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Seasonal Allergies

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

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

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


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


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


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

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

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

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


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

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

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

  1. JohnHawk
    October 15, 2014 at 10:09 am

    TIP due 7/15/24 yields 0.276% w/o inflation adjustment. If I assume CPI going forward will increase at 2% per year for 10 years, that would give the TIP an estimated yield of 2.72% with inflation adjustment. (I.e., 2% compounded annually for 10 years = 2.44%. 0.276% + 2.44% = 2.72%.) Treasury due 8/15/24 yields 2.202. Difference b/t TIP’s estimated yield w. inflation adjustment and Treasury’s yield is 0.52%. That’s pretty close to the 47 bps you mention in your article. Am I doing this correctly? Do I also understand correctly that TIPs don’t adjust downward for deflation? I’m an inflation-investing novice. Thanks for articles.

    • October 15, 2014 at 11:52 am

      Well, that’s not how we get the 47bps, but it’s a not-unreasonable calculation.

      TIPS principal amounts used to calculate coupons can be less than 100, but at maturity they will never pay less than 100 even if there is net deflation. However, to the extent that a bond has already experienced inflation since its issue it can lose that accumulated inflation. So, if a bond was issued a year or so ago and has 2% accumulated inflation, it is still exposed to lose 2% net deflation before that “floor” kicks in. And again, that only applies at maturity.

  2. eric
    October 16, 2014 at 12:39 pm

    So, does Bullard really believe the deflation story, or is the the “most hawking” fed member really blinking because the market was down 7%. Either way: worst.fed.ever. I wonder if today will be remember as the day it all came apart. wow.

  3. eric
    October 16, 2014 at 12:39 pm


    • October 16, 2014 at 1:33 pm

      Yes, it’s really amazing. And as I tweeted yesterday, it’s amazing that people are saying “well, I’ve endured most of the correction already, no point selling now.” We’re down 7%. That’s only most of the correction if it happens to only be 10%. But we’re so overvalued it’s not hard to come up with something worse.

  1. October 15, 2014 at 4:45 pm
  2. October 22, 2014 at 4:54 pm
  3. November 6, 2014 at 1:53 pm

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