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John Mauldin and Long Soapy Showers
I feel like I am falling behind in my articles and commenting on other articles that people have recently written about inflation. After years – literally, years – in which almost no one wrote anything about inflation, suddenly everyone wants to opine on the new shiny object they just found. At the same time, interest in the solutions that we offer – investment strategies, consulting, bespoke inflation hedges, etc – has abruptly picked up, so it feels like the demand for these articles is rising at the same time that my time to write them is shrinking…
But I try.
I want to quickly respond to an article that came out over the weekend, by widely-read author John Mauldin. I’ve corresponded over the years from time to time about inflation, especially when he got way out on the crazy-person “CPI is made up” conspiracy theory limb. To be fair, I think he considers me the crazy person, which is why he’s never referred to me as the inflation expert in his articles. C’est la vie.
His recent article “State of Inflationary Confusion”, though, was much more on-point. Honestly, this is the best article Mauldin has written on this topic in years. I don’t agree with all of it but he at least correctly identifies most of the issues correctly. He even seems to understand hedonic adjustment and the reason we need it, and the reason the PCE/CPI debate exists (which is no easy thing – it depends on what you’re trying to do, which one is ‘better’), and that hasn’t always been the case.
Where I agree with him is when he says that ‘None of us are average’. This is obviously true, and is one reason that we have on our website a calculator where you can look at your own CPI by adjusting the components for what you personally spend (though it doesn’t take into account where you live, which is one reason your experience differs).
But I disagree with him when he says “Reducing this complexity to one number and then using that number to guide monetary policy is asking for trouble.” What an odd remark. We do that for every other piece of data: GDP, home sales, home prices, durable goods sales, retail sales, unemployment, and so on, and we use that information to guide all sorts of policy. Why would it be the case that CPI, of all of the figures, isn’t very useful for this reason? Look, your personal unemployment number is not 4%. It is either 0% or 100%. Totally binary. If Mauldin was making a compelling argument here, you’d throw out the Unemployment Rate long before you’d throw out CPI.
Indeed, if you play with the numbers on our calculator you will find that unless your consumption basket is wildly different, your CPI is likely to be fairly similar to the average. This is why TIPS make sense for many investors – it’s “close enough” to what your consumption basket is actually doing. And it is certainly close enough for policy.
The problem with monetary policy isn’t that they’re using PCE or CPI when they should be using the other, or that neither PCE nor CPI reflects the exact experience of most people. The problem with monetary policy is that policymakers don’t know what the right policy response is given the numbers because they don’t believe in monetarism any more. So their models don’t work. And that’s the problem.
Here’s an analogy (and you know I love analogies). You’re taking a shower, and your impression is “hey, this seems too hot.” It doesn’t really matter if you are using Celsius or Fahrenheit, or just a general visceral sense that it’s too hot. You simply think the water is too hot. So, to solve your problem you apply more soap.
That’s what the Fed is doing. The water is too hot, so they’re applying soap. And they’re really confused when that doesn’t seem to make the water any colder. So they say “gosh, our model must be wrong. The water temperature must be somewhat less sensitive to the amount of soap applied than we thought it was. So let’s recalibrate and apply more soap.” It never occurs to them that they’ve got the wrong model.
That’s the problem with central banking. It isn’t what you use to measure the water temperature, as long as you’re close; it’s how you respond to it that matters. And policymakers don’t understand inflation and, as a result, don’t understand how to affect it.
Re-Blog: Limits on the 500-pound Gorilla
With interest rates flirting with 3% on the 10-year Treasury note, and the potential (and eventuality) that they will go significantly higher, I thought it might be timely to review a blog post from February 10, 2013 called “Limits on the 500-pound Gorilla.” (It’s worth reading that original post for some of the comments attached thereto.)
Well, here’s an interesting little tidbit. (But first, a note from our sponsors: some channels didn’t pick up my article from last Wednesday, “Fun With The CPI,” so follow that link if you’d like to read it.)
The Fed adds permanent reserves by buying securities, as we all know by now. The Open Market Desk buys securities and credits the Fed account of the selling institution. Conversely, when the Fed subtracts reserves permanently, it sells securities and debits the account of the buying institution.
As of February 6th, the Fed owned $1.782 trillion in face value of Treasury and agency mortgage-backed securities. At the closing prices from Friday, those securities are worth $2.069 trillion, plus accrued interest which I didn’t bother to calculate.
So let’s revisit for a second the question of how the Fed would unwind the quantitative easing and actually tighten policy. In order to do that, the Fed would first need to vaporize the $1.58 trillion that exists in excess reserves, before they could actually affect the required reserves which is where the rubber meets the road for monetary policy (at least, in the absence of the “portfolio balance channel”).
We have reviewed some of the options before: sell the securities held in the System Open Market Account (SOMA); conduct massive and long-dated repo operations; sell bills or pay interest on deposits at the Fed (or raise IOER). Some people have suggested that the Fed could just “let the securities in the SOMA roll off”: i.e., let the bonds mature and don’t reinvest the proceeds. I was curious how long, after Operation Twist, such a passive approach would take.
The current value of Excess Reserves is $1.58 trillion. If Excess Reserves did not move for any other reason, it would take until November of 2039 before we saw that many bonds mature. To be fair, with coupon payments and such it would take less time, but we’re still looking at a couple of decades. So that’s not an option, at least by itself.
Then I noticed something interesting. Some economists have suggested that when the economy begins to improve, the Desk could simply start selling securities into the market, since with a stronger economy the Treasury would presumably be running a smaller deficit (now, that’s blind faith if ever there was such a thing) and auctioning fewer securities, so the Fed could take up the slack without impacting the market very much. Leaving aside the question that it isn’t clear that market rates would be in the range they are now if the Fed actually stopped buying (after all, that’s the whole point of the portfolio balance channel – that investors won’t pay the high price the Fed has set so they buy riskier securities), I’m not sure it’s even possible that the Fed could drain the excess reserves even if they sold every single bond on their balance sheet. Here’s why.
The SOMA portfolio has a DV01 of approximately $1.56billion, based on the reported holdings and Bloomberg’s calculated modified duration. For those unfamiliar with bond math, this means that every 1/100th of 1% rise in interest rates causes the value of the Fed’s holdings to decline $1.56bln.
The current market value of the portfolio, as I said, is $2.07 trillion, while Excess Reserves are $1.58 trillion. But the problem is that the ‘market value’ of the portfolio assumes the portfolio is liquidated at mid-market prices. Ask the London Whale how well that works when you are a big player. Ask Long Term Capital.
But forget about the market impact. Suppose interest rates were to rise 300bps, so that the 10-year was around 5% and, with expected inflation remaining (again, let’s go with the blind faith argument) around 2.5%, real interest rates were up to around 2.5%. That would be a fairly neutral valuation for an economy with decent prospects and contained inflation, growing at its sustainable natural growth rate.
The SOMA portfolio, valued 300bps higher in yield, would be worth $2.07T – $1.56B * 300 = 1.60T. In other words, if the Fed sold every single bond in its portfolio, 300bps higher, it would just barely be able to drain all of the excess reserves. Yes, I did ignore the question of convexity, but since the MBS tend to have negative convexity that balances the positive convexity of the Treasuries, I suspect that isn’t a huge effect over this small a move.
So the Fed, in this circumstance, would have used all of its gunpowder just getting back to the point where traditional tools would begin to work again. This is an entirely natural outcome, by the way! If a behemoth market participant lurches into the market to buy securities, and then lurches to sell them, and repeats that pattern over and over, it loses value because it is consuming liquidity in both directions. It is going to be buying high (and again, that’s the Fed’s goal here: to pay more than anyone else wants to pay) and selling low. So in this case, if rates rise 300bps, the Fed will be unwinding its entire portfolio and have no securities left to sell to actually drain the liquidity that matters.
This is obviously a thought experiment – I can’t imagine the Fed could unwind that sort of portfolio with only a 300bp market impact. But it just highlights, for me, the fact that the ‘end game’ for the FOMC almost must involve raising the interest paid on excess reserves – the other tools aren’t only impractical in size, but may be de facto impotent (because, remember, the first thing that needs to happen is that Excess Reserves are drained, before policy has traction again through the traditional channels).
I am sure someone else has pointed out this little mathematics dilemma before, but I don’t think it had previously occurred to me. I guess I’d always stopped at the mechanics/feasibility of selling $2 trillion in securities, and never asked whether that would actually do the job. I don’t think it would! It is not actually true that a 500-lb gorilla sits “anywhere he wants,” as the old joke goes – he can’t sit anywhere that won’t hold a 500-lb gorilla.
Now, the Committee doesn’t really seem to believe in traditional monetary policy any more, so it may be that they figure the reverse of the “portfolio balance channel” effect will be good enough: raise the returns to the ‘less risky’ part of the market enough to pull capital out of the risky parts of the market. But I find it hard to convince myself that, as much as they clearly intended to push housing and equity market prices higher, they’d be willing to do the opposite. And I do believe that other stakeholders (e.g., Congress) would be less accommodating in that direction. Which brings me back again to the conclusion I keep coming to: does the Fed theoretically have the tools to reverse QE? Yes, although they have one fewer than I thought yesterday. But is it plausible that the Fed will have the will to use those tools, to the degree they’d need to be used, to reverse QE? I really don’t believe they’d be willing to crash the housing and stock markets, just to cool down inflation.
We do live in interesting times. And they will remain interesting for a long, long time.
Summary of My Post-CPI Tweets (Feb 2018)
Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guyPV and get this in real time, by going to PremoSocial. Or, sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments or Enduring Intellectual Properties. Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.
- Link to my appearance on TD Ameritrade Network [on Monday]:
- It looks like I will be able to do most of my CPI tweet storm after all. I will be on Bloomberg live at 8:30ET with @adsteel and @DavidWestin, but I will be on the phone and will post my tweets immediately thereafter.
- Going in, we’re facing roughly a 0.21-0.22% consensus on core CPI. I think to get an adverse reaction from equities you need to keep y/y from declining to 1.7%, which means you need core CPI to be near the year-ago comp, which means something that rounds to 0.3%.
- Anything that rounds DOWN to 0.3% will be ugly. Again I’m talking core here.
- It’s important to remember that this is the hardest remaining comp we have in CPI for a long time. In fact, Jan 2017 m/m was higher than any other core print of 2017. The next 6 months are only 1.1% annualized.
- This is why we can talk about the ‘bad optics’. Core CPI will appear to be rapidly accelerating over the next half-year unless we get some weird one-offs like we did last year.
- This month I will be especially focused on Used Cars and Trucks, which is subject to a change in BLS procedure this month. Big difference of opinion out there about whether it’s an add or subtract.
- I believe it will be an add, because the price level is what BLS surveys and this has been very far below what private surveys have shown. Catching up to do unless the BLS just ignores that prices are higher than they thought.
- But a tremendous amount of noise around any element of the data so it could be anywhere of course!
- Have to go now and prep for Bloomberg call. Will be back several minutes after CPI for recap. Thanks for subscribing, everyone.
- oh my…0.349% on core…1.846% y/y…and this was supposed to be the hard comp.
- Supposedly the seasonals were going to dampen this figure. Whoops.
- Remember this is a January number but…it’s hard to ignore. Accelerating major categories: Food/Bev, Apparel, Medical Care, Other.
- Housing decelerated but that was mostly Lodging Away from Home, -2% for the month. AirBnB making a comeback?!? Primary Rents accelerated to 3.73% from 3.68% y/y and OER to 3.20 from 3.17%. This is on our model.
- Here’s last 12 m/m core CPIs. Notice a trend?
- CPI-used cars and trucks…was 0.32% m/m. Sorry, people who thought that it would be down. y/y though it’s still a drag at -0.61%. But last month that was -0.99%.
- In Medical Care, Pharma decelerated to 2.39% vs 2.77%. But Doctor’s Services -1.51% vs -1.77% y/y last; Hospital Services 6.04% vs 5.09%.
- That matters more than you think, because more care is being funneled through hospitals every day.
- CPI for medical care…bottoming?
- CPI pharma
- Now, whilst Used cars and trucks accelerated, New Vehicles decelerated to -1.24% vs -0.53% y/y last month. And New Vehicles have almost twice the weight of used vehicles. So cars, actually, were a net drag. Just not the place that pointy-head economists said it would be.
- I wouldn’t get too overenthused about apparel. Yes, it had a big jump. And with a weaker dollar and some protectionism I’d expect to see this going up. Just…lot of wood to chop.
- Sorry I am jumping around a bit. Back to hospital services. Near longer-term high pace, but really need to see it break higher. This is an important part of core services.
- Here’s CPI-Used Cars vs the Manheim survey. Rate-of-change. Looks like it’s catching up. But…
- Here (again) is the index level (normalized) of CPI vs Manheim. This month’s move doesn’t do much. EVEN IF THE HARVEY JUMP IN MANHEIM GOES AWAY, BLS is still way below where it should be. This is a source of positive variance going forward.
- Here is the distribution of price changes. As expected the weight in the left tail is starting to decline, which will cause core to converge with median eventually (or anyway, get close).
- OER accelerated slightly, but as I mentioned this is what our model expects. Not to anthropomorphize a model. The real question is which of our submodels – which agree at this level but diverge – ends up being ‘correct’.
- So here’s the ‘four pieces’ look. What it shows, frighteningly, is that nothing unusual is happening. As a reminder to people seeing this 1st time…this breakdown of CPI has four roughly-equal pieces.
- Food and Energy
- Now the core pieces. Core Goods. With dollar weakness this will eventually go mildly positive. But this happens with a lag and hasn’t happened yet. Maybe Apparel is first shot?
- Core Services less Rent of Shelter. If Medical Care is bottoming, this is an upside risk. I doubt there’s much downside risk at this point.
- And Rent of Shelter. It’s decelerated, but home prices are still rising and I don’t think this is going to drop out of the sky. Net result: hard to see where disinflation would come from.
- This is where I usually conclude by forecasting Median CPI. But median category looks like a subcomponent of OER, which the Cleveland Fed separately computes a seasonal adj for. However, looks to me like Median won’t be anywhere close to core. Probably around 0.2%.
- Looking forward, remember: the EASY core comps are ahead. Feb 2017 was +0.17%, March -0.07, April +0.09%, May +0.08%. June and July 0.14%. Not until Aug do we have another 0.2% comp. This means core CPI is going to be rising from the current 1.85%.
- …and that in turn is going to scare investors, and the Fed (which usually follows the bond market) might overreact for all their brave talk currently. Today’s data certainly created a WTF moment at Constitution and 20th St. NW
- That’s a wrap for now people. It was a fun one. Thanks for tuning in! Thanks for signing up!
The big takeaway from this month was that this was supposed to be the difficult comp for year/year CPI. With all of the sturm und drang about inflation over the last couple of weeks, this was set up to be a whipsaw when the January data turned out to show a decline in year/year core CPI. Going into the data, I would have preferred the long side of equities (for a trade) because it seemed like the talk around this CPI was overdone.
But instead we got the highest m/m core CPI in 12 years, and it was very close to printing 0.4% with rounding. That would have been heart-stopping.
The stock market seems at this hour to have fallen in love with the idea that this was all due to “weird jump in Apparel.” But Apparel is only 3% of CPI and 4% or so of Core. So a 1.5% miss in Apparel would only add 0.06% to core CPI. And core CPI missed by more than twice that. Moreover, the jump in Apparel is just reversing some curious recent weakness in the series, so arguably it’s an unwind of a one-off, not a new one-off. Year/year, Apparel is still deflating at -0.62%/year even with this month’s jump. That’s steeper deflation, actually, than the four-year average! With the dollar weakening, I would expect Apparel to be adding, not subtracting, from inflation over the balance of this year. But, with such a small weight…who cares?
I agree that one should not exaggerate the importance of any one month’s data, for any data series (including Average Hourly Earnings, which seems very likely to reverse some next month). But the next six months are going to see core inflation continue to rise, optically. If we get “only” 0.2% prints for each of the next six months, then July core CPI will be around 2.5% y/y. At that point, people will be extrapolating crazy numbers. But for now, we still have all of the ugly optics to look forward to.
This is a bad figure. There are no two ways about it.
Kicking Tails
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Like many people, I find that poker strategy is a good analogy for risk-taking in investing. Poker strategy isn’t as much about what cards you are dealt as it is about how you play the cards you are dealt. As it is with markets, you can’t control the flop – but you can still correctly play the cards that are out there.[1] Now, in poker we sometimes discover that someone at the table has amassed a large pile of chips by just being lucky and not because they actually understand poker strategy. Those are good people to play against, because luck is fickle. The people who started trading stocks in the last nine years, and have amassed a pile of chips by simply buying every dip, are these people.
All of this is prologue to the observation I have made from time to time about the optimal sizing of investment ‘bets’ under conditions of uncertainty. I wrote a column about this back in 2010 (here I link to the abbreviated re-blog of that column) called “Tales of Tails,” which talks about the Kelly Criterion and the sizing of optimal bets given the current “edge” and “odds” faced by the bettor. I like the column and look back at it myself with some regularity, but here is the two-sentence summary: lower prices imply putting more chips on the table, while higher volatility implies taking chips off of the table. In most cases, the lower edge implied by higher volatility outweighs the better odds from lower prices, which means that it isn’t cowardly to scale back bets on a pullback but correct to do so.
When you hear about trading desks having to cut back bets because the risk control officers are taking into account the higher VAR, they are doing half of this. They’re not really taking into account the better odds associated with lower prices, but they do understand that higher volatility implies that bets should be smaller.
In the current circumstance, the question merely boils down to this. How much have your odds improved with the recent 10% decline in equity prices? Probably, only a little bit. In the chart below, which is a copy of the chart in the article linked to above, you are moving in the direction from brown-to-purple-to-blue, but not very far. But the probability of winning is moving left.
Note that in this picture, a Kelly bet that is less than zero implies taking the other side of the bet, or eschewing a bet if that isn’t possible. If you think the chance that the market will go up (edge) is less than 50-50 you need better payoffs on a rally than on a selloff (odds). If not, then you’ll want to be short. (In the context of recent sports bets: prior to the game, the Patriots were given a better chance of winning so to take the Eagles at a negative edge, you needed solid odds in your favor).
Now if, on the other hand, you think the market selloff has taken us to “good support levels” so that there is little downside risk – and you think you can get out if the market breaks those support levels – and much more upside risk, then you are getting good odds and a positive edge and probably want to bet aggressively. But that is to some extent ignoring the message of higher implied volatility, which says that a much wider range of outcomes is possible (and higher implied volatility moves the delta of an in-the-money option closer to 0.5).
This is why sizing bets well in the first place, and adjusting position sizes quickly with changes in market conditions, is very important. Prior to the selloff, the market’s level suggested quite poor odds such that even the low volatility permitted limited bets – probably a lot more limited than many investors had in place, after many years of seeing bad bets pay off.
[1] I suspect that Bridge might be as good an analogy, or even better, but I don’t know how to play Bridge. Someday I should learn.
What Has Changed (but Only a Little)
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A ten percent decline in stocks is not exactly a big deal. Perhaps it feels like a big deal because 10% in one week is somewhat dramatic, but then so is +7% in one month, on top of already-richly-valued markets, in the grand scheme of things. But can we put this in perspective?
Oh dear! How awful!
I pointed out on Monday that saying “nothing has changed in the economy – it’s still strong” is useless pablum if we are entering a bear market. But it’s useful to remember that over a one-week period, literally almost nothing changes about the backdrop. We have no new information on inflation, not much new information on earnings, not much new on the interest rate cycle. Bob Shiller won a Nobel prize in part for pointing out that market volatility is very much higher than can be explained by changes in underlying fundamentals, so this shouldn’t be a surprise. What does change when the market move is expectations for forward returns. When prices are lower, future expected returns are higher, and vice-versa. (This is why anyone under 40 years old, for whom the lion’s share of their investing life is in front of them, should be totally cheering for a massive market rout: that would imply they have the opportunity to invest at lower prices).
So let’s look at how those forward returns look now, and how they have changed. Of course, we look at these things every day, and every day develop a forecast of expected real returns across a number of asset classes. A subset of these is shown below, for prices as of January 26th: the day of the market high.
On January 26th, our expectations for the annualized 10-year real return for equities was -0.39%. In other words, we expected investors to underperform inflation by about 40bps per year on average over the next decade. 10-year TIPS yields were at 0.57%, and we expected commodity indices to return about 1.57% per annum. So, commodities had an advantage of about 2% per year over equities – plus some inflation-protection beta to boot. Expected commodities returns have been fairly stagnant, actually, because while the indices have rallied (implying lower future spot commodity returns) they have also gotten a push from higher interest rates and carry. (I wrote in mid-January about “Why Commodities Are a Better Bet These Days” and that’s worth reviewing.)
After the debacle of the last ten days or so, here is where our expected returns stand, as of the close on February 8th:
The expected total real return to equities over the next decade is now positive, if only barely. Our model has equity expected real returns at 0.35% per annum over the next decade, compared to 0.74% for TIPS (so the equity risk premium is still negative, though less so) and 2.33% for commodities (higher interest rates and lower spot prices have helped there). Again, these are entirely model-based, not discretionary. It is interesting that the premium for commodity index investing is still about 2% over stocks. Also interesting is that the slope of the risk curve is steeper: in late January, you had to accept 11% more annualized real risk to get just 1% additional real return; as of today, that slope implies 7% as risky assets have cheapened up. But as recently as 2014, that slope was 3%!
A flattening of the risk/reward curve over the last half-dozen years was no accident. I’ve written over the years about the “Portfolio Balance Channel,” which is how the Fed referred to helping the economy by taking all of the safe instruments away so that people had to buy riskier assets. The result, of course, was that riskier assets got much more expensive, as they intended. (Back in July I wrote a piece called “Reversing the ‘Portfolio Balance Channel’” where I pointed out that unwinding QE implies that the Portfolio Balance Channel would eventually cause money to come out of equities and other asset classes to go into bonds.)
In my mind, an expected real return of 0.35% from stocks while TIPS yield more (with no risk at the horizon) is still not very attractive. I think the risk curve needs to steepen more, and we know that in the long run the expected return to equities and commodities should re-converge. Whether that’s from commodity returns coming down because commodity prices rally, or from equity returns going up because equity prices fall, I don’t know. But I would skew bets at the risky end of the curve to commodities, personally (it’s not like I haven’t said this before, however).
I started this article by pointing out how relatively insignificant the movement in the markets has been so far. I don’t mean, by pointing this out, that investors should therefore dive back in. No, in fact I think it is fairly likely that the decline has much further to go. Merely retracing 38% of the bull market – which is a minimum retracement in a normal Fibonacci sequence – would put the S&P back to 2030. This would also have the advantage from a techie’s standpoint of causing the decline to terminate in the range of the prior fourth wave…but I digress.[1] A decline of that magnitude would also, in conjunction with rising earnings, bring the Shiller P/E back to the low-20s – still above average, but not outrageous. And it would raise the expected 10-year real return up to around 3%, which is arguably worth investing in. It would also mean that, in real terms, the S&P 500 index would have had no net price appreciation since the peak of the tech bubble – your dividends would be your whole return, and not so bad as all that, but…that’s thin gruel for 18 years of “stocks for the long run.”
[1] Although I have used some technical analysis terms recently, I’m not really a technician. However, I recognize that many traders are, and having some knowledge of technical analysis gives one some guideposts around which a tactical plan can be formulated.
Are Rising Yields Actually a Good Thing?
I’ve recently been seeing a certain defense of equities that I think is interesting. It runs something like this:
The recent rise in interest rates, which helped cause the stock market swoon, is actually a good thing because interest rates are rising due to a strong economy and increasing demand for capital, which pushes up interest rates. Therefore, stocks should actually not mind the increase in interest rates because it’s an indication of a strong economy.
This is a seductive argument. It’s wrong, but it’s seductive. Not only wrong, in fact, but wrong in ways that really shouldn’t confuse any economist or strategist writing in the last twenty years.
Up until the late 1990s, we couldn’t really tell the main reason that nominal interest rates were rising or falling. For an increase in market rates there are two main potential causes: an increase in real interest rates, which can be good if that increase is being caused by an increasing demand for credit rather than by a decreasing supply, and an increase in inflation expectations, which is an unalloyed negative. But in 1995, we would have had to just guess which was causing the increase in interest rates.
But since 1997, we’ve had inflation-linked bonds, which trade on the basis of real yield. So we no longer have to guess why nominal rates are rising. We can simply look.
The chart below shows the decomposition of 10-year nominal yields since early December. The red line, which corresponds to the left scale, shows “breakevens,” or the simple difference between real yields and nominal yields; the blue line, on the right-hand scale, shows real yields. So if you combine the two lines at any point, you get nominal yields.
Real yields represent the actual supply and demand for the use of capital. That is, if I lend the government money for ten years, then in order to entice me to forego current consumption the government must promise that every year I will accumulate about 0.68% more ‘stuff.’ I can consume more in the future by not consuming as much now. To turn that into a nominal yield, I then have to add some premium to represent how much the dollars I will get back in the future, and which I will use to buy that ‘stuff’, will have declined in value. That of course is inflation expectations, and right now investors who lend to the government are using about 2.1% as their measure of the rate of deterioration of the value of the dollar.[1]
So, can we say from this chart that interest rates are mainly rising for “good” reasons? On the contrary! The increase in inflation expectations has been much steadier; only in the last month have real interest rates risen (and we don’t know, by the way, whether they’re even rising because of credit demand, rather than credit supply). Moreover – although you cannot see this from the chart, I can tell you based on proprietary Enduring Intellectual Properties research that at this level of yields, real yields are usually responsible for almost all of the increase or decrease in nominal yields.[2] So the fact that real yields are providing a little less than half of the selloff? That doesn’t support the pleasant notion of a ‘good’ bond selloff at all.
As I write this, we are approaching the equity market close. For most of the day, equities have been trading a bit above or a bit below around Monday’s closing level. While this beats the heck out of where they were trading overnight, it is a pretty feeble technical response. If you are bullish, you would like to see price reject that level as buyers flood in. But instead, there was pretty solid volume at this lower level. That is more a bearish sign than a bullish sign. However, given the large move on Friday and Monday it was unlikely that we would close near unchanged – so the last-hour move was either going to be significantly up or significantly down. Investors chose up, which is good news. But the bad news is that the end-of-day rally never took us above the bounce-high from yesterday’s last hour, and was on relatively weak volume…and I also notice that energy prices have not similarly rallied.
[1] In an article last week I explained why we tend to want to use inflation swaps rather than breakevens to measure inflation expectations, but in this case I want to have the two pieces add up to nominal Treasury yields so I am stuck with breakevens. As I noted in that article, the 2.1% understates what actual inflation expectations are for 10 years.
[2] TIPS traders would say “the yield beta between TIPS and nominals is about 1.0.”
Historical Context Regarding Market Cycles
I really enjoy listening to financial media outlets on days like this. Six days removed from all-time highs, the equity guys – especially the strategists, who make their money on the way up – talk about “capitulation,” and how “nothing has changed,” and how people need to “invest for the long-term.” If equities have entered a bear market, they will say this all the way down.
It helps to have seen a few cycles. Consider the early-2000s bear market. In 2000, the Nasdaq crested in March. After a stomach-churning setback, it rallied back into August (the S&P actually had its highest monthly close for that cycle in August). The market then dropped again, bounced, dropped again, bounced, and so on. Every bounce on the way down, the stock market shills shrieked ‘capitulation’ and called it a buying opportunity. Eventually it was, of course. But if there is a bear market, there will be plenty of time to buy later. This was also true in ’09, which was much more of a ‘spike’ bottom but let’s face it, you had months and months to get in…except that no one wanted to get in at the time.
If it is not a bear market, then sure – it’s a buying opportunity. But what I know from watching this drama play out several times is that you cannot tell at the time whether it’s a buying opportunity, or a dead-cat bounce. It does not help at all to say “but the economy is okay.” Recalling that the Nasdaq’s peak was in March 2000: the Fed was still hiking rates in May of that year, and didn’t cut rates until 2001. In late July 2000, GDP printed 5.2% following 4.8% in Q1. In October 2000, GDP for Q3 was reported to still be at 2.2%. Waiting for the economy to tell you that all was not well was very costly. By the time the Fed was alarmed enough to ease, in a surprise move on January 3, 2001, the S&P was down 16%. But fortunately, that ended it as stocks jumped 5% on the Fed’s move. Buy the dip!
By mid-2002, stocks were down about 50% from the high. Buying the dip was in that case precisely wrong.
Then there is the bear market of a decade ago. The October 2007 market high happened when the economy was still strong, although there were clearly underlying stresses in mortgages and mortgage banking and the Fed was already easing. Yet, on January 10, 2008, Fed Chairman Bernanke said “the Federal Reserve is not currently forecasting a recession.” On January 18, he said the economy “has a strong labor force, excellent productivity and technology, and a deep and liquid financial market that is in the process of repairing itself.” In June 2008, he said “The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.” Stocks were already down 19%. It got somewhat worse…and it didn’t take long.
So the thing to remember is this: equities do not wait for earnings to suffer, or for forecasts of earnings to suffer, or for everyone to figure out that growth is flagging, or for someone to ring a bell. By the time we know why stocks are going down, it is too late. This is why using some discipline is important – crossing the 200-day moving average, or value metrics, or whatever. Or, decide you’ll hold through the -50% moves and ignore all the volatility. Good luck…but then why are you reading market commentary?
I don’t know that stocks are going to enter a bear market. I don’t know if they’ll go down tomorrow or next week or next month. I have a pretty strong opinion about expected real returns over the next 10 years. And for that opinion to be realized, there will have to be a bear market (or two) in there somewhere. So it will not surprise me at any time if a bear market begins, especially from lofty valuation levels. But my point in this article is just to provide some historical context. And my general advice, which is not specific to any particular person reading this, is that if anyone tells you that price moves like this are ‘capitulation’ to be followed by ‘v-shaped recoveries,’ then don’t just walk away but run away. They haven’t any idea, and that advice might make you a few percent or lose you 50%.
To be sure, don’t panic and abandon whatever plan you had, simply because other people are nervous. As Frank Herbert wrote, “fear is the mind-killer. Fear is the little-death that brings total obliteration.” This is why having a plan is so important! And I also think that plans should focus on the long term, and on your personal goals, and matching your long-term investments to those goals. Rebalancing and compounding are powerful tools, as is a value ethic of buying securities that have a margin of safety.
And, of course, diversification. Bonds today did what they’re supposed to do when ‘risky assets’ take a tumble: they rallied. As I noted on Friday: “I am not saying that interest rates are going directly from 3% to 6%. Indeed, the rates/equity ecosystem is inherently self-dampening to some degree (at least, until we reach a level where we’ve exceeded the range of the spring’s elasticity!) in that if equity prices were to head very much lower, interest rates would respond under a belief that central bankers would moderate their tightening paths in the face of weak equities.” The problem with nominal bonds at this point, though, is that they’re too expensive. At these yields, there is a limit to the diversification they can provide, especially if what is going to drive the bear market in stocks is rising inflation. Bonds will diversify against the sharp selloff, but not against the inflation spiral. (I’ve said it before and I will say it again. If you haven’t read Ben Inker’s piece in the latest GMO quarterly, arguing why inflation is a bigger risk for portfolios right now than recession, do so. “What happened to inflation? And What happens if it comes back?”)
Which brings us to commodities. If the factor driving an equity bear market turns out to be inflation, then commodities should remain uncoupled from equities. For the last few days, commodity indices have declined along with equities – not nearly as much, of course, but the same sign. But if the problem is a fear of inflation then commodities should be taking the baton from stocks.
So there you go. If the problem is rising interest rates, then that is a slow-moving problem that’s self-limiting because central banks will bring rates back down if stocks decline too far. If the problem is rising inflation, then commodities + inflation bonds should beat equities+nominal bonds. Given that commodities and inflation bonds are both relatively cheaper than their counterparts, I’d rather bet that way and have some protection in both circumstances.
The Era of Bizarro Bill Gross is Beginning
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It’s hard to believe that 10-year yields in the US have doubled in the last 18 months. It’s the last 50bps, taking us from 2.35% to 2.84% since December, that has received the most attention but 10yr Treasury rates have literally spanned the width of the nearly 40-year-old channel over that 18 months (see chart, source Bloomberg).
Such a long-term chart needs to be done in log scale, of course, because a 200bp move is more significant when rates are at 2% than when they are at 10%. I have been following this channel for literally my entire working career (more than a quarter-century now), and only once has it seriously threatened the top of that channel. Actually, that was in 2006-07, which helped precipitate the last bear market in stocks. Before that, the last serious test was at the end of 1999, which helped precipitate that bear market.
You get the idea.
The crazy technicians will note that a break above about 3.03%, in addition to penetrating this channel, would also validate a double bottom from the last five years or so. Conveniently, both patterns would project 10-year rates to, um, about 6%. But don’t worry, that would take years.
Let’s suppose it takes 10 years. And let’s suppose that velocity does what it does and follows interest rates higher. The regression below (source: Bloomberg) shows my favorite: velocity as a function of 5y Treasury rates. Rates around 5% or 6% would give you an eyeball M2 velocity of 2.1.
So, let’s go to the calculator on our website, and see what happens if money velocity goes to 2.1 over the next decade, but real growth averages a sparkling 3%.
Looking down the “2.1” column for velocity, we can see that if we want to get roughly 2% inflation – approximately what the market is assuming – then we need to have money growth of only 1% per annum for a decade. That is, the money supply needs to basically stop growing now. The only problem with that is that there are trillions in excess reserves in the banking system in the US, and trillions upon trillions more on the balance sheets of other central banks, and not only does the Fed not plan to remove all of those reserves but rather to maintain a permanently larger balance sheet, but other central banks are still pumping reserves in. So, you can see the problem. If money growth is only 3%, then you’re looking at average inflation over the next decade of 3.9% per annum. By the way, average money growth in the US since the early 1980s has been 5.9% (see chart, source Bloomberg). Moreover, it has been below 3% only during the recessions of the early 1990s and the global financial crisis, and never for more than a couple of years at a time.
The bottom line is that rising interest rates and more importantly rising money velocity create a very unfortunate backdrop for inflation, and this is what creates the trending nature of inflation and the concomitant ‘long tails’: higher rates create higher velocity, which creates higher inflation, which cause higher rates. Etc. The converse has been true for nearly 40 years – a happy 40 years for monetary policymakers. Yes, I know, there are a lot of “ifs” above. But notice what I am not saying. I am not saying that interest rates are going directly from 3% to 6%. Indeed, the rates/equity ecosystem is inherently self-dampening to some degree (at least, until we reach a level where we’ve exceeded the range of the spring’s elasticity!) in that if equity prices were to head very much lower, interest rates would respond under a belief that central bankers would moderate their tightening paths in the face of weak equities. And if interest rates were to head much higher, we would get such a response in equities that would provoke soothing tones from central bankers. So tactically, I wouldn’t expect yields to go a lot higher from here in a straight shot.
I am also not saying that money velocity is going to gap higher, and I am not saying that inflation is about to spring to 4% (in fact, just the other day I said that it will likely be mainly the optics on inflation that are bad this year because some one-off events are rolling out of the data). Just as with interest rates, this cycle will take a long time to unwind even if, as I suspect, we have finally started that unwind. We’re going to have good months and bad months in the bond market. But the general direction will be to yields that are somewhat higher in each subsequent selloff. And some Bizarro Bill Gross will be the new Bond King by riding yields higher rather than riding them lower.
I am also told that mortgage convexity risk, which in the past has taken rallies and selloffs in fixed-income and made them more extreme, is less of a problem than it used to be, since the Fed holds most mortgages and servicing rights have been sold from entities that would hedge extensions to those who “just want yield” (unclear how this latter group responds to the same yield, at longer maturities). On the other hand, the Volcker Rule has gutted a lot of the liquidity provision function on Wall Street, so if you have a million to sell you’re okay; if you have a yard (a billion) then best of luck.
I will note that real yields are still lower (10year TIPS yields 0.70%) than they reached at the highs in 2016, which were lower than they got to in 2015, which were lower than they hit in 2013. The increase in interest rates is not coming from a surge in belief about rising real growth. The increase is coming from a surge in concern about the backdrop for inflation. For nominal interest rates to go much higher, real yields will have to start contributing more to the selloff. So I think we are probably closer to the end of the bond selloff, than to the beginning…at least, this leg of it.
Forward Inflation is Nothing to be Alarmed About (Yet)
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It’s time to get a little wonky on inflation.
Recently, I saw a chart that illustrated that 5y, 5y forward inflation – “what the Fed watches” – had recently risen to multi-year highs. While a true statement, that chart obscures a couple of important facts that are either useful, or interesting, or both. Although probably just interesting.
First, the fact that 5y, 5y forward inflation (for the non-bond people out there, this is the rate that is implied from the market for 5-year inflation expectations starting 5 years from now) has recently gone to new highs is interesting, but 5y5y breakevens are still at only 2.20% or so. Historically, the Fed has been comfortable with forward inflation (from breakevens) around 2.50%-2.75% even though its own target is 2% on core PCE (which works out to be something like 2.25%-2.35% on core CPI). That’s because yield curves are typically upward-sloping; in particular, inflation risk ought to trade with a forward premium because the inflation process exhibits momentum and so inflation has long tails. Ergo, long-dated inflation protection is much more valuable than shorter-dated inflation protection, not just because there is more uncertainty about the future but because the value of that option increases with time-to-maturity just like any option…but actually moreso since inflation is not naturally mean-reverting, unlike most financial products on which options are struck.
[As an aside, the fact that longer-term inflation protection is much more valuable than shorter-term inflation protection is one of the reasons it is so curious that the Treasury keeps wanting to add to the supply of 5-year TIPS, as it just announced it intends to do, even though the 5-year auction is usually the worst TIPS auction because not many people really care about 5 year inflation. On the other hand, 10-year TIPS auctions usually do pretty well and 30-year TIPS auctions often stop through the screens, because that’s very valuable protection and there isn’t enough of it.]
A second interesting point about 5y5y inflation is that it is only at recent highs if you measure it with breakevens. If you measure it with inflation swaps, forward inflation is still 10bps or so short of the 2016 highs (see chart, source Bloomberg and Enduring Investments calculations).
This chart also illustrates something else that is really important: actual 5y5y forward inflation expectations are up around 2.40%, not down at 2.20%. Inflation swaps are a much better way to measure inflation expectations because they do not suffer from some of the big problems that bond-based breakevens have. For example:
- The inflation swaps market is always trading a clean 5-year maturity swap and a clean 10-year maturity swap. By contrast, the ’10-year note’ is a 10-year note for only one day, but remains the on-the-run 10-year note until a new one is auctioned.
- The 5-year breakeven consists of a “5-year” TIPS bond and a “5-year” Treasury, even though these may have different maturities. They are always close, but not exact, and the duration of the TIPS bond changes at a different rate as time passes than the duration of the Treasury. In other words, the matching bonds for the breakeven don’t match very well.
- A minor quantitative point is that the “breakeven” is typically taken as the difference between the nominal Treasury yield and the real TIPS yield, but since the Fisher equation says (1+n) = (1+r)(1+i), the breakeven (i in this notation) should actually be (1+n)/(1+r)-1. At low yields this is a small error, but the error changes with the level of yields.
- A more important quantitative point is that the nominal bond’s yield not only has real rates and expected inflation, but also a risk premium which is unobservable. So, in the construction above, I ignored the fact that the Fisher equation is actually (1+n)=(1+r)(1+i)(1+p), with the breakeven therefore representing both the i and the p. Inflation swaps, on the other hand, represent pure inflation.
- But then why is the inflation swap always higher than the breakeven? This is the biggest point of all: the breakeven is created by buying a TIPS bond and shorting a nominal Treasury security. Shorting the Treasury security involves borrowing the bond and lending money in the financing markets; because nominal Treasuries are coveted collateral – especially the on-the-run security used for the breakeven – they very often trade at “special” rates in the financing markets. As a result, nominal Treasury yields are ‘too low’ by the value of this financing advantage, which means in turn that the breakeven is too low. If TIPS also traded “special” at similar rates, then this would be less important as it would average out. However, TIPS almost never trade special and in particular, they don’t trade as deep specials. Consequently, breakevens calculated as the spread between a TIPS bond and nominal bond understate actual inflation expectations.[1]
This is all a very windy way to say this: ignore 5y5y forward breakevens and focus on 5y5y forward inflation swaps. Historically the Fed is comfortable with that up around 2.75%-3.25%, although that’s probably partly because they are iffy on bond math. In any case, there is nothing the slightest bit alarming about the current level of forward inflation expectations; indeed, central bankers had much more cause to be alarmed when forward inflation expectations were down around 1.50% – implying that investors had no confidence that the Fed could get within 50bps of its own stated target when given half a decade to do it – than where they are now.
But check with me again in 50bps!
[1] This is widely known, although I think I get the credit for being the first person to point it out in 2006, only two years after the inflation swaps market in the US got started. I figured it out because I was a market maker in swaps and when I was paying inflation in the swap, and receiving a fixed rate higher than the breakeven, and hedged with the breakeven, I was breaking even. The answer was in the financing. I formalized my argument in this paper although my original article was credited and cited in this much more widely read article by Fleckenstein, Longstaff, and Lustig. But the bottom line is that as the Dothraki say, ‘it is known.’
