Archive

Archive for December, 2021

Summary of My Post-CPI Tweets (November 2021)

December 10, 2021 2 comments

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy. Or, sign up for email updates to my occasional articles here. Investors, issuers and risk managers with interests in this area be sure to stop by Enduring Investments! Get the Inflation Guy app in your app store! Check out the Inflation Guy podcast!

  • It’s #CPI Day again. And it’s official, this is now the MOST WATCHED economic number of the month. It’s crazy to think that if you had told me two years ago that we would be pushing 40-year highs on #inflation in 2021, I’d have thought you were mad.
  • Amazingly, economists’ predictions for today’s figure would take headline inflation to 6.8% and core to 4.9%. The month/month forecast for CORE is actually 0.5% – an amazing testimony in itself.
  • Some economists are ‘getting religion.’ The last couple of numbers have been shocking (especially last month’s). The September CPI released in Oct was only 0.24% core, but it was broad.
  • The October CPI released last month was 0.599%, AND it was incredibly broad. Median CPI rose 0.57% m/m – by far the largest increase since 1982. Not even close.
  • So this month, people aren’t looking for retracements in an outlier. There’s nothing much to retrace. Indeed, it looks like we might get another push from autos.
  • Used car prices in the CPI rose 2.5% m/m last month; it could be 4% this month. It COULD even be more than that.
  • New car prices have also risen 1.3% in each of the last two months. With used car prices skyrocketing, it’s hard to imagine new car prices flattening out. So from autos, you could contribute 0.2% to core, if they play to chalk.
  • Rents have also been jumping. Unlike Used Cars, only the timing was surprising. I thought it would take longer after the end of the eviction moratorium to see 5% rates of increase and more, but here we are. Both OER and Primary rents were +0.42%-0.45% each of last two months.
  • If that repeats, it adds another 0.16% or so to core. So then you just need to find price increases of 0.14% from everything else in the core categories, to get to your 0.5% forecast. So it’s not a big reach.
  • Lots can go wrong in any month, of course, which is why I try not to overanalyze the number pre-snap. But 0.5% doesn’t seem wildly off as a baseline guess, to me. (The inflation swaps market sees more like 6.9% on headline, so upside risk.)
  • The bottom line is this: although next month we may get some drag from gasoline thanks to the sharp fall in wholesale prices at the end of November, we’re still very likely to hit 7% on headline and will certainly exceed 5% on core over the next few months. That’s amazing.
  • It gets more amazing: Because of easy comps from last year, averaging 0.06% on core for Dec, Jan, Feb, it doesn’t take a lot of imagination to get y/y core to 6% by the end of Q1. Then it should recede…but it’s not going back to 2%.
  • So to put it bluntly, inflation right now is not aiming for the 5 o’clock news. It’s aiming for the history books.
  • Why is this happening? Simple: too much spending, too fast, financed with newly created reserves. Period. The shortages result from getting incomes back above pre-covid levels before we were ready to provide the goods and services to the people waving dollars.
  • Going forward it is hard to see how this resolves easily. There are still many more people not in the workforce than there were pre-pandemic…but more income, by a lot. Demand>supply, and financed by 12% money growth.
  • Moreover, one final thought and a h/t to Barclays for their chart of the HH index. The Herfindahl–Hirschman Index is a very widely-used (especially in antitrust) measure of market concentration. Over the last few decades, it has risen precipitously, meaning more concentration.
  • When market power is concentrated, so is pricing power. And those mega-firms that now dominate just about every niche in American life have re-learned that price increases can stick in this kind of environment. Who can blame them? You build market power for exactly this moment.
  • It’s hard to unscramble this egg. So hang on to your juevos, number in a few.
  • Cents and Sensibility: the Inflation Guy Podcast
  • inflationguy.podbean.com
  • As a reminder, I will have a summary of all my tweets at https://mikeashton.wordpress.com  sometime mid-morning and then I plan to put out an Inflation Guy podcast (https://inflationguy.podbean.com) sometime today.

  • Yawn. CPI as-expected. Just a soothing 6.4% annualized pace of core. 0.53% m/m,
  • Core was actually VERY close to printing 5.0%. Using the seasonally-adjusted numbers you’d get 4.96%, which would round up. NSA numbers give you 4.93%. Doesn’t matter; will be over 5% next month.
  • So, highest headline inflation since 1982, highest core since 1991, with more to come on both.
  • Running through the usual suspects: Used cars were 2.50%. That’s less than I expected. There’s still make-up there next month, believe it or not.
  • Owner’s Equivalent Rent +0.44% again this month. Primary Rents +0.42% again this month. Eerily steady at a high level. This month, Lodging Away from Home was +2.98% m/m. Consequently, the Housing subgroup was +0.52% m/m, 4.8% y/y.
  • I mentioned Used Cars; New Cars was 1.13% (seasonally adjusted) m/m. Car and Truck Rental +1.1% m/m. Airfares this month (a “Covid category”) +4.75%
  • So with airfares, lodging away from home, used and new cars, motor vehicle insurance (+0.66% m/m)…doesn’t look like this wave of COVID is doing much to hold down prices.
  • An eye on Medicinal Drugs is warranted. y/y it’s back to flat. Doctors’ Services also up smartly this month, 4.26% y/y. Hospital Services down m/m but still 3.5% y/y.
  • Overall, Core Goods rose to 9.4% y/y, with Core Services up to 3.4% y/y.
  • Interestingly, two of the eight major subgroups declined m/m: Recreation, and Education/Communication. And we still got 0.5% on core!
  • Here are core goods and core services. Supply chain still an issue for goods. Core services the highest since 2008, and will go higher still thanks to rents.
  • Core inflation ex-housing back up to 5.72% y/y. It was higher in June at 5.81%. But otherwise…back to early 1980s.
  • So let’s see. Only category that declined at a faster than 10% annualized rate was Jewelry and Watches (-20.5% annualized m/m).
  • The list of categories >10% annualized growth. Excluding the 6 food/energy line items there: Mens/Boys apparel, public transport, lodging AFH, Used cars, Women’s/Girls apparel, New cars, Motor vehicle parts/equip, misc personal goods, car/truck rental, tobacco,househld frnishings
  • Looks like the median CPI category will be an OER subindex, which gets separate seasonals, so hard to forecast exactly but another 0.44% m/m or so from Median pushing it up to 3.5% (just my early guess).
  • Median m/m. One exhibit in the ‘broadening’ argument.
  • Once again, not a lot of huge outliers here. Although November and December numbers get harder to tell because the seasonal adjustments are more important (e.g. lodging away from home, negative before SA but strong after SA).
  • Why did Recreation decline? Well, thinks like “admissions”, photographic equipment, cable/satellite television service all declined. So the cake we are supposed to eat is at least getting cheaper.
  • Fascinatingly, 10-year breakevens are down HARD, -4bps on the day to 2.45%. With core pushing 5% and rising. Wonder what kind of number folks needed to stay long??
  • Here are the Four Pieces. Food & Energy. Near multi-decade highs as well. And it’s not just energy – there are ripple effects in fertilizer and therefore food. The Food subindex itself was +5.82% y/y.
  • Core Goods – here is where the supply chain argument is most-salient. Obviously cars are in here and a big part of it. But not all of it! it will come down, but all the way to zero? I have my doubts. And…not soon.
  • Core services ex-shelter. Still the best news out there. Medical care not unreasonable. Mind you, this would have scared me two years ago, but right now it looks soothing compared to the other charts.
  • And the part that was the most-predictable (but took an amazingly long time for people to catch on to): rent of shelter. This has another 1% or more to go, at least. And it’s a big chunk of CPI.
  • The distribution of price changes by CPI component weights. Less of a distribution than a splatter, at the moment. Not much going up less than 3%!
  • And let’s put numbers on that. Only 20% of the consumption basket has risen LESS than 3% over the last year.
  • Almost double the weight of the categories slower than 3%? The categories faster than 4%.
  • Lastly, the Enduring Investments Inflation Diffusion Index reached a new record high. The inflation pressures now are broader than the deflation pressures in the Global Financial Crisis.
  • So wrapping this up…what does this mean for the Fed? In the Old Days, the Fed by now would have already tightened a bunch. Currently, we’re talking about reducing the amount they add in liquidity, maybe a little faster. And possibly raising rates in 2022. That is, UNLESS…
  • …unless stocks drop like a stone. And honestly, it’s not really clear to me that the government would care to see much higher interest costs on the debt. Only way Japan has survived its mountain of debt is that is it almost interest-free, after all.
  • But maybe the hawks will storm the Eccles Building and the Fed will not only raise rates, but also slow money growth (these were once tightly connected; now not so much, and it’s the money growth part that matters not the interest rate part). We can hope.
  • In a recent podcast, “How Many Swallows Make a Spring”, https://inflationguy.podbean.com/e/ep-12-how-many-swallows-make-a-spring/ I expressed my opinion that once the peak is in, the valley for inflation won’t be as low – because we have semi-permanently moved the distribution.
  • So we’re not looking, in late 2022, or in 2023, to get core inflation back to 2%. It’s just not going to happen unless housing collapses (which could happen – lots of weird things could happen – but we don’t base outlooks on what weird things COULD happen).
  • IMO, we’re now in a land of 3%-4% core, maybe if we’re lucky it’s 2.5%-3.5%. Getting it back to 1.5%-2.5% will take strong leadership (HA!) and a long time.
  • Recently, 10-year inflation breakevens reached 2.78% – matching the all-time highs (since TIPS were issued in 1997) from 2005. If you think about breakevens in the same way you think about TS…
  • So, as I wrote last month, you haven’t missed this trade yet. https://inflationguy.blog/2021/11/18/you-have-not-missed-it/
  • Thanks for tuning in. I’ll have the collated summary of these tweets up on my blog within a half hour or so, and will drop a podcast summary of it later. Retweet, call, click, visit, like, upvote, forward, or whatever the kids say these days.

The wonderful thing about December trading is that none of the market moves need to make sense. As I write this, stocks are up and inflation breakevens are down. It’s almost as if high inflation that didn’t actually surprise is somehow helping the ‘transitory’ story. Breakevens act as if the Fed is about to be aggressive and suck liquidity out of the system. But if that’s true, then it’s weird that stocks are higher because an elevated discount rate, with the stock market at record multiples, cannot be a good thing.

There is one way that those moves could be consistent, and that’s as if investors now believe that the inflation spike will indeed be transitory, and that the Fed won’t need to do anything after all. If it was all about some supply bottlenecks that will shortly resolve themselves, and the party can continue, then it would make sense to push inflation expectations lower and also not deflate stocks.

But to be clear, there is absolutely nothing in today’s number that would give any shape to that fantasy. For the third month in a row, the inflation figures were high and the price increases were spread across a very wide variety of categories. There is no one-off to point to. Used Cars adds something – but we haven’t yet seen the peak in that – and that rate of change will eventually ebb. At the same time, other categories are showing new life. This is a much more dangerous look than it was in the first half of 2021, when we expected broadening but it was still believable that “COVID categories” could be the main story. That story is dead and buried. This is not about the pandemic any longer; it is about policy response to the pandemic. It is almost entirely policy error. I will show again the picture from last month, which sums it up. Supply has done what supply usually does following a recession – if anything, it has recovered faster than usual and is back to trend. It’s demand that is far above normal, and that’s not an accident and it isn’t due to COVID. It is a policy error, and it will take many tears (and maybe many years) to reverse.

A Guess at the Value of Long Inflation Tails

December 7, 2021 1 comment

In my last post, “You Have Not Missed It,” I promised the following:

“There is one final point that I will explain in more detail in another post. Breakevens also should embed some premium because the tails to inflation are to the upside. When you estimate the value of that tail, it’s actually fairly large.”

So, as promised, here is that explanation.

Viewing the forward inflation curve as a forecast of expected inflation (whether using “breakevens” or, more accurately, inflation swaps) is biased in a particular way. Or, at least, it should be. The “breakeven” inflation rate is the rate at which a long-only investor over the ensuing period would be roughly as well off with a nominal bond (which pays a real rate plus a premium for expected inflation) and an inflation-indexed bond (which pays a real rate, plus actual inflation realized over the period). Obviously the inflation-indexed bond is safer in real space, so arguably nominal bonds should also offer a risk premium to induce a buyer to take inflation risk.[1] Ordinarily, though, we ignore this risk and just consider breakeven inflation to be the difference between real and nominal yields. Inflation swaps are cleaner, in that if inflation is higher than the stated fixed rate, the fixed-rate payer on the swap ‘wins’ and receives a cash flow at the end, whereas if inflation turns out to be lower than the stated fixed rate, it is the fixed-rate receiver who wins. So from here on, I will talk in terms of inflation swaps, which also abstract from various bond-financing issues of the breakeven…but the reader should understand that the concept applies to other measures of expected inflation as well.

Now, suppose that you expect 10-year inflation to come in at 2% per annum. Suppose that in the inflation swap market, the 10-year rate is 2% ‘choice’ – that is, you may either buy inflation at 2% or sell inflation at 2%. Since you expect inflation to be 2%, are you indifferent about whether you should buy or sell?

The answer is no. In this case you should be much more eager to buy 2% than to sell 2%, given that your point estimate is 2%. The reason why is that the distribution of inflation outcomes is not symmetrical: you are much more likely to observe a miss far above your expectation than to observe a miss far below your expectation. Therefore, the expected value of that miss is in your favor if you buy the inflation swap (pay fixed and receive inflation) at 2%. There is, in other words, an embedded option here that means the swap market should trade above where most people expect inflation to be.

We can roughly quantify at least the order of magnitude of this effect. Consider the distribution below. This chart (Source: Enduring Investments) shows the difference, from 1956 until 2011, of 10-year inflation expectations[2] compared with subsequent 10-year actual inflation results. The blue line is at 0% – at that point, actual inflation turned out to be right where a priori expectations had it. The chart obviously only covers until 2011 since that is the last year from which we have a completed 10-year period. Recognize that I am not charting the levels of inflation, but the level of inflation relative to the original expectation.

Notice that the chart has a cluster of outcomes (and in fact, the most-probable outcomes) just to the left of zero, where expectations exceeded the actual outcome by a little bit, but that there are very few long tails to the left. However, misses to the right, where the actual outcome was above the beginning-of-period expectations, were sometimes quite large. The median point (where half of the misses are to the left, and half are to the right) is 0.21%. But this is not a symmetric distribution, so if we randomly sample points from this distribution, we find that the average of that sample is 0.59%.

So, if you buy the inflation swap at 2% when your expectations are at 2%, on average you’ll win by 59bps, at least historically. Of course, past results are no indication of future returns, and a Fed economist would argue that we have much better control of inflation now than we ever have in the past (Ha ha. I crack myself up.). And inflation volatility markets, when they can be found, don’t trade at such high implied volatilities. Noted, although the wild swings in growth and the deficit and the money supply, not to mention recent realized outcomes, might make more cynical observers question whether we should be so confident in that view right at the moment.

Moreover, a counterargument is that at the present time an investor also has the advantage of investing when expectations are fairly low, so the downside tails are not as likely. The worst outcome of that whole 1956-2011 period was an 8.75% undershoot of inflation versus expectations. This happened in the 10 years following September 1981, when expectations were for 10-year inflation of 12.70% and actual inflation was 3.95%. But with expectations at 2.50%, is it really feasible to get a -6.25% compounded inflation rate? That would imply a 50% fall in the price level (and, I should note, it would mean that investors in TIPS would win hugely in real space since they get back no worse than nominal par. But that doesn’t help the swap buyer).

To be a little more fair, then, the following chart considers only the periods where inflation expectations were 5% per annum or less at the beginning of the period. That truncates only 10% of the distribution, but as you might expect the vast majority of the truncation is on the left-hand side. This is fair because it’s naturally harder to miss far below your expectations when your expectations are very low to begin with.[3]

The value of the expected miss in this contingent view is 1.13%. So, in order for the market to be priced fairly if general expectations are for 2.5% average CPI inflation the 10-year inflation swap would have to be around 3.63%. Again, even allowing for the “policymakers are smarter now” argument (an argument quite lacking, I would argue, in empirical evidence) I would feel comfortable saying that 10-year inflation swaps, and breakevens, should embed at least a 50bps or so ‘option premium’ relative to expectations.

I don’t believe that they do. Indeed, consider that the buyer of 10-year TIPS (with breakevens at 2.50%) not only wins if 10-year inflation is above 2.50% but the average win historically (conditioned on breakevens being below 5% to start, and by construction only considering wins) has been about 2.07% per annum – a massive outperformance. Not only that, but any losses are essentially guaranteed to be small because the tails on the left-hand side are truncated: if inflation is negative (that is, if the loss would have been greater than 2.50%) it is limited by the fact that the Treasury guarantees the nominal principal.

As an aside, we do consider this sort of option in other contexts. In the Eurodollar futures market, for example, we recognize that the person who is short the Eurodollar contract (and therefore gets a positive mark-to-market when interest rates rise) is in a better situation than the long (who gets the positive mark-to-market when interest rates fall), because the short gets to invest wins at higher interest rates and borrow losses at lower interest rates, while the long must borrow to cover losses when interest rates are higher, and but gets to invest wins when interest rates are lower. As a result, Eurodollar futures trade lower than the forwards implied from the swap curve, since the buyer needs to be induced by a better-than-expected price. And there are other such examples. But I am pretty sure I have never seen an example of an embedded option like this that is priced so differently relative to history than the embedded options in the inflation market!


[1] However, since this risk is symmetric – the seller of the bond also has risk in real space, but in the opposite direction – it isn’t immediately obvious why one side should get an inducement over the other. So I will leave the ‘risk premium’ aside.

[2] For long-term inflation expectations back before the advent of TIPS, I used the Enduring model relating real yields to nominal yields, about which I’ve written previously. You can find a brief discussion of this and an illustration of the model at this link: https://inflationguy.blog/2016/12/23/a-very-long-history-of-real-interest-rates/

[3] The author’s wife has been known to make something like this observation from time to time.

Categories: Options, Theory, TIPS Tags: , ,
%d bloggers like this: