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We Are All Bond Traders Now
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.
The Quintillion-Dollar Coin
I was going to write a technical column today about how the sensitivity of bonds (and consequently, lots of other asset prices) to interest rates increases as interest rates decline, and discuss the implications for equity investors nowadays as interest rates head back up. That article will have to wait another week. Today, I want to just quickly dispense with a really silly idea that keeps making the rounds every time there is a standoff on the debt ceiling, pushed by the same guys who think Modern Monetary Theory (MMT) will work (even though we just tried it, and it didn’t).
The idea is that, thanks to a law passed back in the 1990s, the Treasury has the right to issue a platinum coin of any denomination. Ergo, it could produce a $1 Trillion coin, deposit it at the Federal Reserve (who does not have the option to not accept legal tender, Secretary Janet Yellen’s recently-voiced concerns notwithstanding), and continue to pay the government’s bills. Why? One well-traveled and entertaining simpleton started explaining the reasoning for doing this by saying “there’s this silly, anachronistic and ineffectual law on the books called the Debt Ceiling…”
If we started doing really really silly, not to mention stupid, things to get around every law that we thought was silly and anachronistic, legislators would be busy 24 hours a day, 7 days a week. (And, obviously, the law isn’t “ineffectual”; if it was then we wouldn’t need to get around it.)
I am continually amazed by how durable the really stupid ideas are. For instance, the notion that the government is lying about inflation to the tune of 6% per year is an idea that never seems to die even though you can show with basic math that it can’t possibly be the case. So, let’s dispense with this one even though I am sure I will have to keep slaying this dragon when it inevitably comes back from the dead.
A useful tool of logic that’s handy when you are trying to smoke out a dumb idea is to ask, “If that works, why don’t we do lots more of it?” Let’s not try to figure out why a $1 Trillion coin is a bad idea. Let’s try to figure out why a $1 Quintillion coin (a million trillions) is a bad idea.
After all, if we are going to mint a coin anyway, it doesn’t cost much more to stamp “Quinti” than it does to stamp “Tri”. And if the Treasury minted a Quintillion-dollar coin and deposited it at the Fed, it would be much more significant. With that balance, the Treasury could pay off all outstanding debt, fully fund Medicare and Social Security, and cancel all taxes basically forever while also dramatically increasing services! Why isn’t that a better idea? I spit on your Trillion-dollar coin.
Naturally, that would be a terrible idea and it’s now obvious why. I can think of several reasons, but I’ll leave most of them for other people to highlight in the comments. The immediate one is that by paying off all federal debt, increasing spending and decreasing taxes to zero, the money supply would increase immensely and immediately. As we saw quite recently, the result that rapidly follows is much higher inflation. Much much higher inflation. I will see your 8% and raise you 800%. Yes, to some extent that would depend on the Congress deciding to do that spending and cut those taxes – but do you doubt that would happen? And the Treasury offering to buy back all of the outstanding bonds wouldn’t need Congressional authorization. That’s trillions in money being suddenly returned to bondholders, which puts it back in circulation.
A trillion here, a trillion there, and pretty soon you’d be talking real money.
The Monetary Policy Revolution in Three Charts
Over the last few years, I’ve pointed out exhaustively how the current operating approach at the Fed towards monetary policy is distinctly different from past tightening cycles. In fact, it is basically a humongous experiment, and if the Fed succeeds in bringing inflation gently back down to target it will be either a monumental accomplishment or, more likely, monumentally lucky. My goal in this blog post is to explain the difference, and illustrate the challenge, in just a few straightforward charts. There are doubtless other people who have a far more complex way of illustrating this, but these charts capture the essence of the dynamic.
Let me start first with the basic ‘free market’ interest rate chart. Here, I am showing the quantity of bank lending on the x-axis, and the ‘price’ of the loan – the interest rate – on the y-axis. If we assume for the moment that inflation is stable (don’t worry, the fact that it isn’t will come into play later) then whether the y-axis is in nominal or real terms is irrelevant. So we have a basic supply and demand chart. Demand for loans slopes downward: as the interest rate declines, borrowers want to borrow more. The supply curve slopes upward: banks want to lend more money as the interest rate increases.
An important realization here is that the supply curve at some point turns vertical. There is some quantity of loans, more than which banks cannot lend. There are two main limits on the quantity of bank lending: the quantity of reserves, since a bank needs to hold reserves against its lending, and the amount of capital. These are both particular to a bank and to the banking sector as a whole, especially reserves because they are easily traded. Anyway, once aggregate lending is high enough that there are no more reserves available for a bank to acquire to support the lending, then the bank (and banks in aggregate) cannot lend any more at any interest rate – at least, in principle, and ignoring the non-bank lenders / loan sharks. We’re talking about the Fed’s actions here and the Fed does not directly control the leverage available to loan sharks.
Now, traditionally when the Fed tightened policy, it did so by reducing the aggregate quantity of reserves in the system. This had the effect of making the supply curve go vertical further to the left than it had. In this chart, the tightening shows as a movement from S to S’. Note that the equilibrium point involves fewer total loans (we moved left on the x axis), which is the intent of the policy: reduce the supply of money (or, in the dynamic case, its growth) by restraining reserves. Purely as a byproduct, and not very important at that, the interest rate rises. How much it rises depends on the shape of the demand curve – how elastic demand for loans is.
As an aside, we are assuming here that the secondary constraint – bank capital – is not binding. That is, if reserves were plentiful, the S curve would go vertical much farther to the right. In the Global Financial Crisis, that is part of what happened and was the reason that vastly increase reserves did not lead to massive inflation, nor to a powerful recovery: banks were capital-constrained, so that the Fed’s addition of more reserves did not help. Banks were lending all that they could, given their capital.
Manipulating the aggregate quantity of reserves was the way the Fed used to conduct monetary policy. No longer. Now, the Fed merely moves interest rates. Let’s see what effect that would have. Let’s assume for now that the interest rate is a hard floor, and that banks cannot lend at less than the floor rate. This isn’t true, but for ease of illustration. If the Fed institutes a higher floor on interest rates then what happens to the quantity of loans?
This looks like we have achieved the same result, more simply! We merely define the quantity of loans we want, pick the interest rate that will generate the demand for those loans, and voila, we can add as many reserves as we want and still get the loan production we need. The arrows in this third chart show the same movements as the arrows in the prior chart. The quantity of loans is really determined entirely by the demand curve – at the prescribed interest rate, there is a demand for “X” loans, and since banks are not reserve-constrained they are able to supply those loans.
However, it’s really important to notice a few things. The prior statement is true if and only if we know what the demand curve looks like, and if the floor is enforced. Then, a given interest rate maps perfectly into Q. But:
- D is not known with precision. And it moves. What is more, it moves for reasons that have nothing to do with interest rates: for example, general expectations about business opportunities or the availability of work.
- Moreover, D is really mapped against real rates, while the Fed is setting nominal rates. So, for a given level of a nominal floor, in real space it bucks up and down based on the expected inflation rate.
- Also, the floor is not a hard floor. At any given interest rate where the floor would be binding, the desire of banks to lend (the location of the S curve) exceeds the demand for loans (by the amount of the ?? segment in the chart above). The short-term interest rate still affects the cost to banks of that lending, but we would still expect competition among lenders. This should manifest in more aggressive lending practices – tighter credit spreads, for example, or non-rate competition such as looser documentary requirements.
In the second chart I showed, the Fed directly controlled the quantity of reserves and therefore loans. So these little problems didn’t manifest.
Now, there is one advantage to setting interest rates rather than setting the available quantity of reserves as a way of reducing lending activity. Only the banking sector is reserve-constrained. If there is an adequate non-bank lending network, then the setting of interest rates to control the demand for loans will affect the non-bank lenders as well while reserve constraint would not. So this is somewhat “fairer” for banks. But this only means that non-bank lenders will also be competing to fill the reduced demand for loans, and the non-bank lending sector is less-vigorously regulated than the banking sector. More-aggressive lending practices from unregulated lenders is not, it seems to me, something we should be encouraging but what do I know? The banks aren’t lobbying me to help level the playing field against the unregulated.
Hopefully this helps illuminate what I have been saying. I think the final chart above would be a lovely final exam question for an economics class, but a bad way to run a central bank. Reality is not so easily charted.
2022 Year-End Thoughts About 2023
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When I was a Street strategist, and/or producing ‘sales and trading commentary’ as a trader, it was de rigueur to produce an annual outlook piece. Naturally, everyone does one of those; consequently, I stopped doing them. It seems to me like it would get lost in the shuffle (this is one of the reasons that Enduring’s “Quarterly Inflation Outlook,” which we distribute to customers and is also available by subscription here, is produced on the ‘refunding schedule’ of February, May, August, and November rather than at quarter-end). Having said that – it does seem that, given what inflation has done recently, there are more people asking for my outlook.
I do have to raise one point of order before I begin. As regular readers of this column know, in my writing, I generally try to propose the ‘right questions,’ and I don’t claim to have all the right answers. An outlook piece is often interpreted as being the analyst’s best guess at the answers. While it is that, for me the answers I suggest here are likely to be less valuable to the reader (I do not recommend that you blindly place trades based on my outlook for where markets will go!) than the thought process that is going into them. You may and probably will disagree with some of my answers. But hopefully, you’ll be able to identify where in my reasoning you have specific disagreements, which will either enhance your own view or cause you to thoughtfully reconsider it. That’s the whole point, and I don’t care at all if you disagree! That’s what makes markets.
Moreover…even if my guesses end up being “wrong,” or “right,” based on the actual outcomes in the future, that doesn’t mean they were wrong or right in terms of being a good approach/positioning. Investing is not really all about making the “right” bet in terms of whether you can call the next card off the deck, but about making the “right” bet with respect to the odds offered by the game, and betting the right amount given the odds and the edge. On this topic, I recommend “Thinking in Bets” by Annie Duke as excellent reading.
So, here goes.
MACROECONOMICS
For most of this year, I have been saying that we would get a recession by early 2023. In 2022Q1 and Q2, US GDP contracted. This produced the predictable shrill announcements of recession, coupled this year with sadly simple-minded declarations that the Biden Administration had “changed the definition of recession” by saying we weren’t in one. One television commentator I saw strongly profess the view that the two-quarters-of-negative-growth-is-a-recession definition is “in every economic textbook.” Having read my fair share of economic textbooks and having taught or tutored from a few, I can assure you that is not the case.
I was, and remain, sympathetic to the incoming fire that the Biden Administration took then, because they were basically right: whether we chose to call it a ‘recession’ or not, there was scant sign of any economic distress. Employment (which lags, of course) remained strong, corporate earnings were solid, confidence was reasonably high except for inflation, and citizens still had a substantial cash hoard left over from the COVID stimmy checks. However, while the critics were wrong on the timing they weren’t wrong about the eventuality of a recession. As I also said a bunch of times, there has never been a period where energy prices rose as rapidly as they did between early 2021 and mid-2022, combined with interest rates increasing as rapidly as they did thanks to Federal Reserve policy, that did not end in recession. But it takes Wile E. Coyote some time to figure out that there is nothing under his feet, before he falls, and recessions work similarly. We will have a recession in 2023.
We are already seeing the early signs of this recession. One indicator I like to look at is the Truck Tonnage index, which falls significantly in every recession (see chart, source Bloomberg). The last two months have seen a decline in this seasonally-adjusted index. It is early yet – we saw a similar-sized decline in 2016, for example, so there are false signals for small changes – but the fact that this decline happened heading into the Christmas season gives it more significance.
That’s the goods side. The services side shows up more in the labor market, which lags behind the overall cycle. Yet there too we have started to see some hints of weakness. Jobless claims are well off the post-COVID lows, although they are still roughly “normal” for the tight pre-COVID labor market. And the labor market is really hard to read right now, given the continuing crosswinds from the COVID-period volatility and the fact that so many services jobs now are at least partly virtual. Upward wage pressure is continuing, partly because virtual workers are less productive (shocker reveal there), so this recession in my view will probably not feel as bad as the last couple of recessions (GFC, Covid) have felt. However, we will have a recession in 2023.
The bad news, though is that a recession does not imply that inflation, ex-energy, will decline. Look at this chart, which captures the last three recessions. The post-GFC recession was the worst in 100 years, and while core inflation slowed that was almost entirely a function of the housing market collapse and not the general level of activity. The COVID recession was worse than that, and core inflation accelerated. And the post-tech-bubble recession wasn’t a slouch either; core inflation accelerated throughout 2001 until it started to decline, but only got down to 1.1%, in late 2003.
This chart shows y/y changes, but helpfully shows core-ex-shelter (Enduring Investments calculations). There isn’t a lot to see here in terms of the effect of these three huge recessions.
Lest you think I am just cherry-picking the 2000-2022 period, here is core CPI and GDP normalized as of December 1979. Again, you can see in the GDP line the recessions of the early 1980s, of the early 1990s, and that post-tech-bubble recession. I can’t see those, in the CPI line.[1]
And hey, as long as we are doing this…how about the 1970s malaise when the multiple recessions and flat growth led to … well, not disinflation.
I think the evidence is very clear: forecasters who are relying on the “recession” forecast (which I share) to make a “hard disinflation” forecast are simply ignoring the data. Those two concepts, outside of energy, are not related historically.
That being said, I expect core inflation and median inflation to decelerate in 2023. I just don’t think they will decelerate nearly as much as Wall Street economists think. Shelter inflation is already well above my model, and I expect will come back towards it, but my model otherwise doesn’t see a lot of downward pressure on rents yet. The strong dollar, and some healing of supply chains, will help core goods – but core goods inflation will remain positive next year and probably for a long time, thanks to secular deglobalization, instead of being in persistent slow deflation. And core services ex-rents will decelerate, but mainly because of the technical adjustment in health insurance. Until wages start to ebb, it’s hard to see a crash in core services ex-rents inflation. So that brings me to this forecast for core CPI:
| Current | 2023 Fcast | |
| Core Goods | 3.7% | 2.3% |
| Rent of Shelter | 7.2% | 4.8% |
| Core Services less ROS | 6.3% | 5.1% |
| Core CPI | 6.0% | 4.2% |
Most of the Street is in the mid-2s for core inflation; the Conference Board forecast for Core PCE recently was raised to 2.8% which would put core CPI at 3% or 3.1%. They’re getting there, but frankly it’s hard to see how you can get to those levels. In my view, most of the risks to my forecast are to the upside.
MONETARY POLICY
An important disclosure should be made here: in 2022, I was utterly wrong about the path the Fed would take. Almost as wrong as it is possible to be. Ergo, take everything I say hereafter in this section with a grain of salt.
Coming into 2022, I thought the Fed would follow the same script they had used for more than a quarter-century with respect to tightening policy: slow, late, tentative, and quickly reversed. Although inflation was already plainly not transitory, I know that the Fed’s models assume a strong homeostasis especially with inflation, to the extent that the persistent part of inflation is essentially (albeit with a lot more math) modeled as a very slow moving average and overall inflation is assumed to pull back to that level. When the Fed talks about the “underlying inflation trend,” that is in simple terms what they are saying. But if you believe that, then there’s very little reason to pursue something similar to a Taylor Rule where policy is driven by simple deviations of growth and inflation from the target levels.
So, when the Fed started to move I expected them to tighten a few times and then to stop and ultimately reverse when financial markets started doing ugly illiquid things. One thing I didn’t anticipate: the markets never really did ugly illiquid things. Investors welcomed the tighter policy, and ran ahead of the Fed to give them room. Especially considering that, at the end of 2021, I think most sophisticated investors viewed the Fed as incompetent (at best) or counterproductive (at worse), the markets gave the Committee an amazing amount of latitude. The Fed, to its credit, saw the gap in the defense and sprinted through it. I did not see that coming.
After nearly 500bps of rate hikes, and a small decline in the Fed’s balance sheet, money supply growth has come to a screeching halt. That’s largely spurious, I think, since money supply growth is a function of bank lending and banks are neither capital-constrained nor reserve-constrained at the moment, and longer-term interest rates have risen but not very much (except in the mortgage market). I suspect that most of the decrease in loan demand that is evidently happening is not in response to the increase in short-term rates but rather to the increase in mortgage rates almost entirely. If that’s the case, then it’s a one-time effect on M2 growth: mortgage origination can only go to zero once. The chart below shows the connection between M2 growth (in blue) and the MBA Purchase index (black). The correlation is not as incredible as it looks, because one is a rate of change that is off-center by 6 months (it’s y/y) and one is a level of activity, but if I expressed both in rate of change you would still say they look suspiciously similar.
If I am right about that point, then the money supply will shortly resume its growth as the overall volume of lending continues to grow without the negative offset of declining mortgage origination. With money velocity on the upswing now, this will support the level of inflation at a previously-uncomfortable level. So what will the Fed do?
Importantly, the Fed won’t really know that inflation isn’t dropping straight to 2% until after the midpoint of the year. But they’ll make the decision to pause rate hikes sooner than that. I think a 5% Fed funds rate is a reasonable target given their assumptions, a key one of which is that if “underlying inflation” is really 2%-3% then a 5% nominal rate will be plenty restrictive.
What is really amazing to me – which the ‘me’ of 2021 would never have anticipated – is that Fed watchers and market participants are starting to talk as if they believe the Fed might overdo the tightening, raising rates higher than needed to restrain the economy and inflation (yes, I know I said that a recession doesn’t cause lower inflation but it’s an article of faith at the Fed so we need to pretend as if we believe it). It’s incredible, when you think about it: the Fed hasn’t come close to ‘overdoing it’ in a tightening cycle in decades, if by ‘overdoing it’ we mean that they caused a deflationary crash. The Fed has caused plenty of recessions, but core inflation hasn’t been negative since the Great Depression. And we’re worried about them overdoing it?
Naturally, if you don’t think that raising rates causes inflation to come down then any rate hikes at all…actually, any active monetary policy at all…is too much. But in any event, it’s striking to me that the Fed has somehow restored some credibility as a hawkish central bank. Not that credibility per se matters, since expectations don’t cause inflation. But I digress. It’s still pretty amazing.
When Powell was first named Chairman, I was hopeful that a non-economist could help break the Fed out of its scholarly stupor. As time went on I lost that hope, as Powell trotted out various vacuous terms like “transitory” and leaned on discredited models (nevertheless still in vogue at the Fed) such as those which utilize the ‘anchored expectations’ hypothesis. But I have to say, my opinion of him has risen along with the Fed funds rate.
In my view, the biggest Fed error of the last forty years was Greenspan’s move to make the Fed transparent, which caused the pressures on the Fed to be entirely one-way. The second-biggest Fed error follows from that, and that is the tendency to move rates further and further away from neutral, holding rates at such a level by maintaining vastly higher levels of liquidity than were needed to run the banking system. The consequence of this has been a series of bubbles and asset markets at levels where the prospect of future real returns was abysmal. Plus, it led to the heyday of hedge funds where cheap money levered small returns into big returns.
The Powell Fed, for all of its flaws and awful forecasting, has succeeded in getting the yield curve to the vicinity of long-term fair value, which I define as sovereign real rates near the long-term growth rate of the economy (2.00-2.25% in the US – see chart below, source Enduring Investments before 1997 and Bloomberg after 1997). With a Fed inflation target at 2.25% or so in CPI terms, this means long-term nominal interest rates should be in the vicinity of 4%-4.5% over the long term in the context of a responsible central bank. We’re not there, but we’re getting close.
All of which means that I think the FOMC is just about done with hiking rates for this cycle. I believe they will get to 5%, pause, and stay paused for a long time. I do not expect them to lower interest rates, even if there is a recession, unless markets or banks start to have difficulties or Unemployment gets above 6%. That might happen in late 2023, but even if it does I think the Fed will be much more measured about cutting rates than they have in previous cycles. Credit to Powell for the change in attitude.
Those pieces, the Macro and the MonPol, along with my assessment of relative valuations, inform everything else.
RATES, BREAKEVENS, AND CURVES
The long, long, long downtrend in interest rates is decisively finished. As noted above, when inflation is under control and in the vicinity of the Fed’s 2% target, long-term interest rates should be in the vicinity of 4-4.5%. Over the last century, when rates have been away from the 3-5% range it has generally been either because inflation was unstuck on the high side (1970s, 1980s) or unstuck on the low side (1920s, 1930s, 2010s) (see chart, source Federal Reserve and Bloomberg). The long-term downtrend can be thought of as going from unstuck-high inflation, to normal, and overshooting to the downside in the last decade. But we have now definitively ended that low-rates period.
At a current level of roughly 3.5% nominal, 1.4% real, interest rates are ‘too low’ again, but this is normal for an economy headed into recession. Ordinarily, this configuration of events – a Fed nearing the end of a tightening cycle, a recession looming, and interest rates that have risen 320bps over two years – would make me bullish on bonds. And I do think that the first part of 2023 may see a decent rally as the Fed finishes their business and the stickiness of inflation is not yet apparent, but the recession is. Seasonally, you’d really prefer to be long the bond market/out of equities in the last quarter of the year and out of the bond market/long equities in the first quarter of the year, but I think the seasonal pattern will be reversed this year. So we will come in all happy as bond investors, and get unhappy later in the year.
The reason I think the first quarter of the year will be pretty decent for bonds is because of the timing of the recession and of the end of the Fed tightening cycle. But why the selloff as the year progresses? Well, investors will start to see that inflation is not falling as fast as they had expected, the Fed is showing no signs of easing…and the Federal deficit is blowing up.
In FY 2022, the US government had a $1.38 trillion deficit,[2] in an expansion during peacetime. But there are some inexorable effects pushing that higher next year. For example, interest on the debt: higher interest rates will affect only the part of the public debt that has rolled over, but that is an awful lot of it.
In December 2021, the rolling-12-month interest expense on US Debt Outstanding (see chart, source Bloomberg) was $584bln.[3] As of November 2022, the rolling-12-month expense was $766bln. It will be up another $100bln, at least, in 2023. Social Security benefits paid this year were roughly $1.2 trillion, and benefit payments are due to increase 8.7% next year – so, even neglecting the fact that there will be more recipients next year, Social Security should also be $100bln further in the red. That’s $200bln, on top of the approximately $1.4trillion deficit, and I haven’t even considered Medicare, the decline in tax receipts that will occur thanks to a decline in asset markets this year, or the decline in taxes on earned income when the economy enters a recession. A $2 trillion, peacetime deficit is easily in reach and will be much more if it’s a bad recession. The last time we had that big a deficit, the Fed happened to also be buying a couple trillion dollars’ worth of Treasuries. This time, though, the Fed is shrinking its balance sheet.
It is fairly easy to imagine that longer interest rates will have to rise some, in order to roll the maturing debt. As I said, higher interest rates don’t really bother me because I don’t run a highly-levered hedge fund. (But if the rise in rates were to get sloppy or rates were to rise enough to threaten a spiral in the deficit, then I can imagine the Fed stepping in to reverse its balance sheet reduction and being under even more pressure to guide rates lower. However, it’s not my base case.)
Also, as the year goes along the stickiness of inflation will become more apparent and investors will rightly start to put that assumption back into their required return for nominal bonds. One of the really crazy things that happened in 2022 was that inflation compensation in nominal bonds (aka ‘breakevens,’ the mathematical difference between yields on nominal bonds and yields on inflation-linked bonds that pay inflation on top) declined even as the overall level of inflation continued to climb. At the time of this writing, Median CPI has not yet even decisively peaked, although I think it will. But with Median CPI at 6.98%, it’s incredible that the market is demanding only 2.28% annual compensation for inflation over the next decade (see chart, source Bloomberg). That basically says investors are comfortable earning an increment that underpays them for inflation in the near term, and in the long term will only compensate them for what the Fed says they are trying to pin inflation at.
That’s not as easy a trade as it was when 10-year breakevens were at 0.94% in March 2020, but it still seems to me that most of the risk over that decade would be for inflation to miss too high, rather than too low. I understand that the FOMC wants inflation down around 2%. And as for me, I want a Maserati. Neither one of us is likely to get what he wants, just because we want it.
As the first quarter of the year passes and long-term interest rates decline, the curve may invert further from its current level. But I don’t think it can invert that much, which limits the value to being long, say, 10-year notes from this level. Given the current level of inversion, it is fairly easy to construct steepener trades that throw off positive carry. For that matter, a leveraged investor who is financing at 4.5% and earning 3.75% is more likely to want to go the other way! I think it’s going to be difficult to get a good bull market rally going in bonds, and if I was a leveraged hedge fund investor I’d be playing from the short side/steepener side even in the first quarter of the year (albeit cautiously). The chart below (source: Bloomberg) shows 2s/10s monthly going back to 1980. The only time the curve was more inverted was in the early 1980s, a couple of years after Volcker’s Saturday Night Special and with the hiking campaign solidly underway as it is now. I’m expecting 2s/10s to go positive in 2023, although the best shot at something like +50bps would come if the Fed actually did ease. Ergo, a steepening trade is also nice because it works in my favor more if I’m wrong about the Fed staying on hold for a while after they finish hiking to 5%.
Put those together and I see Fed funds at 5%, 2yr Treasuries at 4.25%, and 10s at 4.5%.
We obviously look deeper than that, though, on this channel. We can separate nominal yields into real yields (represented by TIPS) and inflation compensation (breakevens, or inflation swaps). Here are what the curves look like today (source: Enduring Investments).
From here, it looks fairly obvious that a good deal of the steepening should come from longer-term real rates rising. The 2y TIPS bond is at roughly 2%, so 2s-10s in reals is about the same as it is in nominals. The inflation curve is ridiculously flat. I do think that the inflation curve is more likely to shift higher in parallel than to steepen; a steepening inflation curve would imply accelerating inflation going forward and I don’t think investors really believe we’ll get acceleration. So I think that the movement in the shape of the TIPS curve will be very similar to the movement in the nominal curve, but with the level of the nominal curve being driven by an upward parallel-ish shift in the inflation curve.
| 2y | 10y | |
| Current TIPS Yields | 1.96% | 1.42% |
| EOY TIPS Yields | 1.80% | 1.85% |
| Current Breakevens | 2.30% | 2.27% |
| EOY Breakevens | 2.45% | 2.65% |
VOLATILITY
Generally speaking, a higher-inflation environment is a higher-volatility environment. The chart below (source: Bloomberg) shows core CPI in blue against the ICE BofA MOVE Index of fixed-income option volatility. True to form, the higher-inflation regime has correlated with higher levels of fixed-income volatility.
It isn’t terribly shocking that volatility is higher in bonds than it had been during the years when interest rates were fixed within a stone’s throw of zero. And it shouldn’t be terribly shocking that I expect volatility to stay somewhat higher than the 2017-2019 and 2020-early 2021 levels, even as core inflation recedes somewhat. What may be surprising is the observation that a sizeable gap has opened up in the behavior of fixed-income volatility and equity volatility, as the following chart comparing the VIX (equity vol) and MOVE (fixed-income vol) shows. Note that these are different axes, but you can clearly see the uptrend in the MOVE that has not been replicated by the VIX.
I mentioned earlier how regular and controlled the decline in the stock market has been, and how this has allowed the Fed to push rates further than anyone thought they would, a year ago. There have not been too many periods where option sellers have been punished for being short vol in equities. On the other hand, bond vol has been very different now from what it was a few years ago. In short, there has been a regime change in bond vol, but not in equity vol. At some level, this will continue, but the spread should narrow as the Fed gets to the end of the tightening regime. I think we will end 2023 with the VIX above 22 log vol – where it is today or slightly higher – but with the MOVE around 90 norm vol.
Both of those figures represent more-volatile conditions than we have seen for some years pre-COVID.
EQUITIES
It hurts to say, but equities are still far, far, far overvalued.
For many years, there has been a running tension between people who use the “Fed model” as a way to justify the current level of the stock market and the people who point out that the “Fed model” does not imply that the current level of the market is fair. The “Fed model” essentially says that when interest rates are very low, the present value of future cash flows is higher; ergo, the equilibrium value of the average equity (whose fair value is dependent on the present value of future earnings) and hence the overall stock market is higher, when interest rates are lower. This is analytically true. However, it does not mean that your expectation of future returns, when P/E multiples are at 40 but interest rates are low, should be the same as your expectation when P/E multiples are at 15 but interest rates are high. The level of interest rates explains higher equity prices, but it does not imply that those are now long-term fair value levels.
But this tension was almost always resolved in favor of the people who thought that rock-bottom interest rates meant that stocks should be at sky-high multiples, and value investors were left in the dust for more than a decade.
Unfortunately, this tension is being reduced because interest rates are going higher, and may never go back to those levels again. Consequently, equity price/earnings multiples need to re-rate for the new level of interest rates. The same logic that was used to justify the stock market at a 35 Shiller P/E, reconciles to lower prices now and going forward. The chart below (source: Robert J Shiller, updated with Enduring Investments calculations) shows the Shiller P/E (aka Cyclically-Adjusted P/E Ratio, or CAPE) versus 10-year interest rates in the post-WWII period. There is, ex-Internet bubble, a pretty clear relationship between interest rates and valuations. The red dot is where current multiples and interest rates are.
My forecast of 4.5% 10-year Treasuries implies something like a 23 Shiller P/E, down from 30 now. Without earnings growth, that 23% decline in the multiple implies a 23% decline in the stock market from these levels. I don’t think earnings themselves will increase or decrease very much unless the recession is much worse than I think it’s going to be, but the same lag between wages and product prices that flattered earnings when inflation was heading higher will detract when inflation decelerates. Moreover, if I’m right that Powell is intentionally steering interest rates to a level that is consistent with a long-term equilibrium around 4%-4.5% then this 23% adjustment in prices will not necessarily be followed by another massive bull market the likes of which we became accustomed to during the long bond bull market of the last 40 years. A Shiller P/E in the low-20s is still fairly generous historically but it may be sustainable.
So, my point forecast is for the S&P to get to 3,000 sometime in 2023. I don’t think the current bear market will last the entire year, and in fact I am sure there will be a rollicking rally when it is clear the Fed is done tightening. But sticky inflation will hurt here, too, and after that rollicking rally I think we’ll have another low, and from that low is where a modest bull market will begin.
However, I should also note that 1-year equity vol is around 25%, so my projection is within 1 standard deviation of unchanged!
COMMODITIES
From 1999 through 2008, commodities were in a bull market. After a brutal crash in the Global Financial Crisis, commodity indices had another mini-bull market from 2009-2011 before enduring a 9-year bear market. Since March 2020, the massive increase in the quantity of money has driven down the value of money relative to commodities or, to put it in the normal way, has driven up the price of commodities.
The Bloomberg Commodity Index (spot) rose from 59 in March 2020 to 124 in March 2022, and has come off the boil a bit since then. At the highs, though, the level of the index was only back to the levels of 2014. This is normal with spot commodities, which thanks to improved production and extraction technology over time tend to be perpetually deflating in real terms.[4] The good news is that an investor in commodities does not generally buy spot commodities but rather invests through collateralized futures contracts or invests in an index based on collateralized futures contracts. Over time, the collateral return happens to be a very important source of return (in addition to spot returns, the return from normal backwardation, and the volatility/rebalancing return), and this year there is terrific news in that collateral returns are ~4% higher than they were before the Fed started to hike. This means that, all else equal, commodities index returns should be expected to be 4% better (in nominal terms) this year than over the last couple of years. All else is not equal, but I expect gains in investible commodities indices in 2023.
That’s entirely separate from the question of whether we are in a commodity supercycle, due to chronic underinvestment in exploration and extraction technologies and more difficult geopolitical pressures that increase the costs of mining, growing (e.g. because of fertilizer costs/shortages), and transporting the raw commodities. I think the answer there appears to be ‘yes,’ which means that in general I want to play the commodity market from the long side more than from the short side. Of course there will be brutal moves in both directions, and bears will really want to sell commodities as the recession comes to the fore. But most of that is already in the price, with gasoline at levels much closer to the GFC lows than to anything approximating the highs. The chart below shows retail gasoline prices, adjusted for inflation (using 2012 dollars).
Energy prices of course could fall further, but considering that part of the reason prices have fallen this far is that the Strategic Petroleum Reserve has been flushing oil into the system (and that has ended, in theory) and China’s economy has been sputtering under Zero Covid (which has also ended, in theory), it is hard to think that is the better direction at the moment.
OTHER THINGS
I want to append one very important admonition for investors and investment advisors. I mention this frequently on podcasts, TV and radio appearances, at cocktail parties and to random strangers on mass transit:
The next decade will be very unlike the decades we have just experienced. Not only will inflation and interest rates be higher than we’ve become accustomed to, and markets more volatile, but some important drivers of portfolio construction will shift. The good news is that at least some of those shifts are systematic and predictable. The table below shows how 60/40 returns correlate with inflation, with inflation expectations, and with inflation surprise over two periods. The first period was the 30 years ending in 2004, when inflation averaged 4.89% and was three times as volatile as during the subsequent period. During that period, a 60-40 portfolio was significantly exposed to inflation. The more-recent period, during which inflation was low and stable, produced placid 60/40 returns and correlations with inflation that are mostly spurious because there was more noise than signal. Inflation didn’t move!
The first implication of this is that portfolios which have productively ignored inflation-fighting elements over the last two decades need them now, because the main asset classes used in portfolio construction are terribly inflation-exposed. All portfolios for investors who do not have sufficient ‘natural’ inflation hedges should include such assets as commodities and an allocation to inflation-linked bonds in lieu of some of the nominal bond allocation.
The second implication is related but less conspicuous. The entire correlation matrix is shifting away from what it has been over the last couple of decades, and back to something that incorporates the inflation factor that has been dormant. As the most obvious example, stocks and bonds which have been inversely correlated for a while, due to the fact that they respond differently to economic growth, are becoming correlated again. This is not an aberration but entirely normal for regimes in which inflation is not low and stable. The chart below illustrates this. When 3-year average inflation is above 3% (the red shaded area), then 3-year correlations of stocks and bonds tend to be positive (blue line). When inflation is below that level, correlations tend to be negative.
Negative correlations between stocks and bonds are great because they lower portfolio risk. But in the coming decade, 60/40 won’t be as low risk as it has been. But beyond that, the entire covariance matrix that an advisor relies on to simulate and optimize portfolios needs to be examined. The normal way is to use recent returns (say, the last 10 years) to generate this covariance matrix, which then is used to find the mean/variance-optimized portfolio for a given level of risk. That’s normally okay, but as inflation proves sticky that sort of covariance matrix will be wrong, and wrong in a systematic way. What I am doing for our customers is comparing portfolios optimized with a recent covariance matrix to portfolios optimized using a covariance matrix from the 1980s-1990s. It’s important to be aware of this potential problem in portfolio construction, and to get ahead of it.
Finally, let me take a moment to thank the readers of this blog for their interest in it. I write partly because the discipline of arguing my points out thoroughly makes me (I think) a better trader and investor, but I also garner a lot of value from the information and ideas I receive reciprocally from readers who agree or disagree with what I write. I appreciate this feedback very much, and I thank the readers who take the time to share their opinions with me.
Aside from the personally selfish reason I have for writing, there is also the corporate mission the blog is meant to accomplish, and that is to raise the profile of Enduring Investments and the Inflation Guy franchise with prospective clients, and to encourage them to do business with us. If prospective clients see value in these musings, then I hope they will choose to do business with us. Yes, that’s crassly commercial. But ‘tis the season! And if you read this far in this missive, please consider what that means about the value you’re getting, and how much more value you might get from a deeper relationship with Enduring Investments!
And if not, Merry Christmas anyway! Happy holidays and Happy New Year.
– Mike ‘The Inflation Guy’ Ashton
DISCLOSURE – My company and/or funds and accounts we manage have positions in inflation-indexed bonds and various commodity and financial futures products and ETFs related to them that are discussed in this column.
[1] It bears noting, though, that until 1982 the shelter component of CPI was tied to mortgage rates and home prices and not rents, so that the early-80s rise in core CPI partly reflected the Volcker rate hikes. Fixing that problem was what released the conspiracy nuts who plague us to this day claiming that the BLS “manipulated” CPI downward.
[2] https://fiscaldata.treasury.gov/americas-finance-guide/national-deficit/
[3] Net interest was about $110bln less, since some of that interest is paid to other parts of the government, for example the Federal Reserve system. For now.
[4] I wrote a nice, short little piece called “Corn Prices – Has the Correction Run its Course?” that is worth reading if you are interested in commodities.
Fair is Fair, and TIPS are There (Almost)
For a very long time, I have been writing in our Quarterly Inflation Outlook that TIPS were “relatively cheap, but absolutely expensive.” By that I meant that TIPS real yields at -1%, -2%, etc were not exciting (implying as they did that a buyer would have long-term real wealth destruction), but that compared with nominal Treasury yields of 1%, 1.5%, or 2% any investor in fixed income should have vastly preferred TIPS.
I have repeatedly said – as far back as 2016 – that with breakevens below 1.5% there wasn’t even a decent strategic case to own nominal bonds rather than inflation-linked bonds (ILBs) except to defease specific nominal liabilities and that at times those low breakevens meant that owning nominals instead of ILB amounted to a really big bet (as I said in this article from March 2020). Those are relative concepts.
But 10-year real yields were below zero, and as low as -1.2%, for most of 2020, 2021, and the first half of 2022. And 10-year real yields have been below +1% almost continuously since 2011. When real yields were below zero or just fractionally positive, it meant that TIPS were absolutely expensive. That wasn’t just a TIPS problem of course: low real yields were the most obvious in TIPS, but you couldn’t avoid them by trafficking in other asset classes because they were a characteristic of the environment we were in. Everything was absolutely expensive, but TIPS were at least relatively cheap.
More recently, our models indicated TIPS getting quantitatively fair on a relative basis, which is historically unusual (see chart, source Enduring Investments); they even got somewhat rich a couple of months ago and that’s historically unheard of.[1] Real and nominal yields were still low, but at least it was a fair horse race between which ones to hold. And if you’d bought TIPS when I said there was “a big bet” being made against them, and sold them when we said they were fair, you crushed a nominal portfolio’s return. (As an aside, the rich/cheap chart and value is available every day on my private Twitter feed. Sign up for that private feed here: https://inflationguy.blog/shop/ I keep adding more charts etc, in addition to the main event, my live CPI report coverage each month).
As of today, 10-year TIPS yields are all the way up to 1.67%, the highest they’ve been since 2010. I explained back in June why the equilibrium risk-free real interest rate is approximately 2.25%, so TIPS are getting to the neighborhood of long-term fair values in an absolute sense. TIPS have no risk in real space, when held to maturity, so if you can get an annual 2%ish real increase in wealth with no risk, that’s a good deal. And inflation-linked bond yields in developed markets basically never yield more than 4% or 4.5%, so the higher the yield goes the less your potential mark-to-market downside. A 5-yr or 10-yr TIPS yield of 4% is back-up-the-truck stuff if you see it. At those real yields, with no risk, other asset classes simply can’t compete. At 1% breakevens there was no reason to own nominal bonds rather than TIPS; at 4% real yield there would be no reason to own stocks rather than TIPS.
But that sort of yield is of course very rare and we won’t see it unless nominal yields get up to double-digit land. At the current level, with TIPS at fair or slightly-cheap relative value and approaching fair absolute value, it is worth accumulating TIPS as a long-term hold.
It has been an astonishingly long time since I could make that statement. And TIPS may well get cheaper from here. I hope they do! But in the meantime, you can do a lot worse than guarantee yourself that your wealth will increase 18% more over the next decade than the price level rises.[2]
[1] I have written previously though about the value of long inflation tails, and how that value is NOT reflected in TIPS so that even when our model says TIPS are fair, they’re still very cheap if that tail option is reasonably valued. But that isn’t included here.
[2] (1+1.67%)^10 – 1 = 18%.
And Now Their Watch is Ended
At one time, fiscal deficits mattered. There was a time when the bond market was anthropomorphized as a deficit-loathing scold who would push interest rates higher if asked to absorb too much new debt from the federal government. The ‘bond vigilantes’ were never an actual group, but as a whole (it was thought) the market would punish fiscal recklessness.
Of course, any article mentioning the bond vigilantes must include the classic account by Bob Woodward, describing how then-President Bill Clinton reacted to being told that running too-large deficits would cause interest rates to rise and tank the economy: “Clinton’s face turned red with anger and disbelief. ‘You mean to tell me that the success of the program and my re-election hinges on the Federal Reserve and a bunch of ****** bond traders?’”
Truth be told, this was always a bit of a crock in the big scheme of things. Although the bond market occasionally threw a tantrum when Big Government programs were announced, the bond traders have always been there when the actual paper hit the street. The chart below shows 10-year yields versus the rolling 12-month federal deficit. Far from being deficit scolds, bond market investors have always behaved more as if bonds were Giffen goods (whose price gets higher when there is more supply, and lower when there is less supply, in the opposite manner from ‘normal’ microeconomic dynamics). I guess so long as we are doing a walk down economic history lane, we could also say that the bond market followed a financial version of Say’s law: that supply creates its own demand…
Well, if ever there was a time for the market to get concerned about deficits, now is surely it. While the Fed continues to buy massive quantities of paper (to “ensure the smooth functioning of the markets”, as it surely does since if they were not buying such quantities the adjustment may be anything but smooth), there is still an enormous amount of Treasury debt in private hands. And it all yields far less than the rate of inflation. Clearly, these private investors are not alarmed by the three-trillion-dollar deficit, nor of the effect that the Fed buying a large chunk of it could have on the price level.
If investors are not alarmed by a $3T deficit – and, aside from market action being so benign, consider whether you’ve read any such alarm in the financial press – then it’s probably fair to say that there isn’t a deficit amount that would alarm them. Always before, if the market absorbed an extra-large deficit there was always at least the concern that it might choke on all that paper. Or, if it didn’t, that surely we were at the upper level of what could be absorbed. I don’t sense anything like the unease we’ve seen in prior deficit spikes. And that’s what alarms me. Because, as I tell my kids: a rule without enforcement means there isn’t a rule. Investors are not putting any limitation on the federal balance; ergo there is no limit.
Well, perhaps by itself that’s not a big deal. Heck, maybe deficits really don’t matter. But what bothers me is that the risk to that possibility is one-sided. If deficits don’t matter, then no biggie. But if they do matter, and the bond vigilantes are dead so that there is no push-back, no enforcement of that rule, then it follows that the only speed limit that will be enforced is when the car hits the tree. That is, if there is no alarm that causes the market to discipline the government spenders before there’s a crack-up, then eventually there will be a crack-up with 100% probability (again, assuming that deficits do matter at some level, and maybe they don’t).
While the vigilantes kept watch, there was scant worry that a government auction would fail. Although, as I’ve pointed out, the vigilantes weren’t macro-enforcers there were sometimes micro-aggressions: sudden interest rate adjustments where yields would jump 100bps in six weeks, say. This doesn’t happen any longer. So, while there’s plenty of money floating about right now to buy this zero-yielding debt, the larger the bond market gets the more of that money it will be sucking up. Unless, that is, the amount of money expands faster than the amount of debt (so that the debt shrinks in real terms), which is another way to say that the price level rises sharply. In that case, in order to keep the markets “orderly” the Federal Reserve will have to take more and more of that zero-yielding debt out of the market, replacing it with cash. It’s easy to see how that could spiral out of control quickly, as well.
I am not sure how close we are to such a crack-up. It could be years away; it could be weeks. But without the bond vigilantes, there’s no law in this town at all.
Low Real Yields – You Can’t Avoid Them
Recently, 10-year real yields went to new all-time lows. Right now, they’re at -0.96%. What that means is that, if you buy TIPS, you’re locking in a loss of about 1% of your purchasing power, per year, over the next decade. If inflation goes up 2%, TIPS will return about 1%. If inflation goes up 8%, TIPS will return 7%. And so on.
With that reality, I’ve recently seen lamentations that TIPS are too expensive – who in the world would buy these real yields?!?
The answer, of course, is everybody. Indeed, if you can figure out a way to buy an asset without locking in the fundamental reality that the real risk-free rate is -1%, please let me know.
Because when you buy a nominal Treasury bond, you are buying them at a nominal interest rate that reflects a -1% real interest rate along with an expectation of a certain level of inflation. The whole point of the Fisher equation is that a nominal yield consists of (a) the real cost of money, and (b) compensation for the expected deterioration in the value of that money over time – expected inflation.[1] So look, if you buy nominal yields, you’re also getting that -1% real yield…it’s just lumped in with something else.
Well golly, then we should go to a corporate bond! Yields there are higher, so that must mean real yields are higher, right? Nope: the corporate yield is the real yield, plus inflation compensation, plus default risk compensation. Your yield is higher because you’re taking more (different) risks, but the underlying compensation you’re receiving for the cost of money is still -1%.
Commodities! Nope. Expected commodity index returns consist of expected collateral return, plus (depending how you count it) spot return and roll return. But that collateral return is just a fixed-income component…see above.
Equities, of course, have better expected returns over time not because they are somehow inherently better, but because buyers of equities earn a premium for taking on the extra risk of common equities – cleverly called the equity risk premium – over a risk-free investment.
In fact, the expected returns for all long positions in investments consist of the same basic things: a real return for the use of your money, and a premium for any risk you are taking over and above a riskless investment (the riskless investment being, we know, an inflation-linked bond and not a nominal bond). This is the whole point of the Capital Asset Pricing Model; this understanding is what gives us the Security Market Line, although it’s usually drawn incorrectly with T-bills as the risk-free asset. Here is the current market line we calculate, using our own models and with just a best-fit line in there showing the relationship between risk and return. Not that long ago, that entire line was shifted higher more or less in parallel as real interest rates were higher along with the expected returns to every asset class:
So why am I mentioning this? Because I have been hearing a lot recently about how people are buying stocks because TINA (There Is No Alternative) when yields are this low. But if the capital asset pricing model means anything, that is poor reasoning: your return to equity investment incorporates the expected real return to a riskless asset. There is an alternative to equities and equity risk; what there’s no alternative to is the level of real rates. The expected real return from here for equities is exceptionally poor – but, to be fair, so are the expected real returns from all other asset classes, and for some of the same reasons.
This is a consequence, of course, of the massive amount of cash in the system. Naturally, the more cash there is, then the worse the real returns to cash because a borrower doesn’t need to compensate you as much for the use of your money when there’s a near-unlimited amount of money out there. And the worse the real returns to cash, the worse the real returns to everything else.
You can’t avoid it – it’s everywhere. I don’t know if it’s the new normal, but it is the normal for now.
[1] Unhelpfully, the Fisher equation also notes that there is an additional term in the nominal yield, which represents compensation being taken on by the nominal bondholder for bearing the volatility in the real outcome. But it isn’t clear why the lender, and not the borrower, ought to be compensated for that volatility…the borrower of course also faces volatility in real outcomes. In any event, it can’t be independently measured so we usually just lump that in with the premium for expected inflation.
The Big Bet of 10-year Breakevens at 0.94%
It is rare for me to write two articles in one day, but one of them was the normal monthly CPI serial and this one is just really important!
I have been tweeting constantly, and telling all of our investors, and anyone else who will listen, that TIPS are being priced at levels that are, to use a technical term, kooky. With current median inflation around 2.9%, 10-year breakevens are being priced at 0.94%. That represents a real yield of about -0.23% for 10-year TIPS, and a nominal yield of about 0.71% for 10-year Treasuries. The difference in these two yields is 0.94%, and is approximately equal to the level of inflation at which you are indifferent to owning an inflation-linked bond and a nominal bond, if you are risk-neutral.
First, a reminder about how TIPS work. (This explanation will be somewhat simplified to abstract from interpolation methods, etc). TIPS, the U.S. Treasury’s version of inflation-linked bonds, are based on what is often called the Canadian model. A TIPS bond has a stated coupon rate, which does not change over the life of the bond and is paid semiannually. However, the principal amount on which the coupon is paid changes over time, so that the stated coupon rate is paid on a different principal amount each period. The bond’s final redemption amount is the greater of the original par amount or the inflation-adjusted principal amount.
Specifically, the principal amount changes each period based on the change in the Consumer Price All Urban Non-Seasonally Adjusted Index (CPURNSA), which is released monthly as part of the Bureau of Labor Statistics’ CPI report. The current principal value of a TIPS bond is equal to the original principal times the Index Ratio for the settlement date; the Index Ratio is the CPI index that applies to the coupon date divided by the CPI index that applied to the issue date.
To illustrate how TIPS work, consider the example of a bond in its final pay period. Suppose that when it was originally issued, the reference CPI for the bond’s dated date (that is, its Base CPI) was 158.43548. The reference CPI for its maturity date, it turns out, is 201.35500. The bond pays a stated 3.375% coupon. The two components to the final payment are as follows:
(1) Coupon Payment = Rate * DayCount * Stated Par * Index Ratio
= 3.375% * ½ * $1000 * (201.35500/158.43548)
= $21.45
(2) Principal Redemption = Stated Par * max [1, Index Ratio]
= $1000 * (201.35500/158.43548)
= $1,270.90
Notice that it is fairly easy to see how the construction of TIPS protects the real return of the asset. The Index Ratio of 201.35500/158.43548, or 1.27090, means that since this bond was issued, the total rise in the CPURNSA – that is, the aggregate rise in the price level – has been 27.09%. The coupon received has risen from 3.375% to an effective 4.2892%, a rise of 27.09%, and the bondholder has received a redemption of principal that is 27.09% higher than the original investment. In short, the investment produced a return stream that adjusted upwards (and downwards) with inflation, and then redeemed an amount of money that has the same purchasing power as the original investment. Clearly, this represents a real return very close to the original “real” coupon of 3.375%.
Now, there is an added bonus to the way TIPS are structured, and this is important to know at times when the market is starting to act like it is worried about deflation. No matter what happens to the price level, the bond will never pay back less than the original principal. So, in the example above the principal redemption was $1,270.90 for a bond issued at $1,000. But even if the price level was now 101.355, instead of 201.355, the bond would still pay $1,000 at maturity (plus coupon), even though prices have fallen since issuance. That’s why there is a “max[ ]” operator in the formula in (2) above.
So, back to our story.
If actual inflation comes in above the breakeven rate, then TIPS outperform nominals over the holding period. If actual inflation comes in below the breakeven rate, then TIPS underperform over the holding period. But, because of the floor, there is a limit to how much TIPS can underperform relative to nominals. However, there is no limit to how much TIPS can outperform nominals. This is illustrated below. For illustration, I’ve made the x-axis run from -4% compounded deflation over 10 years to 13% compounded inflation over 10 years. The IRR line for the nominal Treasury bond is obviously flat…it’s a fixed-rate bond. The IRR line for the TIPS bond looks like a call option struck near 0% inflation.
Note that, no matter how far I extend the x-axis to the left…no matter how much deflation we get…you will never beat TIPS by more than about 1% annualized. Never. On the other hand, if we get 3% inflation then you’ll lose by 2% per year. And it gets worse from there.
Because annualizing the effect makes this seem less dramatic, let’s look instead at the aggregate total return of TIPS and Treasuries. For simplicity, I’ve assumed that coupons are reinvested at the current yield to maturity of the 10-year note, which would obviously not be true at high levels of inflation but is in fact the simplifying assumption that the bond yield-to-maturity calculation makes.
So, if you own TIPS in a deflationary environment, you’ll underperform by about 10% over the next decade. Treasuries will return 7.3% nominal; TIPS will return -2.3% nominal. Unfortunate, but not disastrous. But if inflation is 8%, then your return on Treasuries will still be 7.3%, but TIPS will return 103%. Hmmm. Yay, your 10-year nominal Treasuries paid you back, plus 7.3% on top of that. But that $1073 is now worth…$497. Booo.
So the point here is that at these prices you should probably own TIPS even if you think we’re going to have deflation, unless you are really confident that you’re right. You are making a much bigger bet than you think you’re making.
Summary of My Post-CPI Tweets (February 2020)
Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy. Or, sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments (updated site coming soon). Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.
- Welcome to CPI day! Before we get started, note that at about 9:15ET I will be on @TDANetwork with @OJRenick to discuss the inflation figures etc. Tune in!
- In leading up to today, let’s first remember that last month we saw a very weak +0.11% on core CPI. The drag didn’t seem to come from any one huge effect, but from a number of smaller effects.
- The question of whether there was something odd with the holiday selling calendar, or something else, starts to be answered today (although I always admonish not to put TOO much weight on any single economic data point).
- Consensus expectations call for +0.2% on core, but a downtick in y/y to 2.2% from 2.3%. That’s not wildly pessimistic b/c we are rolling off +0.24% from last January.
- Next month, we have much easier comparisons on the y/y for a few months, so if we DO drop to 2.2% y/y on core today that will probably be the low for a little while. Feb 2019 was +0.11%, March was +0.15%, April was +0.14%, and May was +0.11%.
- So this month we are looking to see if we get corrections of any of last month’s weakness. Are they one-offs? We are also going to specifically watch Medical Care, which has started to rise ominously.
- One eye also on core goods, though this should stay under pressure from Used Cars more recent surveys have shown some life there. Possible upside surprise because low bar. Don’t expect Chinese virus effect yet, but will look for signs of it.
- That’s all for now…good luck with the number!
- Small upside surprise this month…core +0.24%, and y/y went up to 2.3% (2.27% actually).
- We have changes in seasonal adjustment factors and annual and benchmark revisions to consumption weights this month…so numbers are rolling out slowly.
- Well, core goods plunged to -0.3% y/y. A good chunk of that was because Used Cars dropped -1.2% this month, down -1.97% y/y.
- Core services actually upticked to 3.1% y/y. So the breakdown here is going to be interesting.
- Small bounce in Lodging Away from Home, which was -1.37% m/m last month. This month +0.18%, so no big effect. But Owners Equivalent Rent jumped +0.34% m/m, to 3.35% y/y from 3.27%. Primary Rents +0.36%, 3.76% y/y vs 3.69%. So that’s your increase in core services.
- Medical Care +0.18% m/m, 4.5% y/y, roughly unchanged. Pharma fell -0.29% m/m after +1.25% last month, and y/y ebbed to 1.8% from 2.5%. That goes the other way on core goods. Also soft was doctors’ services, -0.38% m/m. But Hospital Services +0.75% m/m.
- Apparel had an interesting-looking +0.66% m/m jump. But the y/y still decelerated to -1.26% from -1.12%.
- Here is the updated Used Cars vs Black Book chart. You can see that the decline y/y is right on model. But should reverse some soon.
- here is medicinal drugs y/y. You can see the small deceleration isn’t really a trend change.
- Hospital Services…
- Primary Rents…now, this and OER are worth watching. It had been looking like shelter costs were flattening out and possibly even decelerating a bit (not plunging into deflation though, never fear). This month is a wrinkle.
- Core ex-housing 1.53% versus 1.55% y/y…so no big change there. The upward pressure on core today is mostly housing.
- Whoops, just remembered that I hadn’t shown the last-12 months’ chart on core CPI. Note that the next 4 months are pretty easy comps. We’re going to see core CPI accelerate from 2.3%.
- So worst (core) categories on the month were Used Cars and Trucks and Medical Care Commodities, which we’ve already discussed. Interesting. Oddly West Urban OER looks like it was down m/m although my seasonal adjustment there is a bit rough.
- Biggest gainers: Miscellaneous Personal Goods, +41% annualized! Also jewelry, footwear, car & truck rental, and infants/toddlers’ apparel.
- Oddly, it looks like median cpi m/m will be BELOW core…my estimate is +0.22% m/m. That’s curious – it means the long tails are more on the upside for a change.
- Now, we care about tails. If all the tails start to shift to the high side, that’s a sign that the basic process is changing.
- One characteristic of disinflation and lowflation…how it happens…is that prices are mostly stable with occasional price cuts. If instead we go to mostly stable prices with occasional price hikes, that’s an inflationary process. WAY too early to say that’s what’s happening.
- Appliances (0.2% of CPI, so no big effect) took another big drop. Now -2.08% y/y. Wonder if this is a correction from tariff stuff.
- Gotta go get ready for air. Last thing I will leave you with is this: remember the Fed has said they are going to ignore inflation for a while, until it gets significantly high for a persistent period. We aren’t there yet. Nothing to worry about from the Fed.
Because I had to go to air (thanks @OJRenick and @TDAmeritrade for another fun time) I gave a little short shrift on this CPI report. So let me make up for that a little bit. First, here’s a chart of core goods. I was surprised at the -0.3% y/y change, but it actually looks like this isn’t too far off – maybe just a little early, based on core import prices (see chart). Still, there has been a lot of volatility in the supply chain, starting with tariffs and now with novel coronavirus, with a lot of focus on the growth effects but not so much on the price effects.
It does remain astonishing to me that we haven’t seen more of a price impact from the de-globalization trends. Maybe there is some kind of ‘anchored inflation expectations’ effect? To be sure, it’s a little early to have seen the effect from the virus because ships which left before the contagion got started are still showing up at ports of entry. But I have to think that even if tariffs didn’t encourage a shortening of supply chains, this will. It does take time to approve new suppliers. Still I thought we’d see this effect already.
Let’s look at the four pieces charts. As a reminder, this is just a shorthand quartering of the consumption basket into roughly equal parts. Food & Energy is 20.5%; Core Goods is 20.1%; Rent of Shelter is 32.8%; and Core services less rent of shelter is 26.6%. From least-stable to most:
We have discussed core goods. Core Services less RoS is one that I am keeping a careful eye on – this is where medical care services falls, and those indices have been turning higher. Seeing that move above 3% would be concerning. The bottom chart shows the very stable Rents component. And here the story is that we had expected that to start rolling over a little bit – not deflating, but even backing off to 3% would be a meaningful effect. That’s what our model was calling for (see chart). But our model has started to accelerate again, so there is a real chance we might have already seen the local lows for core CPI.
I am not making that big call…I’d expected to see the local highs in the first half of 2020, and that could still happen (although with easy comps with last year, it wouldn’t be much of a retreat until later in the year). I’m no longer sure that’s going to happen. One of the reasons is that housing is proving resilient. But another reason is that liquidity is really surging, so that even with money velocity dripping lower again it is going to be hard to see prices fall. M2 growth in the US is above 7% y/y, and M2 growth in the Eurozone is over 6%. Liquidity is at least partly fungible when you have global banks, so we can’t just ignore what other central banks are doing. Over the last decade, sometimes US M2 was rising and sometimes EZ M2 was rising, but the last time we saw US>7% and EZ>6% was September 2008-May 2009. Before that, it happened in 2001-2003. So central banks are providing liquidity as if they are in crisis mode. And we’re not even in crisis mode.
That is an out-of-expectation occurrence. In other words, I did not see it coming that central banks would start really stepping on the gas when global growth was slowing, but still distinctly positive. We have really defined “crisis” down, haven’t we? And this isn’t a response to the virus – this started long before people in China started getting sick.
So, while core CPI is currently off its highs, it will be over 2.5% by summertime. Core PCE will be running up on the Fed’s 2% target, too. If the Fed maintains its easy stance even then, we will know they are completely serious about letting ‘er rip. I can’t imagine bond yields can stay at 2% in that environment.
A Generous Fed Isn’t Really the Good News it Sounds Like
I understand why people are delighted about Powell’s remarks yesterday, about how the Fed would need to see a significant and sustained increase in inflation before hiking rates again. This generation, and the last, does not see inflation as a significant threat, nor a significant cost should it get going, and believes firmly that the Fed can easily squelch it if it gets going. (They believe this because, after all, the Fed told them so).
Older investors might be more reticent to believe that there’s a pony in there somewhere, since the evidence suggests that not only does inflation erode purchasing power (thereby demanding even more nominal return be provided by portfolios that are already overstretched valuation-wise) but it also ruins the diversification effect of bonds relative to stocks. The main reason that 60:40 is a dramatically lower risk portfolio (and more efficient in an investing sense) than 100% stocks is that stock and bond returns have tended to be inversely correlated for a long time. When stocks go up, bonds go down, in general (and vice-versa). But that’s because they have inverse sensitivities to the economic growth factor. In recent years, that has been the only factor that matters, but stocks and bonds have the same sensitivity to the inflation factor: when inflation goes up, both stocks and bonds tend to decline (and vice-versa). Consequently, when inflation becomes an important element in investors’ calculations the correlation of stocks and bonds tends to be positive and in the immortal words of Billy Joel in “Goodnight Saigon,” “We would all go down together.” Along these lines I recently prepared this chart for Real Asset Strategies,[1] illustrating that when inflation is over about 2.5%, correlations tend to flip. This is a 3-year average of y/y inflation (and shown on the chart as inflation minus 2.5% so the zero line is what matters, not the line at 2.5%) versus 3-year correlations; the point is that you don’t need 4% inflation to drastically change the value of the 60:40 portfolio.
I also think that people give the Fed much more credit for their ability to squelch inflation – which after all they haven’t had to do for more than 30 years after spending 15 years squelching the last round – than they deserve. But that’s a ‘show me’ situation and it’s hard to prove my suspicion that they won’t be so successful when push comes to shove.
So, I understand why people are partying about a Fed that is even looser than it had been. I don’t think that’s the correct response, but I understand it.
I also understand why people are somewhat morose about trade frictions. It isn’t for the right reason, that in the long run it will hurt real growth a smidge and increase inflation a smidge-and-a-half, but because they think it will have a drastic effect on near-term growth. That’s why everyone gets so excited about any inkling the US and China are nearing a trade détente and so depressed when it looks like they aren’t. We are told that the current global slowdown is being caused largely by the trade war.
In my view that’s nonsense. The global economy has been expanding for a decade on exceptionally loose liquidity but no tree grows to the sky. The global economy was slowing well before the trade frictions could possibly have had any impact. But it is hard to convince people of that, because everyone knows that:
GDP = C + I + G + (X-M),
or consumption plus investment plus government spending plus trade. And we learned in school about Ricardian comparative advantage and how trade enriches (or anyway, can enrich) both parties at the same time. So if China doesn’t import anything from the US and doesn’t export anything to the US, growth is going to be crushed, right?
But that’s not how trade works. Frankly, that’s not how anything in the GDP equation works. If you remove the final term, you don’t reduce GDP by (X-M). Sure, if this was an algebra problem you would, but it’s not. In the real world, what you lose from trade gets partially replaced by an increase in consumption, investment, or government. Just as I pointed out last year with soybeans, if China buys zero from us it means they have to buy them from someone else, which means that supplier doesn’t have them to sell to one of their traditional customers…who then buys them from us. Incidentally, neither beans nor corn went to zero after mid-2018 (see chart, source Bloomberg, normalized to December 2017=100).
The rest of trade works the same way if the two parties are “internal customers” and “external customers.” Though there will always be winners and losers, if we don’t have international trade then we won’t have a destination for our merchandise overseas…but we will also have consumers who don’t have Chinese goods to buy and so need to buy something from a domestic producer instead. This is not a zero sum game; it clearly results in a loss for all players. But the order of magnitude of this loss in the short run is not very big at all, especially for a country with a large fraction of its domestic production going to domestic consumption, as in the US but not even for the world at large. The world economy has lots of reasons to slow and go into recession, and trade frictions are one of those reasons, but certainly not the only one and not even the largest reason.
An overreaction by markets to anything in a stream of economic news is not unique or new, of course; those overreactions won Robert Shiller a Nobel Prize after all for his work pointing out the “excess volatility puzzle” as an early highlight of the nascent field of behavioral economics. But there’s a good reason to ignore most of these wiggles and focus on the long-term effect of these developments. Which, in the case of both the general climate of trade and the Fed’s reaction function to inflation, are negatives for both stocks and bonds.
[1] As part of Enduring Intellectual Properties’ investment in Real Asset Strategies, I serve as Director of Research for the firm. Real Asset Strategies LLC offers liquid real asset strategies focused on diversification benefits and inflation protection at reasonable fees.
