Archive for February, 2023

Is Inflation Mean-Reverting?

February 28, 2023 2 comments

Over the last couple of decades, the assumption that inflation is mean-reverting to something approximating the Fed’s target level (or to where inflation expectations are supposedly – without any evidence advanced to support the notion – ‘anchored’) has become a key component of most economists’ models. I’ve pointed out a number of times in podcasts (including my own Inflation Guy Podcast as well as numerous others) and in articles that after a quarter-century of having low and stable inflation any model which did not assume mean-reversion has been discarded because it made bad predictions over that period compared to one which did.

A critical follow-up question is whether a model should assume mean reversion in inflation. My observation implicitly says that it should not. If I’m wrong, and inflation in fact is mean-reverting, then the right models won and there’s no real problem.

So, did the right models win?

There are many sophisticated ways to test for mean reversion, but an intuitive one is this: for a given current level of inflation, which is a better guess: (a) inflation will be closer to the ‘mean’ in the next period; (b) inflation will be about the same distance from the mean (homeostasis), neither pulling towards the mean nor pushing away from the mean; or (c) inflation will be further away from the mean, such that deviations from mean get amplified over time. In case (b) we would say that inflation itself has momentum; in case (c) we would say the acceleration of inflation has momentum. The latter case seems an unlikely case of extreme instability: it says that once prices move away from equilibrium, the economy either enters into an inflationary spiral or a deflationary spiral with no clear end. While this clearly can eventually happen in the hyperinflation case, those cases seem to have other causes that tend to amplify the swings (notably, an accelerating loss of faith in the currency itself).

Let’s consider case (a) and (b), and look at some historical data.

The chart below shows the period 1957-2022. The x-axis indicates the current level of inflation, (I collapse the range from -0.5% to +0.5% and call it 0%, +0.5% to +1.5% and call it 1%, etc), and the y-axis shows the average inflation over the subsequent one year. So, the point that is at [2%, 2.3%] shows that between 1957 and 2022, if inflation was between 1.5% and 2.5% then the average inflation over the ensuing 12 months was 2.3%.

I’ve drawn a line that indicates inflation at the same level at the point of observation and subsequently (x=y). Notice that for any number below x=2%, y tends towards 2%. This shows that when the current reading is very low inflation or deflation, the subsequent year we tend to get something close to 2%. Notice that at higher rates of inflation, the dots are below the line – meaning that if inflation is high, the following year tends to see inflation closer to the target. So, this is what we would think mean reversion would look like (and FWIW, it is more pronounced if you choose a longer historical period but because the next chart I am showing is core CPI and we only have data to 1957, I wanted to use the same range).

Case closed! Inflation mean reverts!

Well, not exactly. This is headline inflation. We already know that food and energy tend to mean-revert; that is, after all, why economists exclude food and energy – because we know that high energy readings lead to high inflation prints, and we don’t want monetary policy to overreact to inflation that isn’t really persistent. So, let’s look at core instead.

This chart looks different in key aspects. Except for very high core readings (with comparatively few observations that happen to coincide with when Volcker was aggressively tightening policy), the best estimate for core inflation over the next 12 months is not something closer to the assumed mean; the best estimate is the same level as what we have right now.

What that means – and it is super important – is that inflation has momentum. Keep in mind that during most of the period shown here, the Federal Reserve was actively trying to make inflation mean-revert. And they didn’t succeed, at least on a one-year basis.

Well, monetary policy works with long and variable lags, right? How about core inflation over the period 12-24 months from now? Surely then we should see some mean reversion?

The answer, at least for core inflation, is decidedly no…except for very high current readings of inflation.

Two takeaways:

  1. Inflation has momentum. This means that forecasting core inflation to return to the target level, just because we think it should, is a bad forecasting approach.
  2. Monetary policy seems to have had, at least over this period, very little effect. Generously, it didn’t have effect on average…so perhaps sometimes the Fed overshot and other times it didn’t do enough. There is indeed a range. For example: starting from 5% y/y core inflation (between 4.5% and 5.5%), the 10th percentile of the 1y CPI outcomes after that was 3.5% and the 90th percentile was 6.0%. Starting from 7%, the 10th percentile was 3.1% and the 90th was 9.6%. So the average includes some times when inflation kept going up and some times when it was going back down.

The corollary to the second takeaway…call it takeaway 2a…is this: by the same token, there’s not a lot of reason for the Fed to be super aggressive raising rates to rein in inflation. We know that they can do harm. It’s less clear that they can do a whole lot of good!

Airline Loyalty Miles Have Become Money, not Tokens

February 22, 2023 Leave a comment

I noticed something recently about the many, many airline loyalty miles that my family has accumulated over the years.

Loyalty miles began as a way for airlines to induce brand loyalty in a market that was very fractured post-deregulation (the U.S. airline industry was deregulated in 1978; the American Airlines and United Airlines loyalty programs were created in 1981…although Texas International Airlines is credited with creating the first loyalty program in 1979). In the Old Days, miles worked something like the punch card at the ice cream store, but instead of getting a free scoop of ice cream after ten purchases, it was a free trip after so many segments flown. Because airlines get compensated basically by the number of passenger-miles they create, the loyalty programs were tied to how many miles you flew. Fly more miles, get more miles. But the redemption was fixed: originally, 20,000 miles got you one round-trip domestic coach ticket anywhere the airline flew.

When you get your free scoop of ice cream, it isn’t the scooper’s decision what flavor you get. It’s yours. With ice cream, that’s no big deal; one flavor costs the ice cream parlor about the same amount to deliver to you as another. But with airlines, the problem is somewhat bigger.

Quantitative aside: experienced rates traders may see an echo of the bond-contract structure where it is the seller of the contract who gets to decide which bond to deliver. This optionality is worth something to the seller, and costs something to the buyer, so the bond contract trades at a lower price than it would if there were no delivery options. In this case, it is the buyer who gets to choose what product the seller must deliver (with limitations, of course). So it is very clear that loyalty programs, at least in the traditional structure where the price of the benefit was fixed at 20k or 25k miles, were very valuable to the customer. So did the customer pay more for a fare than he/she otherwise would, to get miles? We may never know.

When the award was “any flight [other than some blackout dates]” and the cost was “20,000 miles”, the strategy was fairly clear. You wanted to wait until you had to buy a high-priced ticket, and buy that ticket with miles instead. In fact, spending the miles on a $400 ticket had a potential opportunity cost because then you wouldn’t be able to spend them on a subsequent ticket that cost $500. So the strategy was to wait, because the option had value. Moreover, inflation worked in your favor as tickets over time rose. There was no realize cost of carry to penalize not spending the miles…so the strategy was to wait. Your loyalty miles were an inflation-linked bond, whose value was linked to airline fares. Actually, an option on an inflation-linked bond…but I digress.

This has changed.

A few years ago, airlines started varying the amount of miles needed to book certain tickets. Tickets on high-load-factor flights started to cost more. In a way, this was not terrible because it meant that some tickets were available at a higher cost, that previously would have been blacked out. So your 25,000-mile award wouldn’t buy the ticket, but you could get it for 50,000. This was successful, and over time what happened is that ever-finer gradations of mile-award-amounts-needed began to show up.

I took an hour this morning and went on United’s website. I priced economy, non-stop, round-trip tickets for EWR-LAX, EWR-ORD, EWR-DFW, EWR-IAD, EWR-BOS, and MIA-SEA(one stop as there were no directs), for March 24-March 26. I collected the price for each departure time. Then I collected the mileage required to buy the ticket in lieu of cash. The chart of this little experiment is below. The x-axis is the miles needed; the y-axis is the dollar cost, and each dot represents one fare pair.

You may notice that the blue dots are arranged in a surprisingly linear way, at least until 32,500 where it seems there is a cap of sorts. In fact, a linear regression line run through the points produces an r-squared of 0.88, and you can get it to 0.95 or so if you use an exponential curve. But the linear line is instructive because the slope of the line indicates that one airline mile on United is worth almost exactly 2.5 cents. As an aside, I didn’t check other loyalty programs but I would be surprised if the slope of American’s line or Delta’s line was meaningfully different.

The red line is where the old 25,000 award would be. If that was still the cost of a ticket, a buyer would not waste it on the tickets to the left of the line and would only use it on those to the right of the line.[1]

So, let’s call a spade a spade: one airline mile on United is 2.5 cents. When airfares go up, your pile of miles becomes less valuable in real terms. Loyalty miles are now indistinguishable from money, in the air travel marketplace.

Here’s the interesting part. Because loyalty miles are now money, the strategy that you the customer should take completely changes. Before, your best strategy was to wait, allow miles to accumulate, and only use them when prices spiked. Now, because miles are money, your best strategy is to spend them as quickly as you can. They don’t earn interest, so they are a wasting asset in real space. It doesn’t matter if you buy one $800 ticket for 32,000 miles, or two $400 tickets for 16,000 miles each. The value is exactly the same.[2] Ergo, they’re money. Not only that, they’re money that can only be spent on airline tickets, and they have a credit component because if the company goes out of business *poof* there go your miles.

Actually, they can be spent on other things, but the optimal way to spend them is probably on airline tickets. I looked at how many miles I would have to exchange to rent various car sizes from Avis in Newark, for two days starting March 24. I added these dots to the chart below.

So the final moral to this story is: don’t rent cars with airline miles!

[1] Class exam question: draw the consumer surplus that the airline reclaimed by changing the pricing structure.

[2] A small caveat to this would be if the current apparent cap at 32,500 for a coach economy class ticket is fixed, because over time more and more tickets would be pricey enough to be capped. However, I think it is unlikely airlines will hold a cap in that way.

Summary of My Post-CPI Tweets (January 2023)

February 14, 2023 2 comments

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy, but subscribers to @InflGuyPlus get the tweets in real time and a conference call wrapping it all up by about the time the stock market opens. Subscribe by going to the shop at , where you can also subscribe to the Enduring Investments Quarterly Inflation Outlook. Sign up for email updates to my occasional articles here. Individual and institutional investors, issuers and risk managers with interests in this area be sure to stop by Enduring Investments! Check out the Inflation Guy podcast!

  • We get the first CPI of 2023 this morning! A fair number of things are changing, but I don’t think the net result is going to be all that large.
  • A reminder to subscribers of the path here: At 8:30ET, when the data drops, I’ll be pulling that in and will post a number of charts and numbers, in fairly rapid-fire succession. Then I will retweet some of those charts with comments attached. Then I’ll run some other charts.
  • Afterwards (recently it’s been 9:30ish) I will have a private conference call for subscribers where I’ll quickly summarize the numbers.
  • After my comments on the number, I will post a partial summary at and later will podcast a summary at .
  • Thanks again for subscribing! And now for the walkup.
  • First, let’s look at what the market has done over the last month. The front of the curve has gone from incorporating disinflation down to 2%, to disinflation down to 2.65%. Nominal and real yields are both higher as well.
  • It’s still hard for me to imagine we could be at 2.65% y/y CPI by this time next year. I suppose it’s possible but a lot of things need to go right.
  • For one thing, services inflation needs to stop going up, and reverse hard. Core Goods has already fallen to 2.1% y/y. It’s unlikely to go into hard deflation given deglobalization but even if the strong dollar gets us to 0%, that doesn’t get core to 2.65%.
  • Consider, for example, Used Cars. There is some talk this month about the surprising rise in the Manheim index, but Black Book has a higher correlation and BB is still declining. I don’t have Used Cars adding this month.
  • However, it’s probably about done dragging…this chart shows the aggregate rise in M2 versus the aggregate rise in Used Car CPI. Yes, prices probably went up ‘too much’ but they’re in the zone of what we SHOULD expect all prices to be doing.
  • FWIW, New Car prices haven’t risen nearly so much, but they’ve been steadily accelerating. This month, the BLS shifts to JD Power as its source for new car prices. No real idea what that should do to the report – one hopes, not much.
  • Let’s set the overall context, by the way: we have passed the peak of Median CPI (unless something really wacky happens today) and we are going to decelerate from here for a while. Probably to 4-5%.
  • But this is likely to happen lots more slowly than people think! Everyone expects rents to collapse. But everyone also expected home prices to collapse. Guess what: neither is going to happen.
  • Look, home prices were high relative to rents. But that doesn’t mean home prices need to plunge. What has happened so far has been what you’d expect: home prices have fallen a small amount in nominal space, and rents have gone up a lot. This will probably continue.
  • Rents can’t go down a LOT without home prices collapsing – and rents would have to lead that. But I have a hard time understanding how home prices OR rents collapse when you have a few million new heads to put roofs over, and a shortage of housing as it is.
  • Now, this month we also have a re-weighting of the CPI basket. It is based on 2021 consumption, which means it partially retraces the prior re-weight which was on 2019-2020 and so had a lot of COVID.
  • This means more weight on the sticky categories and less on core goods. Keep in mind that at the margin this only adds a couple of bps per month, but it will also lower inflation volatility a little bit and slow the disinflationary tendency. But just at the margin!
  • Putting this together, the consensus economists are a bit stronger this month than they have been. But there are some forecasters out there calling for a MASSIVELY bad print. I don’t see where they get that from. Here are my forecasts vs market.
  • I am a little higher, despite the fact that I am not weighting anything to a Used Cars bounce. I keep waiting for Airfares to stop declining in the face of fares that seem massively higher on every route I check. I don’t get that.
  • I have to think that the stock market is potentially quite vulnerable to a high number, unless there’s an obvious outlier. We are at high exuberance for the Fed pausing, despite declining earnings.
  • OK, that’s all for the walkup. As I am tweeting more stuff intra-month, I think the pre-CPI walkup can be a little shorter on CPI morning. LMK if you disagree as I’m trying to offer a service people think is worthwhile! Good luck today. I will be back live at 8:31ET.

  • m/m CPI: 0.517% m/m Core CPI: 0.412%
  • ok. Headline and core slightly higher than expected. Consensus was for +0.45% and +0.36%. I was at +0.44% and +0.42%, so closer on core. The NSA was the surprise, at +0.800%, which pushed y/y to 6.41% against expectations for 6.2%. Y/Y core barely rounded up to 5.6%.
  • Last 12 core CPI figures
  • Second month in a row with an 0.4% core. That means we’re running at just under 5% on core CPI. Not exactly great. But better than it was!
  • M/M, Y/Y, and prior Y/Y for 8 major subgroups
  • Note the drag on medical care. And note the large jump in Apparel, which goes in the ‘surprise’ category.
  • Core Goods: 1.44% y/y            Core Services: 7.16% y/y
  • Yeah, this isn’t going to get us to a 2.0%-2.5% CPI at year-end. Core Goods continues to decelerate but the deceleration is running out of steam. Core Services is still rising!
  • Primary Rents: 8.56% y/y              OER: 7.76% y/y
  • Further: Primary Rents 0.74% M/M, 8.56% Y/Y (8.35% last)      OER 0.67% M/M, 7.76% Y/Y (7.53% last)         Lodging Away From Home 1.2% M/M, 7.7% Y/Y (3.2% last)
  • Again, this isn’t playing to form if you’re looking for disinflation. It’s consistent with my view, but lots of people will scream about this since “private surveys of rents” show something very different. But it would be a weird conspiracy theory to push inflation HIGHER.
  • Do note, the m/m for shelter decelerated a little bit (except for Lodging Away from Home) on a m/m basis. But 0.67% m/m on OER and 0.74% m/m on Primary Rents is still very strong.
  • Some ‘COVID’ Categories: Airfares -2.15% M/M (-2.05% Last)         Lodging Away from Home 1.2% M/M (1.1% Last)         Used Cars/Trucks -1.94% M/M (-1.99% Last)           New Cars/Trucks 0.23% M/M (0.58% Last)
  • AIRFARES MAKES NO SENSE. Who is seeing lower airfares? I’m trying to book RT to San Antonio from Newark and it’s $600. New Cars continues to rise. The Used Cars increase that some people were looking at from Mannheim (I wasn’t!) didn’t materialize and we STILL got a high core.
  • Here is my early and automated guess at Median CPI for this month: 0.481%
  • This is not coming down very fast, but it’s coming down on a y/y basis. I have the median category as Recreation, so this is probably a decent guess at median.
  • Add’l observation on rents: Piped Gas was +6.7% m/m (SA) this mo. Utilities are subtracted from some rents to get the pure rent number, when utilities are included in the rent. Mechanically this means that a high utilities number will tend to shave a little off of Primary Rents.
  • Piece 1: Food & Energy: 9.63% y/y
  • Food and energy actually slightly higher y/y this month. Food & Beverages at +0.50% for the month, still running about 10% y/y. That hurts.
  • Piece 2: Core Commodities: 1.44% y/y
  • Piece 3: Core Services less Rent of Shelter: 6.03% y/y
  • Core Services less Rent of Shelter – this is the big one where the wage feedback loop happens. It’s not decelerating very quickly. At least it’s going in the right direction but since wages aren’t decelerating, there’s really not much good news here.
  • Piece 4: Rent of Shelter: 7.96% y/y
  • The deflation in Medical Care is basically all due to the continuing drag from Health Insurance. Pharma was +1.2% m/m, matching the highest m/m since 2016. Y/y that’s still just 3.15%. Doctors’ Services was flat, Hospital Services +0.7% NSA. Med Equipment negative but small cat.
  • Some good news is that core ex-shelter is down to 3.9% y/y. But with the huge divergence between core GOODS and core SERVICES ex-rents, I’m not sure that number means as much as it once did. Still, the lowest it has been since April 2021.
  • I ran this chart earlier. Assuming the same seasonal change in median home prices this month as last January, the rise in rents pushes this down to 1.43. Almost back to trend. Home prices are NOT as extended as people think.
  • Kinda funny watching stocks. They really don’t know what to think. Hey, stocks! This is a bad number. Higher than expected, even with Used Cars still a drag. Airfares a drag. Health Insurance a continued drag. I am looking at the breadth stuff now.
  • In fact, outside of Used Cars, the only other non-energy category with a <-10% annualized monthly change was Public Transportation. On the >10% side we have:
  • Infants/Toddlers’ Apparel (55% annualized m/m), Misc Personal Goods (+44%), Car/Truck Rental (+43%), Mens/Boys Apparel (+18%), Motor Vehicle Insurance (+18%), Vehicle Maint & Repair (+17%), Jewelry/Watchs (+16%), Lodging Away from Home (+15%), Motor Vehicle Fees (+15%), >>>
  • Medical Care Commodities (+14%), and Water and sewer and trash collection services (+11%).
  • So, this is NOT the picture of a disinflationary price distribution. It’s actually a little quirky because the Median CPI is lower than the median category arranged by the y/y changes. (Median CPI is chained monthlies).
  • I mean…this is improving? But not crashing.
  • Last “distribution” chart. Our EIIDI is weighted a little differently, and it’s still declining but this month it was only a BARE decline. It tends to lead median, so I remain confident Median CPI is going to drop significantly this year…but it isn’t going to 2-3%.
  • Last chart and then I’ll wrap up. This is just showing that the CPI for Used Cars and Trucks was just about where it should be this month. The Mannheim though may just be leading by more. As I said in the walk-up, there’s no reason to expect used car prices to drop much more.
  • OK, here’s the bottom line today: higher number than expected and for all the wrong reasons. The things which were supposed to push the number higher didn’t, but we got there anyway. The sticky categories didn’t look good, and they have higher weights.
  • We will have to wait another month for good news. The Fed is still going to tighten to 5% before they stop, and this isn’t a good enough reason to keep going…but it’s a good enough reason to talk tougher this month. And they already were talking kinda tough.
  • In 5 minutes, let’s say 9:35ET, I’ll have the conference call. <<REDACTED>> Access Code <<REDACTED>> and we’ll sum it all up.
  • BTW here is another reason to not worry too much about rents plunging. These are quarterly series that tracked very well until the pandemic/eviction moratorium. Red line is sourced Reis; blue is census bureau. ASKING rents are coming down. EFFECTIVE still rising.

Here’s the simple summary for today’s number: the data was close to expectations, although a bit on the high side. But you have to remember that some of the reasons people were forecasting that high of a number in the first place included “Manheim used car survey suggests an increase” (Used Cars actually were -1.9% m/m), “Medicare re-pricing should push medical care higher for the consumer sector too” (Medical Care CPI actually was -0.4% m/m), and “Airfares are going up, not down” (Airfares actually were -2.2% m/m).

Okay, that last one was mainly me because I still don’t understand how airfares are dropping steadily when I can’t find a single fare within 50% of the normal price I pay for the regular routes I price. But the point is that we did not get a boost from the expected places, but still exceeded expectations; ergo, the boost came from unexpected places. It was broader. Forecasters were looking for a broader slowdown with some one-off increases keeping the m/m number high; in fact they got broad strength with one-off decreases holding it back. This is not good news.

Now, if I am on the FOMC I still want to pause at 5% and take a look around – this isn’t so surprising, unless you really were looking for inflation to hit 2.2% in June (the inflation swaps market’s last trade for June y/y is still at 2.54%, which remains mind-boggling to me). But I keep saying it and everyone will gradually come around to this view: inflation is not getting to 2% in 2023. It’s not getting to 3%. We should count ourselves fortunate if median inflation gets to 4%. The disinflation will be a multi-year project, and the tough part frankly doesn’t even happen until we get to 4%.

Right now, you’ve squeezed most of the juice out of the Core Goods category. You need to see Core Services at least stop accelerating. Deceleration of Core Services inflation, especially rents, are a sine qua non for the Fed getting to its target. We aren’t on the bombing run to the target yet. We’re still at 40,000 feet and slowly descending.

**Late breaking news, after I’d written this whole thing. The Cleveland Fed’s calculation of Median CPI was a LOT higher than mine. The m/m figure was 0.654% and the y/y rose to a new high of 7.08% y/y. I am not sure how I missed by that much and will need to do some diagnosis (it’s not that hard a number to calculate, except for the regional OER numbers), but the bottom line is that we evidently have not yet reached the median CPI peak!

We Are All Bond Traders Now

February 6, 2023 3 comments

When I started working in the financial markets, bond traders were the cool kids. The equity guys drove Maseratis and acted like buffoons, but the bond guys drove sensible style like Mercedes and cared about things like deficits and credit. The authoritative word on this subject came from the book Liar’s Poker by Michael Lewis, about 1980s Salomon Brothers, where the trainees dreaded being assigned to do Equities in Dallas.

Back then, equities guys worried about earnings, the quality of management and the balance sheet, and the really boring ones worried about a margin of safety and investing at the right price. That seems Victorian now, but I guess so does the idea that sober institutions should only own bonds.

Down the list of concerns, but still on it, were interest rates. Ol’ Marty Zweig used to have a commercial in which he said “if you can spot meaningful changes (not just zig-zags) in interest rates and momentum, you’ll be mostly in stocks during major advances and out during major declines.” The reason that interest rates matter at all to a stock jockey is that the present value of any series of cash flows, such as dividends, depends on the interest rate used to discount those cash flows.

In general, if the discount curve (yield curve) is flat, then the present value of a series of cash flows is the sum of the present values of each cash flow:

…where r is the interest rate.

As a special case, if all of the cash flows are equal and go on forever, then we have a perpetuity where PV = CF/r. Note also that if all of the cash flows have the same real value and are only adjusted for inflation, and the denominator is a real interest rate, then you get the same answer to the perpetuity problem.[1]

I should say right now that the point of this article is not to go into the derivation of the Gordon Growth Model, or argue about how you should price something where the growth rate is above the discount rate, or how you treat negative rates in a way that doesn’t make one’s head explode. The point of this article is merely to demonstrate how the sensitivity of that present value to the numerator and the denominator changes when interest rates change.

The sensitivity to the numerator is easy. PV is linear with respect to CF. That is, if the cash flow increases $1 per period, then the present value of the whole series increases the same amount regardless of whether we are increasing from $2 to $3 or $200 to $201. In the table below, the left two columns represent the value of a $5 perpetuity versus a $6 perpetuity at various interest rates; the right two columns represents the value of a $101 perpetuity versus a $102 perpetuity. You can see that in each case, the value of the perpetuity increases the same amount going left to right in the green columns as it does going left to right in the blue columns. For example, if the interest rate is 5%, then an increase in $1 increases the total value by $20 whether it’s from $5 to $6 or $100 to $101.

However, the effect of the same-sized movement in the denominator is very different. We call this sensitivity to interest rates duration, and in one of its forms that sensitivity is defined as the change in the price for a 1% change in the yield.[2] Moving from 1% to 2% cuts the value of the annuity (in every case) by 50%, but moving from 4% to 5% cuts the value by only 20%.

What this means is that if interest rates are low, you care a great deal about the interest rate. Any change to your numerator is easily wiped out by a small change in the interest rate you are discounting at. But when interest rates are higher, this is less important and you can focus more on the numerator. Of course, in this case we are assuming the numerator does not change, but suppose it does? The importance of a change in the numerator depends not on the numerator, but on the denominator. And for a given numerator, any change in the denominator gets more important at low rates.

So, where am I going with this?

Let’s think about the stock market. For many years now, the stock market has acted as if what the Fed does is far more important than what the businesses themselves do. And you know what? Investors were probably being rational by doing so. At low interest rates, the change in the discount rate was far more important – especially for companies that don’t pay dividends, so they’re valued on some future harvest far in the future – than changes in company fortunes.

However, as interest rates rise this becomes less true. As interest rates rise, investors should start to care more and more about company developments. I don’t know that there is any magic about the 5% crossover that I have in that chart (the y-axis, by the way, is logarithmic because otherwise the orange line gets vertical as we get to the left edge!). But it suggests to me that stock-picking when interest rates are low is probably pointless, while stock-picking when interest rates are higher is probably fairly valuable. What does an earnings miss mean when interest rates are at zero? Much less than missing on the Fed call. But at 5%, the earnings miss is a big deal.

Perhaps this article, then, is mistitled. It isn’t that we are all bond traders now. It’s that, until recently, we all were bond traders…but this is less and less true.

And it is more and more true that forecasts of weak earnings growth for this year and next – are much more important than the same forecasts would have been, two years ago.

But the bond traders are still the cool kids.

[1] I should also note that r > 0, which is something we never had to say in the past. In nominal space, anyway, it would be an absurdity to have a perpetually negative interest rate, implying that future cash flows are worth more and more…and the perpetuity has infinite value.

[2] Purists will note that the duration at 2% is neither the change in value from 1% to 2% nor from 2% to 3%, but rather the instantaneous change at 2%, scaled by 100bps. But again, I’m not trying to get to fine bond math here and just trying to make a bigger point.

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