fed wasn’t telegraphing everything, because then investors would have invested with much more caution. The reaction this week was partly due to the shock of actually hearing the Fed mention a date for the first time.

2. Speaking of investing with much more caution, the amazing stress in certain ETFs that has accompanied significant but not exactly dramatic moves in (for example) emerging markets should blare two huge lessons to investors. The first is that you can’t increase liquidity of a pool of assets by putting them in an ETF wrapper. A pile of illiquid securities, or securities that can become illiquid in a crisis, are not more liquid because you can get a quotation every second. An ETF consisting of emerging markets bonds is never going to be more liquid than the underlying emerging markets bonds (although it may be more granular, and there are other ETF advantages…but not liquidity). An ETF consisting of commodity futures, by contrast, will be tremendously liquid because the underlying commodity markets are tremendously liquid. The second lesson is more subtle, and that is that an ETF of less-liquid securities is, in a crisis, only as liquid as the least liquid element. If you present an ETF to me for redemption and there is 1% of it that I can’t get any bid on, then the best you’re going to get is a quote at 99% of the “fair” market price. And that is especially true these days, since dealers and market-makers are capital-constrained and can’t merely take those illiquid positions on the books.

3. There is a lot of dry tinder around in the world today, and never for a minute suppose that they are not related. Stress begets stress. Two million people protesting in Brazil are doing so partly because of economic stress. Tight money market rates in China (persistent since if the central bank adds too much liquidity it will cause the CNY to depreciate) is a partial consequence of economic stress. A return of Greece from the frying pan to the fire: economic stress. And so on. This is not a safer world for all of the QE.

4. Finally, remember that growth and inflation are not related in any meaningful way. Median home prices rose more than 15% over the last year according to a report this week, and not because of great economic results. Money velocity is rising with interest rates although we may not see the results for some months. Inflation, which got a boost in the US this week with a strong CPI report (see my brief comments here), surprised on the high side in the EU and UK. TIPS yields are at +0.56% in the 10-year sector and 10-year breakevens are at 1.92%. There is absolutely no reason to own Treasuries rather than TIPS at this point. The 10-year expected real return of stocks is now less than 1.5% per annum above 10-year TIPS, and there is absolutely no reason to own equities rather than TIPS. Are TIPS cheap on an absolute basis? No. But they are screamingly cheap on a relative basis in an environment of rising inflation (and nothing the central banks can do about it – at least those who aren’t actively trying to boost it). Long-time readers will know I have been tepid at best about TIPS for some time. But, while 0.56% isn’t ridiculously cheap (and they could still get there!), our models are already maxed out on breakeven exposure and are starting to add to outright long exposure in TIPS.

  1. June 21, 2013 at 3:44 pm

    The 10-year Treasury closed today at 2.51% and the 10-year TIPS at about 0.59%, putting the breakeven rate at 1.92%. That’s cheap, at least historically cheap, at least relatively historically cheap as you say. The 5-year breakeven closed the day at an even cheaper 1.66%.

    The 5-year TIPS has taken a wild swing in yield from -1.43 on April 26 to -0.24% today. That’s 119 basis points in 56 days!

    I decided today to get back into TIPS mutual funds in my retirement account, after being out for 2 years. But I am just putting a small amount in and I am going to put future contributions there, to dollar-cost average. Exciting times.


    • June 21, 2013 at 4:07 pm

      Gosh, thanks for pointing out the 10y break…I was looking at 10y inflation swaps. It has moved so quickly!! I have corrected it in the comment.

  2. HP Bunker
    June 22, 2013 at 4:46 pm

    Just out of curiosity, if the concerns of some of our esteemed Fed governors turn out to be well founded and we actually experience deflation in the US, will TIPS’ principal be adjusted downward on maturity? In other words, is your worst possible 10-year nominal TIPS yield right now .59%, or can you actually experience a negative nominal yield?

  3. eric
    June 23, 2013 at 3:57 am

    Not cumulatively, but in any particular periods, yes. So, if you buy a brand new TIP today, you are guaranteed your nominal principle back at maturity. But if you buy a TIP that has accrued inflationary value, you could lose that. Mike can correct me if I wrong on that.

    • June 23, 2013 at 10:34 am

      You are correct. Your accretive value can be below par PRIOR to maturity (so your coupon, say 2%, which is usually 2% * the accretion factor, can be less than 2%), but your principal will never be below 100% at maturity. Unless you’re in Japan, since JGBis have no floor.

  4. eric
    June 24, 2013 at 12:11 pm

    Here’s another question: why is the liquidity so crappy on INFL? right now I’m seeing almost $1.50 spread on a ~$45 security. Any ideas on how to get into (and eventually out of) this vehicle without getting killed on slippage? Is UINF a better option? And if so, in what proportion would you buy the latter over the former?

    • June 24, 2013 at 6:14 pm

      Right now, liquidity in TIPS is really, really poor. Ordinarily the spread is nowhere near that large, but dealers are having a really bad quarter in everything, and with quarter-end approaching there are very restrained balance sheets. Now, INFL also has some small Deutsche Bank risk, b/c it’s technically an ETN, so that’s probably not helping. I personally prefer RINF or UINF because they’re purer instruments (only one point on the breakeven curve) and easier to price.

  5. Chris
    July 1, 2013 at 10:01 pm

    May I ask how exactly you have calculated the 10-year expected real return of stocks?

    • July 1, 2013 at 10:38 pm

      I have remarked on it before in these articles…in a nutshell it is the current dividend yield, plus long term equilibrium real economic growth, plus or minus the “pull to fair” of the 10-year Shiller P/E to the long-run average of 16 (actually, 2/3 of the way to that average). Right now, the Shiller P/E is very high compared to that historical average, so the drag from that factor takes a bunch of the starch out of the other two pieces.


  1. June 21, 2013 at 4:15 pm

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