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“The Great Demographic Reversal”

July 6, 2022 4 comments

I don’t often write book reviews and, strictly speaking, this isn’t one. I am not going to go into great detail about The Great Demographic Reversal, by Charles Goodhart and Manoj Pradhan. And yet, if you are reading about inflation – and in particular, you’ve read what I’ve written about inflation – then I think this is a book that you should read. It is important.

One of the dilemmas that people who model inflation have is that any given model of inflation in the United States tends to have a state shift around 1992 or so. Any model that you design works at best on the pre-1992 period or the post-1992 period. I mention this a lot, because while modern-day economists and policymakers are very content with their models because they’ve worked well for nearly 30 years (until 2021-2022, when the Fed has been so befuddled that Chairman Powell last week admitted that “We’ve lived in that world where inflation was not a problem.  I think we understand better how little we understand about inflation”), in my view they don’t really understand the underlying dynamics of big inflation shifts unless they can explain the state shift in or around 1992.

The most popular explanation is that inflation expectations abruptly became anchored at that point, causing inflation to suddenly become mean-reverting in a way it never did before. There have been plenty of takedowns of this idea, most notably by the Fed’s own Jeremy Rudd. My theory for some time has been that the sudden globalization and expansion of Free Trade following the fall of the Berlin Wall and the disintegration of the Soviet sphere of influence in the late 1980s, most-aptly summed up in this chart from Deutsche Bank, gave us a better tradeoff of growth and inflation for a given amount of money supply growth, but that that game was coming to an end at about the time Donald Trump was elected.

Goodhart and Pradhan, in the book I’ve referenced above, provide some additional support for that view but also go much farther and highlight the massive demographic wave that was cresting over the last quarter-century. It isn’t just the Baby Boom generation in the United States, but also (and critically) the opening up of China and the movement of rural Chinese to the cities that caused a massive outward shift of the labor supply curve. Since the title of the book gives away the ending I don’t mind sharing the point they make that the China demographic is shifting into reverse (as a foreseeable consequence of the one-child policy) and many other demographics-related trends are also. One of their big conclusions is that “for the past few decades, central banks have given too much credit to their own inflation targeting regimes and too little to demography in accounting for the disinflation we have seen.” (p.189-190)

The authors discuss the changing demographic landscape, and how this leads to a resurgence of inflation. They address a number of counterarguments, including (thank heavens) the “Why Didn’t It Happen in Japan” argument, and examine whether there is likely to be sufficient contrary forces coming from (for example) automation and the continued growth of India and Africa. They tinker with various policy proposals. I should say that I disagree with many of their policy proposals, which are redolent of some of the redistributional schemes common on the left.

But while I don’t like their solutions, I agree that they’ve identified the right problems and supported those views with plenty of charts and data. The book was published in late 2020, before the current inflation spike makes them look prescient. It was written prior to the COVID crisis, and there is an addendum chapter where the authors discuss whether and how Coronavirus changes their views. However, I think the authors would admit that they weren’t writing about the inflation spike of 2021-202x. They are really looking farther out. In their view – which I share – the basic forces which made the disinflation of the last 40 years possible (and possibly even inevitable) are moving into reverse, and we will struggle for many years with the difficult choices an underlying inflationary dynamic forces upon us.

I highly recommend this book.

We Were Shocked – Shocked! – that Massive Stimulus Caused Inflation

June 23, 2021 2 comments

At one time, when I worked for big global banks, I wrote a commentary daily. As a consequence, I would remark on almost literally every “important” fed speech (the quotation marks being because, in the last decade or two, almost none of those speeches were at all meaningful since they had already given us the playbook in plain English). Nowadays, I delight in the fact that I don’t regularly have to comment on the drivel that dribbles from fed mouthpieces. At times, though, it becomes too much to ignore and something need to be said.

“A pretty substantial part, or perhaps all of the overshoot in inflation comes from categories that are directly affected by the re-opening of the economy such as used cars and trucks.”

Jerome Powell, June 22, 2021

This has become a very easy meme for Fed officials and disinflationistas: inflation is “transitory” over some unstated period, because almost everything we are seeing is the direct result of the abrupt reopening of the global economy.

Let’s examine that. In what way is the price increase in used cars and trucks due to the reopening?

In a normal cycle, there wouldn’t be sudden and huge demand for used cars all of a sudden. Nor would there be a sudden and huge demand for all sorts of other goods and services – shipping containers, chlorine, semiconductor chips, polypropylene, contract labor. In a normal cycle, demand recovers gradually and supply adjusts to the new demand gradually. Suppliers have time to read market signals and to bring new production on-line. A manufacturer of plastic doodads forecasts that in three months, he’s going to have enough demand to need a second shift – so, he puts advertisements in the paper and starts to selectively hire workers for a second shift. When the demand shows up, he is ready.

So clearly, the big mismatch between supply and demand in this cycle is the problem. And it isn’t just in used cars and trucks. It isn’t just in hotels and airfares. In fact, it is a myth that there is a small set of categories that are inflating wildly while other prices are inert. The chart below shows Enduring Investments’ Inflation Diffusion Index. More categories are seeing acceleration inflation, than are not.

Sure, a few categories add most of the acceleration, mathematically. That is always true. The combination of weight in the basket and size of the move means you can always point to one item or set of items that this month caused a big increase. I first mentioned my “microwave popping corn” analogy back in October. The fact that you can identify a particular reason that a kernel popped does not mean that you have found the root cause of all of the kernels popping. (As an aide, that article addressed the rise in used car prices that was just starting to happen. Back in October, when most of the world was still 90% on lockdown).

Again, there’s no question about the fact that one link in the causal chain is that demand came back before supply could prepare for it. But whose fault is that?

It isn’t merely the fact of the reopening. If Administration officials had simply decided on January 1st to let people go back out into the world again, demand would not have exploded overnight. Buying things requires money. In a normal cycle, suppliers would have started to hire for the reopening; they would have paid the workers, who would then have money; some of those people would go and buy used cars. It would surely have happened more quickly this time since the gate was being removed all at once. But many consumers would have had to spend time repairing their personal balance sheets and would not have suddenly gone out to buy new cars. Instead, what happened is that the Congress dropped a couple trillion dollars into consumers’ accounts, and – a crucial part of this sequence – the Fed bought the bonds that the Treasury had to issue in order to spray that money into the economy.

That last step is important. If the Treasury had just spent a trillion dollars and issued a trillion dollars’ worth of bonds, it would have had an impact but only because the money was being sent to consumers with a high propensity to consume, while the money being pulled in to pay for it was coming from investors with a lower propensity to consume (investors buying the bonds now have less cash to spend). So the spending package would matter, but not nearly as much as spending a trillion, and issuing bonds which the Federal Reserve expands the money supply to buy. A great chart from Deutsche Bank Research illustrates this cleanly: the Fed bought a huge proportion of the bonds the Treasury sold.

So trillions of dollars of the demand pressure are coming from debt being sold to a guy with a printing press. That is fake demand. It is not “due to the reopening.” It’s due to spastic fiscal policy, coupled with profligate monetary policy. And, as the used car example shows, it started happening long before the economy was getting “back to normal.” So while Powell and his minions feign surprise and shock at the outcome, it only means they are either deceitful or incompetent. The root cause here is absolutely clear, and the only reason that Chairman Powell can get away with claiming otherwise is that he is speaking to another body that is even more deceitful and incompetent.

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Restructuring the Inflation Guy Content Offering

August 2, 2022 2 comments

For many years, I’ve been producing a blog and pushing free content. Before that, I wrote Sales and Trading commentary for Natixis, and before that Barclays, and before that Deutsche Bank, and before that, Bankers Trust. I never charged for any of that and neither did the banks, at least directly.

Writing, at least with respect to the blog itself, was part of my process of thinking through the economic and investing environment. I had to do that anyway, so distributing those thoughts was easy and the feedback/pushback I got was important and useful as well. It still is.

But over the years, my content offering (which is congruent to the set of Enduring Investments’ content offering) has widened to different channels and even different media. There is now an Inflation Guy podcast, an Inflation Guy mobile app, and even an Inflation Guy album of ‘80s hits. (Okay, not that one.) I’ve written two books and am contemplating a third. And then there’s Twitter. And as the number of content outlets and offerings metastasized, it has also become clear that I have gone way beyond just the idle penning of my musings and that this takes a lot of time. Some other things I would like to do would take even more time. So there needs to be a business purpose!

The hope has always been that some people who find these thoughts useful would become investing or consulting clients of Enduring Investments. Some have! And more will, in the future. But others may want some content and be willing to pay for the value, but not be willing or able to become clients. Consequently, I’ve been discussing with a bunch of my advisors how to capture the value that people are willing to pay, but not in the single avenue we presently offer (that is, becoming a client).

So I took a survey, and many of you participated. I want to tell you that I really appreciate the answers you gave and the time you took to answer the survey. It was well worth the two Visa gift cards (which, incidentally, haven’t yet been claimed – check your spam folders, folks, as I have written to two of you who are winners!). There were some very thoughtful comments and some good ideas. There was also some humor: one person put my address in for the raffle (I didn’t win). And then there was a bot! All of a sudden, one day I received a deluge of hundreds of responses. Some of these responses indicated that Inflation Guy content was worth $50,000 per month. I am flattered, robot, but money means different things to humans I guess. Fortunately, it was easy enough to cleanse the data of bot responses, which were fairly obvious…and, in retrospect, there is probably a thriving business out there of people pouring bot responses into raffles to tilt the odds. Live and learn.

On the basis of the responses, this is what we have decided to do with “Inflation Guy/Enduring Investments” content going forward.

First of all, free stuff:

  • The E-piphany Blog, which was at https://mikeashton.wordpress.com and now can be reached at https://inflationguy.blog . It has always been free, and will remain free. You can subscribe to email alerts of the content. The monthly summary of my CPI-day tweets will continue to appear here, a couple of hours after the release.
  • Cents and Sensibility: the Inflation Guy podcast. Free wherever good podcasts are found. There may someday be advertisements but the podcast itself will remain free.
  • My weekly Investing.com column, which is unique to http://www.investing.com . They have subsidized it so that you don’t have to.
  • The Inflation Guy mobile app. While there may be “premium content” on the app, the app itself will remain free as well as will a goodly amount of its content.
  • @inflation_guy on Twitter will remain a free follow. My blog columns and podcasts and other free content will funnel through that channel. The monthly CPI tweets, though, will not (see below).

And now, the new offerings. These, and any others we add in the future, are available on the blog site at https://inflationguy.blog/shop/ . Please note that Enduring Investments clients pay nothing for these offerings.

  • Inflation Guy Plus on Twitter – Private Twitter account subscription. I am moving the real-time analysis of the CPI report to a private, subscription-only Twitter account. I will release my charts as soon as possible after the number, and will also have a private live audio broadcast as I comb through the charts and data. (I haven’t figured out whether this will be on Discord, Google meet, Zoom/Skype, but will probably start as a simple conference number). @InflGuyPlus will also have other daily/weekly charts and commentary not available on @Inflation_Guy. The cost of a monthly subscription will be $99/month with a discount for an annual subscription. This is in line with other private Twitter offerings. For example, Damped Spring offers a private Twitter feed for $80/mo with similar content though of course less concentrated on inflation. And the results of the survey we took suggested this price is not inappropriate for the people who require the real-time analysis to make trading decisions.

I do know that some people will be disappointed this isn’t cheaper. It’s an unfortunate characteristic of walls: unless there are people on both sides, you don’t need a wall. (Again, Enduring Investments clients are automatically catapulted over the wall. Although that is an unfortunate metaphor come to think of it.)

  • Quarterly Inflation Outlook – I have been writing the QIO for more than a decade now. It comes out on the ‘refunding’ cycle: February, May, August, and November, within a couple of days after the CPI reports in those months. I decided to make single-issue subscriptions available, at least for now, hoping that after trying an issue people will sign up for the discounted monthly subscription. The current issue is $80 (right now, you can buy the August issue, which will be delivered via email when it is published); the preceding issue is $70 (in this case, that is the May issue) for an immediate download; earlier issues may be made available once I have time to sort through them and find ones with staying power. To test whether there’s any demand, I listed the Feb 2022 issue for $50. I also listed the 2020Q4 QIO, in which I look prospectively at the incoming Biden/Harris Administration, for $40. A recurring subscription gets a discount to $75/issue, which seemed to be acceptable to most of the respondents to the survey.

We are going to start with those two paid offerings, and see how it goes. There seemed to be some interest in a $2.99 monthly subscription which would update your personally-weighted inflation index, and in a $20 monthly subscription to a collection of model portfolios, but we will see how the response is to these products before adding other options.

One other quick comment about the prices: being a markets person, I will be attentive to dynamics that suggest I should raise or lower the price. But for you, if the price is acceptable there is no reason to delay subscribing. That’s because if I raise the price, all existing subscribers will be grandfathered at the original price; if I lower the price, I will lower it for all existing subscribers as well. So there is no price risk to you in deciding to buy now.

Now, let me mention one final offering. This has a very narrow audience but which audience seemed, in the survey, to be enthusiastic about deeper access to Inflation Guy.

“You take the blue pill—the story ends, you wake up in your bed and believe whatever you want to believe. You take the red pill—you stay in Wonderland, and I show you how deep the rabbit hole goes. Remember: all I’m offering is the truth. Nothing more.”

Morpheus, The Matrix

Let’s call this “Inflation Guy Prime.” It is really for the institutional investors and traders who want regular forecast updates and detail, some relative-value metrics and possibly trading signals, subcomponent forecasts/curves, and two-way communication with the Inflation Guy. Because of the two-way communication bit, this offering is capacity-constrained and so will be capped at a yet-to-be determined number of subscribers; the price will increase as we get more subscribers who want to be “Prime.” The current price is shown on the shop.

And so now…we see what happens. Thanks again to everyone who participated in the survey and offered independent, helpful suggestions. The offering will change and hopefully improve over time. We will add other offerings for readers/investors who have different needs. And we will figure out the right price points, eventually…but we had to start somewhere. Please let me know of any questions and/or suggestions you may have!

The Re-Onshoring Trend and the Long-Term Impact on Core Goods

February 22, 2022 7 comments

I know that today, and probably for a little while, investors are focused on Ukraine and Russia. I am gratified that for what seems the first time in many years, notes about the conflict tend to include some form of the addendum “and its effect on domestic inflation,” albeit in many cases this is from the perspective of how this engagement will damage or burnish President Biden’s poll numbers at home and the prospects for his party in the midterm elections. How self-absorbed we Americans are! To be fair, in my opinion the importance of the US policy-response operetta was always less about Ukraine than about Taiwan. I hope that doesn’t turn out to be right.

However, today I want to talk about the re-onshoring trend in manufacturing, and the significance of this for inflation going forward.

One of my 2022 themes so far is that the conventional expectation for inflation to peak soon and ebb to a gentle 2% over the next 12-18 months is mostly predicated on the idea that the extraordinary spikes we have seen in certain categories (see: motor vehicles) will eventually pass, and inflation will return to the underlying trend. The simpler observers see it as 12 months since (mechanically) the spikes will all be out of the y/y number in 12 months. Some forecasters are giving themselves a little wiggle-room by saying it will take 18 months as the ports unclog and ‘other knock-on effects’ wash through. But in my opinion, the evidence is strong that the underlying trend is no longer 2%, but more likely 3-4% or higher. Part of that evidence is the great breadth that we have seen in the recent inflation numbers, which suggests either a riot of unfortunate coincidental events all in the same direction, or else a common cause…say, the rapid growth rate of the money supply, which as of the latest report is still growing more than 12% annualized over the last quarter, half-year, and year.

The forecasts of sharply decelerating inflation expect the parade of “one off” causes to end – and, crucially, to be replaced by unbiased random events that are equally likely to be up or down. This is ‘assuming a can-opener,’ and is economist malpractice in my opinion. Because of the continued rapid growth of money, and until that rapid growth slows drastically or reverses, the surprises are mostly going to be on the high side. That’s why I expect inflation to be lower at the end of the year than it is right now, but not lots lower.

All of this, though, obfuscates a trend that had started prior to COVID but has gained great momentum since. When President Trump was first elected, we’d suggested in our customer Quarterly Inflation Outlook that one of the following winds which had kept inflation low despite loose monetary policy throughout the 1990s and 2000s was in the process of stopping and potentially reversing. That following wind was globalization. I eventually ended up talking a lot about de-globalization. Here’s one article from four years ago. I really love the Deutsche Bank chart in it.

In a nutshell, the argument was that domestic goods prices had been kept abnormally low despite strong economic growth and loose monetary policy through the prior quarter-century because businesses had gradually over time offshored production and extended raw materials and intermediate-goods supply chains to cheaper manufacturing locations outside of our borders. But that’s a trick that can only be turned once. When most production is overseas and most intermediate goods imported from the Pacific Rim, costs will resume rising at the rate of inflation in the source country, adjusted for FX changes. For decades, we’d seen core goods inflation near zero despite services inflation in the 2-4% range, as this dynamic played out, but there was no reason that goods inflation should permanently be zero.

So I thought that in 2016 we were already coming slowly to a point where similar monetary policy going forward was going to result in less growth and more inflation because that trick had been used up. The election of President Trump merely accelerated that timeline and increased the probability that the trend wouldn’t only stop but could reverse, causing the division of growth and inflation for a given monetary policy to be distinctly bad and requiring much tighter policy.

COVID-19, and the global response to COVID-19, has more or less totally reversed the arrow of global trade. Businesses are pulling manufacturing back to the US and pulling supply chains back to the Western Hemisphere as much as possible. Geopolitical tensions between the US and Russia, and the US and China, combined with the increased appreciation of the optionality of inventories and the cost imposed by long and variable lead times, which is partly reflected in the need to hold more inventory. And that, in turn, drastically decreases the attractiveness of a long supply chain, especially with global tensions, the rise of democratic populism (“we want what’s ours, not some global citizenship award!”), and the persistent rise in energy and other costs of transportation (driver shortages, etc).

All of which arguments I’ve made before. But I’m not sure I’ve drawn the line clearly enough that the net effect of this changing dynamic – which results in manufacturers choosing higher costs rather than lower costs – is that goods inflation is unlikely in my view to return to being centered around zero. While core services are a bigger chunk of the consumption basket than are core goods, that’s mostly because of shelter services. Core goods is 22% of the consumption basket; core services (less rent of shelter) is 25%. So this is not something that can be idly dismissed. If the mean of the distribution moves from 0% to just 3%, that moves the “normal” level of inflation up ~0.66%. Obviously, I think in the medium-term the number is a lot larger than that, but the key is whether the effect is going to be persistent over a long period of time (think years or decades, not months). I believe it will far outlast COVID, because the causes go far beyond COVID.

The Risk of Confusing Inflation Frames

February 4, 2021 9 comments

People who look at and talk about inflation are always having to move between multiple frames. There is the macro versus the micro, the theoretical versus experiential, and of course the short term, medium term, and long term. I spend a lot of time talking about the macroeconomic backdrop (27% money growth, weak velocity that should be recovering), and mostly address the short-term effects when I do the monthly CPI analysis on Twitter (and summarized here, for example this one from last month). And occasionally I do a one-off piece about more lasting effects (e.g. inventories).

But I rarely tie these things together, except quarterly for clients in our Quarterly Inflation Outlook. Right now, though, this is an exquisitely confusing time where all of these frames are colliding and making it difficult to make a simple, clear argument about where inflation is headed and when. So in this column I want to briefly touch on a number of these effects and tie the story together.

Short-term Effects

There are a bunch of short-term effects, or ones that are at least mostly short-term. We recognize that these are unusual movements in costs and prices, and expect them to pass in either a defined period (e.g. base effects) or over some reasonably near-term horizon. This makes them fairly easy to dismiss, and in fact these are not reasons to be fearful of inflation. They will affect CPI, and therefore they will affect how TIPS carry, but they should not change your view of what medium-to-long-term inflation looks like.

  1. Base effects – We know that last March, April, and May’s CPI reports were incredibly weak, as things like airfare and hotels and used cars absolutely collapsed. Core CPI declined -0.10% in March 2020, -0.45% in April 2020, and -0.06% in May 2020. These were followed by rebounds in some of those categories and in others, with June, July, and August core CPI at +0.24%, +0.62%, and +0.39%. What this means is that if core CPI comes in at 0.20% per month from here, then year/year core CPI will rise to 1.85% in April (when March 2020 rolls off), 2.52% in May, and 2.78% in June. But then it would fall to 2.32% in August (when July 2020 rolls off) and 2.13% in September. You’re supposed to look through base effects like that, and economists will. The Fed will say they’re not concerned, because the rise is mainly base effects – even if other things are going on too. Behaviorally, we know that some investors will react because they fear what they don’t know that is behind the curtain. And that’s not entirely wrong. But in any event this isn’t a reason to be concerned about long-term inflation.
  2. Measurement things, like rents – Quite apart from the question of whether COVID has caused inflation (or disinflation) is the question of what COVID has done to the measurement of inflation. For example, in the early months of the pandemic the BLS made an effort to not try too hard to get doctors and hospitals to respond to their surveys. Not only were many surveyed procedures not actually happening, but also the doctors and hospitals were clearly in crisis and the BLS figured that the last thing they needed was to respond to surveys, so the measurement of medical care data was sketchy at least early on in the pandemic. And there were many other establishments that were simply closed and could not be sampled. Most of those issues are past, and the echo of them will be past once the March-August period is out of the data. But there are some that persist and the timing of the resolution of which remains uncertain. The most important of these is the measurement of rents, both primary rents (“Rent of Primary Residence”) and the related Owners’-Equivalent Rent. In measuring rent, the BLS adjusts the quoted “asking” rent on an apartment unit by the landlord’s assessment of what proportion of the rent will eventually be collected. So, even if a renter is late on the rent, a landlord who expects to eventually expects to receive 100% of the rent due will cause that unit to be recorded at the full rent.

During the pandemic, of course, many renters lost their incomes and many others recognized that eviction moratoria made it feasible to defer rent payments and conserve cash. As a consequence, measured rents have been decelerating as landlords are decreasing their expectations of eventual receipt, even as asking rents have been rising rapidly along with home prices. The chart below (Source: Pantheon Macroeconomics, from the Daily Shot) illustrates this point. The divergence is explained by the increase in expected renter defaults – and it is temporary. Indeed, if the federal government succeeds in dropping more cash into people’s bank accounts, it will likely help decrease those defaults and we could see a quick catch-up. (That’s actually a near-term upward risk to core inflation, in fact). But in any event this isn’t a reason to be concerned about long-run inflation or disinflation…although the boom in home prices, perhaps, is.

  1. Shipping Containers – Another item that is related to COVID is that shipping costs are skyrocketing. Partly, this is because shipping containers are in the wrong places (a problem which eventually solves itself); partly, it is because the stock of shipping containers is too small to handle the sudden surge in demand as businesses reopen and not only re-build inventories but also build them beyond what they were pre-COVID (see my article about inventories for why). Deutsche Bank had a note out yesterday opining that while this spike in shipping costs – see the chart of the Shanghei (Export) Containerized Freight Index, source Bloomberg, below – will eventually ebb, it may not go down to its long-term average. But, still, the majority of this spike in costs, which is felt up and down the supply chain and drives higher near-term inflation for everything from apparel to pharmaceuticals, will ebb and isn’t a reason to be concerned about long-run inflation.
  1. Raw Materials – The same picture we see in the Shipping Containers chart is evident in lots of other raw materials markets. I’m not speaking here as much about the large commodities complexes like Copper, Lead, Oil, and so on but about certain less-widely followed but no less important markets. One you may have seen is steel (see chart, below, of front Hot Rolled Steel futures), which have nearly tripled since the summer and are about 30% above 2018’s highs with no end apparent.

Closer to my heart, and one you’re less likely to have seen, is the chart of resin futures. This is polymer grade propylene, which is a precursor to polypropylene. PP is used in all sorts of applications, from clothing and other fabrics to packaging (soda bottles!) of all kinds. And North American supplies of PP are under what can only be called severe pressure. Front PGP has more than quadrupled since the spring, and is at multi-year highs (if you can find an offer at all). It’s up 142% since mid-December! And PP is up even more, as producer margins have widened. Folks who want to track this and related markets might start by visiting theplasticsexchange. The reasons for this spike are part technical, although caused by the sudden re-start of the global economies, and will eventually pass. As with shipping, it may not go back to what was “normal,” but in any case movements like this, or those with steel or other raw materials, are not reasons to be concerned about long-run inflation. However, they likely will affect CPI prints as these are inputs into all sorts of goods.

That is a non-exhaustive list of some of the short-term effects that are directly or indirectly related to the stop-start of the COVID economy. They will pass, but they add a tremendous amount of sturm und drang to the price system and can confuse the medium and longer-term impacts.

Medium-term Effects

Some of the medium-term things that are happening, and that matter, and that will last, will be missed. Here are a few on my list:

  1. Pharmaceutical prices – One of the really fascinating things we have seen over the last few years has been the slow deceleration in inflation of medical care commodities, specifically drugs. The chart below (source Bloomberg) shows the y/y change in the CPI for Medicinal Drugs. In late 2019, after slipping into deflation, drug prices appeared to find a footing and to be recovering. But even before COVID, this jump was starting to ebb and in the most-recent 12 months pharmaceuticals prices experienced their largest decline in decades. Why?

One reason this happened is because the Trump Administration threatened drug companies with a “Most Favored Nation” clause. This means that the drug companies would not be allowed to sell their products in the United States at a higher price than the lowest price they charged overseas. The Trump Administration said that this would cause massive decreases in drug costs; this clearly wasn’t true (for reasons I discussed here last August) but it would tend to cause drug prices to decline in the US at least a little, especially relative to other countries’ costs. Faced with this, drug companies played nice…until Mr. Biden won the Presidency, in at least small part because some of the large vaccine developers slow-rolled their vaccine announcement until after the election. In January, they started moving prices higher again. This may hit the CPI as early as this month. But unlike with the short-term effects listed above, this is not a response to COVID or its ebbing, and it isn’t something that is likely to change. The Biden Administration is much less antagonistic towards drug companies than the Trump Administration was. And by the way, it isn’t just the drug companies that fall in this category. (Insert snarky comment about Trump here.)

  1. I mentioned earlier my article about how inventory management is going to change as a result of COVID. Indeed, the fact that it is already changing is one reason that the supply/demand imbalance is so bad in the short run: as I have already said, companies are building back inventories and adding additional safety stock, and that is stressing production of all sorts of goods. That was a short-term effect but the more-lasting effect is that carrying larger inventories is itself more expensive. Inventory carrying costs increase the costs of goods sold (which is the main reason managers have been pushing them down for decades). Carry more inventory, prices go up more. I don’t think this trend will ebb.
  2. Another trend I’ve seen directly, and am comfortable generalizing, is a movement among manufacturers towards shortening supply chains. The problems with production during COVID, along with the aforementioned shipping tie-ups, argues for shorter supply chains and diversified country sources (don’t get everything from India, for example, in case India as a whole shuts down). Also, shortening supply chains means that inventories (see #2) can be a little lower (or rather, safer at any given level of inventory) since one of the drivers of inventory size is lead time. Customers seem willing, at least today, to pay up to get suppliers in the same hemisphere and even more to get them in the same country. Every purchasing manager noticed that in the depths of the COVID shutdown many countries toyed with the idea of completely closing borders; some countries required container ships to ‘quarantine’ offshore for a time before they could unload. No one expects another COVID, but the -19 version reminded everyone of how the fragility of the supply chain increases with distance. Because in this country, shorter supply chains imply higher costs (since production is still generally cheaper overseas, though that differential has shrunk a lot), this is a short-term level adjustment followed by a lasting upward trend pressure on pricing. It’s essentially a partial reversal of the globalization trend, which reversal had already begun in little ways under the Trump Administration.

Granted, much of this is manufacturing-focused and most of the consumption basket (thanks mostly to rents) is services. But for many years it had been goods inflation holding down overall inflation, until recently. In the last CPI report, Core Goods inflation moved above Core Services inflation for the first time in a long, long time. That looks more like the inflation we remember from the ‘70s and ‘80s, with a much broader set of services and goods inflating.

Macro-level Effects

The last frame I want to touch on is the macro, top-down inflation concern. I won’t spend much time arguing whether output-gap models are working…if they were, then we would be in heavy deflation right now and there would be no signs of inflation anywhere, so clearly that’s the wrong model…and merely point briefly to the now-well-documented surge in M2 money supply growth (see chart, source Bloomberg), which is currently 27% y/y in the US, 11% y/y in Europe, 14% y/y in the UK, and even 9.2% in Japan. The increase in the transactional money supply in the US is twice as large as anything we have ever seen in this country, aside perhaps from the very early days when “not worth a Continental” became a term of opprobrium. Some people have argued that since money growth in 2008-9 didn’t produce much inflation, we oughtn’t worry about it this time either. But the last crisis really was different, as it was a banking crisis  (I wrote about this almost a year ago).

So, unless central banks have been doing it all wrong for a hundred years, the bare intuition is that this much money supply growth probably won’t be a non-event. Money velocity, in the short term, plunged because (a) mechanically, cash dropped into bank accounts by a generous government takes some time to spend, and (b) understandably, the demand for precautionary cash balances got super high during COVID. Both of these are passing issues, and it takes some heroic assumptions to argue why money velocity should continue to decline. Not merely stay low: if money growth continues at the 27% pace of the last year or even just the 13%-16% pace of the last quarter, even stable money velocity would produce much higher prices.

Over time, the relationship of money to GDP is a great proxy for the price level. That model has been powerful for a hundred years, and it makes sense: increasing the money supply 25% doesn’t increase wealth 25%. The amount of things you can buy with that money doesn’t change very much. So the value of the measuring stick, the dollar itself, must be weakening since 25% more dollars buys the same amount of stuff. To be sure, that’s only if people spend the new dollars as fast as they spent the old dollars, so if there’s a permanent change in velocity this won’t be true. But it needs to be a permanent change in velocity, and outside of lowering interest rates we don’t have a great way to induce permanently lower velocity.

[As an aside, the same reasoning applies to asset markets rather than consumables. Because the real output of businesses, and the stock of physical assets, don’t change very fast, a large increase in money must increase the nominal price of those things (or, more accurately, decrease the value of the measuring stick). But how to account for a decline of the value of the dollar in purchasing financial assets, but no big decline in the value of the dollar for purchasing goods and services? This implies a change in the exchange rate between real goods and financial assets. That is, a person can exchange a Tesla for fewer shares of TSLA. But unless markets are permanently valued at higher multiples when the economy is flooded with cash (and there’s no sign that has happened before in the long sweep of history with episodes of rising money supply), eventually the price of shares must decline or the price of consumption goods rises, or both. Essentially, money illusion is operating in one sphere, but not in the other, and I think that’s unsustainable. Maybe I’ll write more about this another time.]

On the macro front, the alarm bells should be ringing very loudly.

So in the three frames above we have some effects that are easy to look through, and to ignore as temporary. We have some effects that are more subtle, but long-lasting. And we have some effects that are potentially huge, and haven’t come to the fore yet at least in the consumption basket. On the whole, the signs are compelling that inflation is very, very likely to rise in a way that is not just temporary. But, because these frames are confusing, and because the Fed (and others) will easily dismiss some of the one-off effects as temporary COVID effects – which they are – this is actually an acutely dangerous time for investors. The fog of war, provided by these short-term effects, will obfuscate some of the longer-term effects and ensure that policymaker response is late, halting, and inadequate. Markets, though, will be reacting in what some will call an exaggerated reaction. Indeed, some already believe that the rise of 10-year breakevens to near-two-year highs, at 2.17% today, is an overreaction.

I don’t think it is. We are going to see core inflation rise on base effects and one-offs, then decline on base effects, but probably not as much as people expect right now. That’s when the fog will begin to clear, and we will see inflation accelerating from a level that’s already higher than it is now. By the time the fog of war clears in late 2021 or early 2022, it will be late to start planning for inflation. Maybe not too late, but late. By the time everyone agrees inflation is a problem, the price of inflation protection will have moved a lot.

Signs of a Top, OR that I am a Grumpy Old Man

June 20, 2018 4 comments

I was at an alternative investments conference last week. I always go to this conference to hear what strategies are in vogue – mostly for amusement, since the strategies that are in vogue this year are ones they will spit on next year. Two years ago, everyone loved CTAs; last year the general feeling was “why in the world would anyone invest in CTAs?” Last year, the buzzword was AI strategies. One comment by a fund-of-funds manager really stuck in my head, and that was that this fund-of-funds was looking for managers with quantitative PhDs but specifically ones with no market experience so that “they don’t have preconceived notions.” So, you can tell how that worked out, and this year there was no discussion of “AI” or “machine learning” strategies.

This year, credit strategies were in vogue and the key panel discussion involved three managers of levered credit portfolios. Not surprisingly, all three thought that credit is a great investment right now. One audience question triggered answers that were striking. The question was (paraphrasing) ‘this expansion is getting into the late innings. How much longer do you think we have until the next recession or crisis?” The most bearish of the managers thought we could enter into recession two years from now; the other two were in the 3-4 year camp.

That’s borderline crazy.

It’s possible that the developing trade war, the wobbling of Deutsche Bank, the increase in interest rates from the Fed, higher energy prices, Italy’s problems, Brexit, the European migrant crisis, the state pension crisis in the US, Elon Musk’s increasingly erratic behavior, the fact that the FANG+ index is trading with a 59 P/E, and other imbalances might not unravel in the next 3 years. Or 5 years. Or 100 years. It’s just increasingly unlikely. Trees don’t grow to the sky, and so betting on that is usually a bad idea. But, while the tree still grows, it looks like a good bet. Until it doesn’t.

There are, though, starting to be a few peripheral signs that the expansion and markets are experiencing some fatigue. I was aghast that venerable GE was dropped from the Dow Jones to be replaced by Walgreens. Longtime observers of the market are aware that these index changes are less a measure of the composition of the economy (which is what they tell you) and more a measure of investors’ animal spirits – because the index committee is, after all, made up of humans:

  • In February 2008 Honeywell and Altria were replaced in the Dow by Bank of America (right before the largest banking crisis in a century) and Chevron (oil prices peaked over $140/bbl in July 2008).
  • In November 1999, Chevron (with oil at $22) had been replaced in the Dow (along with Sears, Union Carbide, and Goodyear) by Home Depot, Intel, Microsoft, and SBC Communications at the height of the tech bubble, just 5 months before the final melt-up ended.

It isn’t that GE is in serious financial distress (as AIG was when it was dropped in September 2008, or as Citigroup and GM were when they were dropped in June 2009). This is simply a bet by the index committee that Walgreens is more representative of the US economy than GE and coincidentally a bet that the index will perform better with Walgreens than with GE. And perhaps it will. But I suspect it is more about replacing a stodgy old company with something sexier, which is something that happens when “sexy” is well-bid. And that doesn’t always end well.

After the credit-is-awesome discussion, I also noted that credit itself is starting to send out signals that perhaps not all is well underneath the surface. The chart below (Source: Bloomberg) shows the S&P 500 in orange, inverted, against one measure of corporate credit spreads in white.

Remember, equity is a call on the value of the firm. This chart shows that the call is getting more valuable even as the first-loss piece (the debt) is getting riskier – or, in other words, the cost to bet on bankruptcy, which is what a credit spread really is, is rising. Well, that can happen if overall volatility increases (if implied volatility rises, both a call and a put can rise in value which is what is happening here), so these markets are at best saying that underlying volatility/risk is rising. But it’s also possible that the credit market is merely leading the stock market. It is more normal for these markets to correlate (inverted) over time – see the chart below, which shows the same two series for 2007-2009.

I’m not good at picking the precise turning points of markets, especially when values start to get really bubbly and irrational – as they have been for some time. It’s impossible to tell when something that is irrational will suddenly become rational. You can’t tell when the sleepwalker will wake up. But they always do. As interest rates, real interest rates, and credit spreads have risen and equity yields have fallen, it is getting increasingly difficult for me to see why buying equities makes sense. But it will, until it doesn’t.

I don’t know whether the expansion will end within the next 2, 3, or 4 years. I am thinking it’s more likely to be 6 months once the tax-cut sugar high has truly worn off. And I think the market peak, if it isn’t already in, will be in within the next 6 months for those same reasons as companies face more difficult comps for earnings growth. But it could really happen much more quickly than that.

However, I recognize that this might really just mean that I am a grumpy old man and you’re all whippersnappers who should get off my lawn.

Potpourri for $500, Alex

June 1, 2018 5 comments

When I don’t write as often, I have trouble re-starting. That’s because I’m not writing because I don’t have anything to say, but because I don’t have time to write. Ergo, when I do sit down to write, I have a bunch of ideas competing to be the first thing I write about. And that freezes me a bit.

So, I’m just going to shotgun out some unconnected thoughts in short bursts and we will see how it goes.


Wages! Today’s Employment Report included the nugget that private hourly earnings are up at a 2.8% rate over the last year (see chart, source Bloomberg). Some of this is probably due to the one-time bumps in pay that some corporates have given to their employees as a result of the tax cut, and so the people who believe there is no inflation and never will be any inflation will dismiss this.

On the other hand, I’ll tend to dismiss it as being less important because (a) wages follow prices, not the other way around, and (b) we already knew that wages were rising because the Atlanta Fed Wage Tracker, which controls for composition effects, is +3.3% over the last year and will probably bump higher again this month. But the rise in private wages to a 9-year high is just one more dovish argument biting the dust.

As an aside, Torsten Slok of Deutsche Bank pointed out in a couple of charts today that one phenomenon of recent years has been that people staying in the same jobs increasingly see zero wage growth. Although this is partly because wage growth in general has been low, the spread between wage growth for “job switchers” and “job stayers” is now about 1.25% per year, the highest rate in about 17 years. His point is that as we see more switchers due to a tight labor market, that implies more wage growth (again, the Atlanta Fed Wage Growth Tracker does a better job, so this just means average hourly earnings should increasingly converge with the Atlanta Fed figure).


Today I was on the TD Ameritrade Network and they showed a chart that I’d included in our Quarterly Inflation Outlook (which we distribute to customers). I tweeted the chart back on May 22 but let me put it here, with some brief commentary lifted from our quarterly:

“As economic activity has started to absorb more and more unemployed into the workforce, a shortage has developed in the population of truck drivers. This shortage is not easy to overcome, since it takes time to train new truck drivers (and the robo-truck is still no more than science fiction). Moreover, recent advances in electronically monitoring the number of hours that drivers are on the road – there have been rules governing this for a long time, but they relied on honest reporting from the drivers – have artificially reduced the supply of trucker hours at just the time when more were needed because of economic growth…As a result of this phenomenon, total net-of-fuel-surcharge truckload rates are 15% higher than they were a year ago, which is the highest rate of increase since 2004. As the chart (source: FTR Associates and BLS) illustrates, there is a significant connection between truckload rates lagged 15 months and core inflation (0.74 correlation).”

According to FTR Transportation Intelligence, the US is short about 280,000 truck drivers compared to what it needs.


Remember when everyone said Europe was about to head back into deflation, thanks to that surprise dip in core inflation last month? Here is what I had to say about that on my private Twitter feed (sign up here if this stuff matters to you) at the time.

As Paul Harvey used to say, the rest of the story is that core European CPI printed this month at 1.1%, shocking (almost) everyone for a second month.


I had a conversation recently with a potential client who said they didn’t want to get into a long-commodity strategy because they were afraid of chasing what is hot. It’s a reasonable concern. No one wants to be the pigeon who bought the highs.

But some context is warranted. I didn’t want to be impolite, but I pointed out that what he was saying was that in the chart below, he was afraid it was too late to get on the orange line because it is too hot.

Incidentally, lest you think that I chose that period because it flatters the argument…for every period starting June 30, XXXX and ending June 1, 2018, the orange line is appreciably below the white line and has never been meaningfully above it, for XXXX going back to 2002. For 2002-2011, the two indices shown here were pretty well correlated. Since 2011, it has been a one-way underperformance ticket for commodities. They are many things, but “hot” is not one of them!

I haven’t heard back.

Inflation Trading is Not for the Weak

June 27, 2017 1 comment

I was prepared today to write a column about horse racing and value investing…that will have to wait until tomorrow…when this article was sent to me by about a dozen people:

Deutsche Bank Said to Face Possible $60 Million Derivative Loss

The article was sent my way because the loss was tied to a trade that used US dollar inflation derivatives, and since that’s a market I basically started back in 2003 folks figured I might want to know. And I do.

The inflation derivatives market is not huge. The chart below shows rolling 12-month inflation derivative volumes (source: BGC Partners) through last September, which was the last time I went looking for the data for a presentation. Total interbank volumes are around $10-15bln per month; customer volumes are not included here but are not insignificant (any more).

Most inflation books, especially these Volcker Rule days, are run pretty close to the vest. Most of these volumes will be set against customer flows, or against bond breakevens, or against other positions on the inflation curve. Net risk positions for any derivative book, especially these days, are pretty small…which is why Deutsche is investigating whether risk limits were breached in this case. In principle this should be easy to figure out, since DB and every other bank has risk control specialists whose job it is to monitor these risks.

But inflation risks are complex. Our firm breaks fixed-income risks down into six basis risks that add up to the net risk of a bond. For a TIPS bond, there is just one risk; for a corporate bond there will be six. Our risk schematic starts from real rate risks and builds up – unlike in most risk systems, which start with nominal risks and try to force real bonds to fit. Inflation-linked derivatives also have commodity deltas implied, since they are tied to headline inflation and headline inflation is tied largely to energy prices. Geez, I could write a book on this – it would be a combination of “Inflation Risks and Products[1] and, in this case, “Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports.”

Suffice it to say that even really sharp investors don’t always quite get it when it comes to inflation. In early 2014, a prestigious investment management firm took a multi-billion-dollar bath on a “risk-parity” product that hadn’t truly understood how to figure out the risks of TIPS. How much more difficult, then, is it for risk control officers, many of whom have shiny new Ph.D.s and very little direct market experience? A fast-talking trader who knows something about the product can, if he is unscrupulous, persuade risk control that he is not really taking risks that he knows, or ought to know, he is taking.

In short, I am sympathetic with the risk control guys in this case. They were probably outgunned by a slick operator pushing the limits of his limits. It’s almost assuredly the case: the market, as large as it is, is too small in the Volcker Rule era to allow the accumulation of a prudent position of large enough size to cause this sort of loss – especially in the recent period of exceptionally low market volatility.

This, then, is an object lesson: if you’re running inflation risk, and you think it’s pretty much like running nominal rate risk – you’re wrong, and you should get help before your firm’s name is the one in the Bloomberg article.[2]

Tomorrow, we can talk about horse racing.

[1] In which I co-wrote a chapter, on commodities actually, with Bob Greer.

[2] To be fair, in this case the problem was the combination of ignorance and what appears to be malfeasance. If you’re careful with your control structures and only hire high-quality people of sterling reputation, you shouldn’t have a problem with the second part of this formula.

Categories: Bond Market, TIPS, Trading

Trump and Tariffs – Not a New Risk

March 6, 2018 15 comments

Last week, the stock market dove in part because President Trump appeared to be plunging ahead with new tariffs; on Monday, the market recouped that loss (and then some) as the conventional wisdom over the weekend was that Congress would never let that happen and so it is unlikely that tariffs will be implemented.

I’m always fascinated by market behavior around events like this. Investors seem to love to guess right, and to put 100% of their bet on an outcome that depends on being right. Here’s what I know about tariffs – prior to last week, if there was a risk that tariffs would be implemented that risk was not priced into the markets. And markets are supposed to price risks. Regardless of what you think the probability of that outcome is, surely the probability is non-zero and, therefore, ought to be worth something on the price. Putting it another way: if I was willing to pay X for the market when I wasn’t worried about the possibility of the detrimental effect of future tariffs, then assuredly I will pay less than X once I start to consider that possibility. Although the outcome may be binary (there will be increasing tariffs and decreasing free trade, or there won’t be), the risk doesn’t have to be either/or.

This is one of the things that irritates me about the whole “risk on/risk off” meme. There is no such thing as “risk off.” Risk is ever-present, and an investor’s job is not to guess at which risks will actually present themselves, but to efficiently preserve as much upside as possible while protecting against downside risks cheaply. Risk management is really, really important, but it often seems to get overlooked in the ‘storytime’ that 24-hour market news depends on.

To be sure, the risk of tariffs coming out of the Trump Administration is not new…it’s just that it has been ignored completely until now. Right after Trump’s election, in our Quarterly Inflation Outlook I wrote about which elements of Trump’s professed plans were a risk to steady inflation. The one area which I felt could be the real wildcard leading to higher inflation as a result of policy (as opposed to higher inflation from natural dynamics, which are also a risk as interest rates normalize) was the possibility of a Trump tariff. Here is what I wrote at that time – and it’s poignant today:

Policies Which Will Erect Trade Barriers of Some Kind

This is the area in which we would be most concerned about the possible upward pressure on inflation from a Trump Administration. The President-Elect got to this point partly by pledging to “make better deals” with trading counterparties such as China, and to work to “bring jobs back” to the US. While this may be at least partly bluster, Mr. Trump was consistent enough during the campaign on this topic that it is hard to imagine him doing an about-face and strengthening NAFTA, rather than weakening it.

And here is why it matters. We have written in the past that a big part of the reason for the generous growth/inflation tradeoff of the 1990s was the rapid globalization of many industries following the end of the Cold War. Parameterizations of inflation models, in general, cannot be consistently calibrated on any period that spans 1992-1993. That is to say that for any model that we have seen, the parameters if the model is fit to 1972-1992 are different than if the model is fit to 1994-2014. Specifically, models calibrated to the former period consistently over-estimate inflation in the latter period, while models calibrated to the latter period consistently under-estimate inflation in the former period. The Federal Reserve believes that this is because inflation expectations (which we cannot measure very well) somehow became “anchored” in 1993. On the other hand, we believe that the culprit was globalization. In the 2014Q3 QIO, we illustrated that assertion with this chart of Apparel prices, set against domestic apparel production.

The chart (Source Bloomberg) is updated to 2016. We think it illustrates clearly the inflation dividend brought by globalization – as production was moved to cheaper overseas manufacturers, apparel price increases first leveled off, and then actually declined. Prices continued to go sideways or down until apparel production in this country was essentially gone – and thus, there was no further gain in production costs to be passed on to consumers. In late 2012, apparel prices started to rise again, although it has still been only in fits and starts. (We think this is because manufacturing is being moved further downstream, to manufacturers located in even cheaper countries – but this can only go on for so long of course.)

What we haven’t been able to find before, until recently, is more general evidence that there was a dramatic shift in the globalization dynamic in general, rather than in this isolated case. We found the evidence recently in a Deutsche Bank piece, in a chart that plots the number of free trade agreements signed per year. The chart is printed below (sources: as cited).

This chart is the “smoking gun” that supports our version of events, in terms of why the inflation dynamic shifted in the early 1990s. The apparel story is supporting evidence about the next step in the chain, illustrating how free trade helped to restrain prices in certain goods, by allowing the possibility of significant cost savings on production.

The flip side of a cost savings on production, though, is a loss of domestic manufacturing jobs; it is this loss that Mr. Trump took productive advantage of. We believe that Mr. Trump is likely to move to increase tariffs and other barriers to trade, and to reverse some of the globalization trend that has driven lower prices for the last quarter-century. We view this as potentially very negative news for inflation. While there was some evidence that the globalization dividend was beginning to get ‘tapped out’ as all of the low-hanging fruit had been harvested – and such a development would cause inflation to be higher than otherwise it would have been – we had not expected the possibility of a reversal of the globalization dividend except as a possible and minor side-effect of tensions with Russia over the Ukraine, or the effect the Syrian refugee problem could have on open borders. The election of Mr. Trump, however, creates the very real possibility that the reversal of this dividend might be a direct consequence of conscious policy choices.

Entering the RINF Cycle

February 6, 2017 Leave a comment

Because I write a lot about inflation – we all have our spheres of expertise, and this is mine – I am often asked about how to invest in the space. From time to time, I’ve commented on relative valuations of commodities, for example, and so people will ask how I feel about GLD, or whether USCI is better than DJP, or whether I like MOO today. I generally deflect any inquiry about my specific recommendations (years of Wall Street compliance regimes triggers a nervous tic if I even think about recommending a particular security), even though I certainly have an opinion about gold’s relative value at the moment or whether it is the right time to play an agriculture ETF.

But I don’t mind making general statements of principle, or an analytical/statistical analysis about a particular fund. For example, I am comfortable saying that in general, a broad-based commodity exposure offers a better long-term profit expectation than a single-commodity ETF, partly because of the rebalancing effect of such an index. In 2010 I opined that USCI is a smarter way to assemble a commodity index. And so on.

When it comes to inflation itself, however, the answers have been difficult because there are so few alternatives. Yes, there are dozens of TIPS funds – which are correlated each to the other at about 0.99. But even these funds and ETFs don’t solve the problem I am talking about. TIPS allow you to trade real interest rates; but when inflation expectations rise, real interest rates tend also to rise and TIPS actually lose value on a mark-to-market basis. This can be frustrating to TIPS owners who correctly identify that inflation expectations are about to rise, but lose because of the real rates exposure. What we need is a way to trade inflation expectations themselves.

When I was at Barclays, we persuaded the CME to introduce a CPI futures contract, but it was poorly constructed (my fault) and died. Inflation swaps are available, but not to non-institutional clients. Institutional investors can also trade ‘breakevens’ by buying TIPS and shorting nominal Treasuries, since the difference between the nominal yield and the real yield is inflation expectations. But individual investors cannot easily do this. So what is the alternative for these investors? Buy TIP and marry it with an inverse Treasury ETF? The difficulties of figuring (and maintaining) the hedge ratio for such a trade, and the fact that you need two dollars (and double fees) in order to buy one dollar of breakeven exposure in this fashion, makes this a poor solution.

There have been attempts to fill this need. Some years ago, Deutsche Bank launched INFL, a PowerShares ETN that was tied to an index consisting of several points on the inflation-expectations curve. That ETN is now delisted. ProShares at about the same time introduced UINF and RINF, two ETFs that tracked the 10-year breakeven and 30-year breakeven rate, respectively. UINF was delisted, and RINF struggled. I lamented this fact as recently as last March, when I observed the following:

“Unfortunately, for the non-institutional investor it is hard to be long breakevens. The CME has never re-launched CPI futures, despite my many pleadings, and most ETF products related to breakevens have been dissolved – with the notable, if marginal, exception of RINF, which tracks 30-year breakevens but has a very small float. It appears to be approximately fair, however. Other than that – your options are to be long a TIPS product and long an inverse-Treasury product, but the hedge ratios are not simple, not static, and the fees would make this unpleasant.”

And so when people asked me how to trade breakevens, when my articles would mention them, I had to shrug and share my distress with them, and say “someday!”

But recently, this started to change. As TIPS late last year awoke from their long slumber, and went from being egregiously cheap to just typical levels of cheapness (TIPS almost always are slightly cheap to fair value), the RINF ETF also woke up. The chart below shows the number of shares outstanding, in thousands, for the RINF ETF.

rinfsoTo be sure, RINF is still small. The float – although float is less critical in an ETF that has a liquid underlying than it is in an equity issue – is still only around $50mm. But that is up 1200% from what it was in mid-November. The bid/offer is still far too wide, so as a trading vehicle RINF is still not super useful. But for intermediate swing trading, or as a longer-term hedge for some other part of your portfolio…it’s at least available, and the increase in float is the most positive sign of growth in this area that I have seen in a while. So, if you are one of the people who has asked me this question in the past: I no longer have a fear of an imminent de-listing of RINF, and it’s worth a look.

Categories: New Products
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