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How Higher Rates Cause Big Changes in the Bond Contract

October 17, 2023 4 comments

Two weeks ago I pointed out one of the effects of higher interest rates is that leveraged return strategies get swiftly worse as rates rise. Today, I want to talk about another result of higher interest rates which is, to me, much more fun and exciting. It involves the Treasury Bond cash-futures basis.

I know, that doesn’t sound so interesting. For many years, it hasn’t been. But lately, it has gotten really, really interesting – and institutional fixed-income investors and hedgers need to know that one of the major effects of higher interest rates is that it makes the bond contract negatively convex, not to mention that right now the bond contract also looks wildly expensive.

Some background is required. The CBOT bond futures contract (and the other bond contracts such as the Ultra, the (10y) Note, the 5y, and the 2y) calls for the physical delivery of actual Treasury securities, rather than cash settlement. Right now, thanks to ‘robust’ Treasury issuance patterns, there are an amazing 54 securities that are deliverable against the December bond futures contract. The futures contract short may deliver any of these bonds to satisfy his obligations under the contract, and may do so any time within the delivery month.

Now, if we just said the short can deliver any bond, the short would obviously choose the lowest-priced bond. The lowest-coupon bond is almost always going to be the lowest-priced; right now, the 1.125%-8/15/2040 sports a dollar price of 55.5.[1] But if we already know what bond is going to be deliverable, and it’s always the optimal bond to deliver, then the futures contract is just a forward contract on that bond, and it becomes very uninteresting (not to mention that liquidity of that one bond will determine the liquidity of the contract). So, when the contract was developed the CBOT determined that when the bond is delivered it will be priced, relative to the contract’s price, according to a conversion factor that is meant to put all of the bonds on more or less similar footing.[2] The price that the contract short gets paid when he delivers that particular bond is determined by the futures price, the factor, and the accrued interest on the delivery date…and not the price of the bond in the market.

Because the conversion factor is fixed, but the bonds all have different durations, which bond is cheapest-to-deliver (“CTD”) changes as interest rates change. When interest rates fall, short-duration bonds rise in price more slowly than long-duration bonds and so they get relatively cheaper and tend to become CTD. When interest rates rise, long-duration bonds fall in price more quickly than short-duration bonds and so tend to become CTD in that circumstance. And here’s the rub: when interest rates were well below the 6% “contract rate”, the CTD bond got locked at the shortest-duration deliverable, which also usually happened to be the shortest-maturity deliverable, because that bond got cheaper and cheaper and cheaper as the market rose and rose and rose. The consequence is that the bond contract, as mentioned earlier, eventually did become just a forward contract on the CTD (and a short-duration CTD at that), which meant that the volatility of the futures contract was lower, the implied volatility of futures options was lower, and the price of the futures contract was uninteresting to arbitrageurs because it was very obviously the forward price of the CTD. And this situation persisted for decades. The last time the bond and 10-year note yielded as much as 6% (which is where all of the excitement is maximized, since after all the conversion factor is designed to make them all more or less interchangeable at that level) was 2000. [Coincidentally or not, that was right about the time I stopped being exclusively a fixed-income relative value strategist/salesman and started trading options, and then inflation.]

So, now the long bond yields 4.96% and the deliverable bonds in the December bond contract basket have yields between 5.03% and 5.22%. This starts to get interesting. As of today, the CTD bond is the 4.75%-Feb 15, 2041. If you buy that bond and sell the contract,[3] then the worst possible case for you is that you deliver that bond into the contract and lose roughly 12/32nds after carry.

However.

Because you are short the futures contract, you can deliver whatever bond is most-advantageous to you at the time you elect to deliver. If any other bond is cheaper than the 4.75s-Feb41, then you buy that bond, sell the Feb41s, and deliver. And obviously, that’s a gain to you. And you can make that switch as often as you like, up until delivery.

Can you predict approximately when the bonds will switch? Sure, because we know the bonds’ durations we can estimate the CTD – and the value of switching – for normal yield curve shifts. While the steepening and flattening of the deliverable curve also matter, remember that anything that adds volatility to the potential switch point adds value to you, the futures short. Here is, roughly, the expected basis at delivery of that Feb41 bond.

Now isn’t this interesting? If the bond market rallies, then we know that shorter-duration bonds will become CTD, pushing the Feb 41s out. And if the bond market sells off, then we know that longer-duration bonds will replace the Feb 41s as CTD. Notice that this looks something like an options strangle? That’s because it essentially is. You own a strangle, and you’re paying 12/32nds for that strangle. (Spoiler alert: you can sell a comparable options position in the market for roughly 28/32nds, making the basis of that bond about half a point cheap, or equivalently the futures are about half a point rich.

Okay – if you’re not a fixed-income relative value strategist…and let’s face it, they’re a dying breed…then why do you care?

If you’re a plain old bond portfolio manager, you may use futures as a hedge for your position; you might use futures to get long bonds quickly without having to buy actual bonds, or because you aren’t allowed to repo your physical bonds but you can get some of the same benefits by buying the futures contract. You might buy options on futures to get convexity on your position, or to hedge the negative convexity in your mortgage portfolio.

Well guess what! None of that stuff works the same way it did 15 months ago!

Because longer-duration bonds are CTD now, the contract has more volatility. Which means the options on those futures have more implied volatility. Also, the bond contract is no longer guaranteed to be within a tick of fair value because the CTD is locked. When I worked for JP Morgan’s futures group, we thought if the futures contract got 6 ticks rich or cheap it was exciting. Well, we’re looking at a futures contract that’s a half-point mispriced![4]

Finally – as I said, the bond contract now has negative convexity, which means that when you are long the contract you will underperform in a rally and underperform in a selloff (while earning the net basis of 12 ticks, in a best case). Because when you own the bond contract you have the opposite position I’ve illustrated above: you’re short a strangle. If you’re long the contract then as the market sells off the bond contract will go down faster and faster as it tracks longer and longer duration deliverables. And if the market rallies, the contract will rise slower and slower as it tracks shorter duration deliverables. The implication is that especially because the bond contract is rich, it is great as a hedge for long cash positions at the moment, and a pretty bad hedge for short positions. And it’s great to hedge long mortgage positions, since when you sell the contract you also pick up some convexity rather than adding to your short-convexity position.

This all sounds, I’m sure, very “inside baseball.” And it is, because most of the people who used to trade this stuff and understood it are retired, have moved to corner offices, or are old inflation guys who just wonder why we don’t have a deliverable TIPS contract. But just as with my article two weeks ago, it’s something that I think it important to point out. We’re so obsessed with the ‘macro’ implications of higher rates, we stand to miss some of the really important implications on the ‘micro’ side of things!


[1] I’m using decimals to make this more accessible to non-bond folks, but we all know that this really means 55-16.

[2] The conversion factor is the answer to the question, “what would the price of this bond be if, on the first day of the delivery month, it were to yield exactly 6% to maturity”? So the aforementioned 1-1/8 of Aug-40s have a conversion factor into the December contract of 0.4938 while the 3-7/8 of Aug-40 has a conversion factor of 0.7794.

[3] I am abstracting here from the more technical nuances of how one weights a bond basis trade, again for brevity and accessibility.

[4] There’s a big caveat here in that the yield curve dynamics in my model for the shape of the deliverable bond yield curve are out-of-date, as I haven’t used this model in years…so the contract might be anywhere from 10 ticks to 20 ticks rich. But it’s rich!

We Are All Bond Traders Now

February 6, 2023 3 comments

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

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

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

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

…where r is the interest rate.

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

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

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

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

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

So, where am I going with this?

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

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

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

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

But the bond traders are still the cool kids.


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

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

2022 Year-End Thoughts About 2023

December 22, 2022 2 comments

Use: This article may only be reposted in its unedited entirety (including all links), including the title and author with linkbacks to the original. If you wish to repost in serial form, please contact me via the form at https://enduringinvestments.com to discuss.

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:

Current2023 Fcast
Core Goods3.7%2.3%
Rent of Shelter7.2%4.8%
Core Services less ROS6.3%5.1%
Core CPI6.0%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.

2y10y
Current TIPS Yields1.96%1.42%
EOY TIPS Yields1.80%1.85%
Current Breakevens2.30%2.27%
EOY Breakevens2.45%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.

Are Home Prices Too High?

September 2, 2021 3 comments

There is an advantage to squatting in the same niche of the market for years, even decades. And that is that your brain will sometimes make connections on its own – connections that would not have occurred to your conscious mind, even if you were studying a particular question in what you thought was depth.

A case in point: yesterday I was re-writing an old piece I had on the value of real estate as a hedge, to make it a permanent page on my blog and a “How-To” on the Inflation Guy app. At one point, I’m illustrating how a homeowner might look at the “breakeven inflation” of homeownership, and my brain asked “I wonder how this has changed over time?”

So, I went back in the Shiller dataset and I calculated it. To save you time reading the other article, the basic notion is that a homeowner breaks even when the value of the home rises enough to cover the after-tax cost of interest, property taxes, and insurance. In what follows, I ignore taxes and insurance because those vary tremendously by locality, while interest does not. But you can assume that the “breakeven inflation” line for housing ought to be at least a little higher. In the chart below, I calculate the breakeven inflation assuming that mortgage rates are roughly equal to the long Treasury rate (which isn’t an awful assumption if there’s some upward slope to the yield curve, since the duration of a 30-year mortgage is a lot less than the duration of a 30-year Treasury), that a homeowner finances 80% of the purchase, pays taxes at the top marginal rate, and can fully deduct the amount of mortgage interest. I have a time series of the top marginal rate, but don’t have a good series for “normal down payment,” so this illustration could be more accurate if someone had those data. The series for inflation-linked bonds is the Enduring Investments imputed real yield series prior to 1997 (discussed in more detail here, but better and more realistic than other real yield research series). Here then are the breakeven inflation rates for bonds and homes.

It makes perfect sense that these should look similar. In both cases, the long bond rate plays an important role, because in both cases you are “borrowing” at the fixed rate to invest in something inflation-sensitive.

The intuition behind the relationship between the two lines makes sense as well. Prior to the administration of Ronald Wilson Reagan, the top income tax rate was 70% or above. Consequently, the value of the tax sheltering aspect of the mortgage interest made it much easier to break even on the housing investment than to invest in inflation bonds (had they existed). That’s why the red line is so much lower than the blue line, prior to 1982 (when the top marginal rate was cut to 50%) and why the lines converged further in 1986 or so (the top marginal rate dropped to 39% in 1987). The red line even moves above the blue line, indicating that it was becoming harder to break even owning a home, when the top rate dropped to 28%-31% for 1988-1992. Pretty cool, huh?

Now, this just looks at the amount of (housing) inflation of the purchase price of the home needed to break even. But the probability of realizing that level of housing inflation depends, of course, on (a) the overall level of inflation itself and (b) the level of home prices relative to some notion of fair value. This is similar to the way we look at probable equity returns: what earnings or dividends do we expect to receive (which is related to nominal economic growth), and what is the starting valuation level of equities (since we expect multiples to mean-revert over time). That brings me back to a chart that I have previously found disturbing, and that’s the relationship between median household income and median home prices. For decades, the median home price was about 3.4x median household income. Leading up to the housing bubble, that ballooned to over 5x…and we are back to about 5x now.

That’s the second part of the question, then – what is the starting valuation of housing? The answer right now is, it’s quite high. So are we in another housing bubble? To answer that, let’s compare the two pictures here. In the key chart below, the red line is the home price/income line from the chart above (and plotted on the right scale) while the blue line is the difference between the breakeven inflation for housing versus breakeven inflation in the bond market.

In 2006, the breakeven values were similar but home prices were very high, which means that you were better off taking the bird-in-the-hand of inflation bonds and not buying a home at those high prices. But today, the question is much more mixed. Yes, you are paying a high price for a home today; however, you also don’t need much inflation to break even. If home prices rise 1.5% less than general inflation, you will be indifferent between owning real estate and owning an inflation bond. Which means that, unlike in 2006-7, you aren’t betting on home prices continue to outpace inflation. It’s a closer call.

I can come up with a more quantitative answer than this, but my gut feeling is that home prices are somewhat rich, but not nearly as much so as in 2006-07, and not as rich as I had previously assumed. Moreover, while a home buyer today is clearly exposed to an increase in interest rates (which doesn’t affect the cash flow of the owner, but affects the value the home has to a future buyer), a home buyer will benefit from additional “tax shelter value” if income tax rates rise (as long as mortgage interest remains tax deductible!). And folks, I don’t know if taxes are going up, but that’s the direction I’d place my bets.

CPI Forwards Show Inflation Concerns Aren’t Ebbing

August 9, 2021 1 comment

One of the most important things I learned as a markets person was the relationship between “spot” prices and “forward” prices. A spot price is the price today, if you buy a particular investment or commodity. A forward price is the price that you agree today to pay in the future on some date for delivery of that investment/item.

To a non-markets person, this seems odd. If I want to buy a carton of milk, but the grocery store is out of milk so I tell the grocer “hold one of those cartons for me when they come in,” it wouldn’t occur to me that I should pay a different price than is on the shelf. Or, maybe, I might expect to pay whatever the price is, when the milk comes in. But I wouldn’t think that today I should arrange for a different price for that milk just because I get it in the future.

But of course, the idea of the present value of money is super important in investing. A dollar received in the future is worth less than a dollar received today. (That is, unless interest rates are negative. In that case, a dollar in the future is weirdly worth more than a dollar today, and we are in that bizarre situation I described once, in a really neat post, as ‘Wimpy’s World.’) But it isn’t just money that has a different value for future delivery than it does today. There are at least two ways that I can own a pound of gold six months from now. One is to buy a pound of gold, and pay for storage and for insurance for six months. The other is to arrange with someone today to deliver me a pound of gold in six months. In that case, I don’t have to pay for storage and insurance, so I’ll be willing to pay more for gold in the future. In commodities markets, we say that this curve is in “contango,” where futures prices are above spot prices.

The important thing to realize, though, is that all of these things converge. The spot price of gold will eventually converge to the 6-month forward price of gold…in, as it happens, about six months. If there is no change in the price of insurance and storage, every day the spread of the futures price over the spot price will decline by one day’s worth of those expenses. (n.b. – there are other parts of the carry, too; I’m abstracting here for illustration). If nothing else in the market changes, then the spot price will gradually rise towards that forward price. Here is the important bit that markets people learn: in some sense, that is not a true profit:

Buy today: $1700 plus $10 storage plus $10 insurance = $1720 cost of gold 6 months’ forward

Buy for forward delivery: $1720.

In both cases, if I sell the gold six months and one day from now at $1720, I have made zero money, even though in the first case I paid $1700 for it. But it looks like gold rallied.

I’m not really here to talk about gold. I’m here to talk about economists.

Economists don’t really internalize this well. Case in point is the question about whether inflation expectations are ‘anchored.’ An economist – in particular, a Fed economist – looks at the following chart of 2-year inflation swaps since February and says “Expectations for inflation two years in the future rose between February and May, and then have been flat-to-down since then.”

But that’s not really what happened.

Someone who bought inflation swaps in early May got something that a buyer of inflation swaps today doesn’t get. The May 15th version of inflation swaps, because of the way they work with a 3-month lookback, got half of the 0.6% March CPI print, plus the 0.8% April print, the 0.6% May print, and the 0.9% June print. The person who buys inflation swaps today doesn’t get March and April, and only half of the May uptick (plus June). Ergo, if nothing else changes we would expect the price for a 2-year inflation swap today to be lower than the price in mid-May.

As the high prints from the last few months pass into the rear view mirror (although there will be some high ones to come, I don’t really expect +0.9% m/m any time soon), the inflation swaps and breakevens markets should look softer. It’s just carry. But how much softer?

One way to find out what is really happening to inflation expectations is to look at the forwards. Let’s pretend for a minute that the CME had actually launched CPI futures a few years ago, and we had a CPI futures contract that traded in December 2023 (settling to the November CPI print that comes out that month). Over the last few months, what would have happened to the price of that futures contract? The chart below shows that it would have enjoyed a very steady rise over the last six months. The CPI futures contract settles (or anyway, it would have) to a particular price level. We would almost always expect the futures prices to be above the current NSA CPI number, which was 271.696 in June. But these prices – which I’ve calculated from an inflation swaps curve I build every day – are showing that investors have responded to these higher CPI prints by steadily raising their expectation of future prices.

If investors thought these last few months were going to be reversed in the coming months, then the forwards wouldn’t have responded in this way. Investors would be betting that the high prints would be followed by low prints that reverse the changes. However, that’s not what is happening. Investors are taking these high prints and putting them in the bank. While they might think the rise in the inflation rate is transitory, they don’t think the rise in the price level is transitory.

This is a key distinction. The inflation we are seeing, even if it later slackens, represents a permanent loss of purchasing power. How much of a permanent loss have we seen in the last couple of years? Here are my calculations of the theoretical futures curve for CPI, as of August 1st, 2019 compared to last Friday. The last column shows how much higher investors think prices will be on those dates today, compared to what they thought two years ago.

Notice that this is from well before the crisis, and so takes into account the plunge in prices from early 2020 and the recent increases. After all of the zigzags, investors expect prices to be about 5% higher in 2023 than they would have thought previously, and about 8% higher in 10 years.

And I think they’re too sanguine.

Categories: Investing, Theory Tags: , ,

Some Thoughts on Gold, Real Yields, and Inflation

February 23, 2021 6 comments

TIPS-style inflation-linked bonds (more properly known as Canadian-style) pay a fixed coupon on a principal amount that varies with the price level. In this way, the real value of the principal is protected (you always get back an amount of principal that’s indexed to the price level, floored in the case of TIPS at the original nominal value), and the real value of the coupon is protected since a constant percentage of a principal that is varying with the price level is also varying with the price level. This clever construction means that “inflation-linked” bonds can be thought of as simply bonds that pay fixed amounts in real space.

I have illustrated this in the past with a picture of a hypothetical “cake bond,” which pays in units of pastry. The coupons are all constant-sized cupcakes (although the dollar value of those cupcakes will change over time), and you get a known-sized cake at the end (although the dollar value of that cake might be a lot higher). That’s exactly what a TIPS bond is essentially accomplishing, although instead of cupcakes you get a coupon called money, which you can exchange for a cupcake. This is a useful characteristic of money, that it can be exchanged for cupcakes.

The beauty of this construction is that these real values can be discounted using real yields, and all of the usual bond mathematics work just perfectly without having to assume any particular inflation rate. So you can always find the nominal price of a TIPS bond if you know the real price…but you don’t need the nominal price or a nominal yield to calculate its real value. In real space, it’s fully specified. The only thing which changes the real price of a real bond is the real yield.

All TIPS have coupons. Many of them have quite small coupons, just like Treasuries, but they all have coupons. So in the cake bond, they’re paying very small constant cupcakes, but still a stream of cupcakes. What if, though, the coupon was zero? Then you’d simply have a promise that at some future date, you’d get a certain amount of cake (or, equivalently, enough money to buy that certain amount of cake).

Of course, it doesn’t have to be cake. It can be anything whose price over a long period of time varies more or less in line with the price level. Such as, for example, gold. Over a very long period of time, the price of gold is pretty convincingly linked to the price level, and since there is miniscule variation in the industrial demand for gold or the production of new gold in response to price – it turns out to look very much like a long-duration zero-coupon real bond.

And that, mathematically, is where we start to run into problems with a zero-coupon perpetuity, especially with yields around zero.


[If you’re not a bond geek you might want to skip this section.] The definition of Macaulay duration is the present-value-weighted average time periods to maturity. But if there is only one “payment,” and it is received “never,” then the Macaulay duration is the uncomfortable ∞. That’s not particularly helpful. Nor is the mathematical definition of Modified duration, which is Macaulay Duration / (1+r), since we have infinity in the numerator. Note to self: a TIPS’ modified duration at a very low coupon and a negative real yield can actually be longer than the Macaulay duration, and in fact in theory can be longer than the maturity of the bond. Mind blown.  Anyway, this is why the concept of ‘value’ in commodities is elusive. With no cash flows, what is present value? How do you discount corn? Yield means something different in agriculture…


This means that we are more or less stuck evaluating the empirical duration of gold, but without a real strong mathematical intuition. But what we think we know is that gold acts like a real bond (a zero coupon TIPS bond that pays in units of gold), which means that the real price of gold ought to be closely related to real yields. And, in fact, we find this to be true. The chart below relates the real price of gold versus the level of 10-year real yields since TIPS were issued in 1997. The gold price is deflated by the CPI relative to the current CPI (so that the current price is the current price, and former prices seem higher than they were in nominal space).

When we run this as a regression, we get a coefficient that suggests a 1% change in real yields produces a 16.6% change in the real price of gold (a higher yield leads to a lower gold price), with a strong r-squared of 0.82. This is consistent with our intuition that gold should act as a fairly long-duration TIPS bond. Of course, this regression only covers a period of low inflation generally; when we do the same thing for different regimes we find that the real gold price is not quite as well-behaved – after all, consider that real gold prices were very high in the early 1980s, along with real yields. If gold is a real bond, then this doesn’t make a lot of sense; it implies the real yield of gold was very low at the same time that real yields of dollars were very high.

Although perhaps that isn’t as nonsensical as it seems. For, back in 1980, inflation-linked bonds didn’t exist and it may be that gold traded at a large premium because it was one of the few ways to get protection against price level changes. Would it be so surprising in that environment for gold to trade at a very low “gold real yield” when the alternative wasn’t investible? It turns out that during the period up until 1997, the real price of gold was also positively related to the trailing inflation rate. That sounds like it makes sense, but it really doesn’t. We are already deflating the price of gold by inflation – why would a bond that is already immunized (in theory) against price level changes also respond to inflation? It shouldn’t.

And yet, that too is less nonsensical as it seems. We see a similar effect in TIPS today. Big inflation numbers shouldn’t move TIPS higher; rather, they should move nominal bonds lower. TIPS are immunized against inflation! And yet, TIPS most definitely respond when the CPI prints surprise.

(This is a type of money illusion, by which I mean that we are all trained to think in nominal space and not real space. So we think of higher inflation leading to TIPS paying out “more money”, which means they should be worth more, right? Except that the additional amount of dollars they are paying out is exactly offset by the decline in the value of the unit of payment. So inflation does nothing to the real return of TIPS. Meanwhile, your fixed payment in nominal bonds is worth less, since the unit of payment is declining in value. Although this is obviously so, this ‘error’ and others like it – e.g. Modigliani’s insistence that equity multiples should not vary with inflation since they are paying a stream of real income – have been documented for a half century.)

For now, then, we can think of gold as having a very large real duration, along with a price-level duration of roughly one (that is just saying that the concept of a real price of gold is meaningful). Which means that higher inflation is actually potentially dangerous for gold, given low current real yields, if inflation causes yields (including real yields) to rise, and also means that gold bugs should cheer along with stock market bulls for yield curve control in that circumstance. Inflation indeed makes strange bedfellows.

Summary of My Post-CPI Tweets (August 2020)

August 12, 2020 4 comments

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

  • Well, it’s CPI day and I have to tell you I’m looking forward to this one and I’ll tell you why.
  • Used cars! The Black Book retention index jumped about 9% last month after 8.5% the prior month. There’s typically a 3-month lag before it gets into CPI, but w/ a big move it’s harder to say. Each of those jumps would be worth about 0.3% on core, and we have two of them coming.

  • That being said, (a) there is still one dip we haven’t seen yet so we COULD have a dip in used cars this month. It would be surprising, but it would mean we can prep for a couple of really good numbers. So I’m excited either way.
  • And it’s not just used cars. Now that things are opening up, we’re going to see pressures in other places. Medical care started to show some ups last month and I expect that to continue as hospitals are hurting for revenue.
  • Last month we also saw strong apparel, lodging away from home, and airfares, which were rebounding from the covid-induced swoon. I think that could continue, and it’s an interesting story line to watch.
  • On the other hand – this is next month’s story but college tuitions are likely to decline this year because colleges are giving discounts. Even though the product has changed in quality (e-learning not the same as in-person), the BLS has decided it can’t quality-adjust easily.
  • So CPI for college-tuition-and-fees – again, probably next month – will fall and then rebound hard next year. So that’s fun. It’s not right, but it’s okay, as the saying goes.
  • Shelter last month, ex-hotels, was soft. That’s the only fly in the inflationary ointment, but it’s a big one. So far it doesn’t look like rents are likely to decelerate much overall, nor housing prices fall – but if they do, that’s a big deal.
  • I will be looking at core-ex-housing to see if pressures are broadening, but looking at shelter b/c it’s a big, slow item. If shelter weakens appreciably, it will be news – historically, with the last recession being an exception, housing prices and rents almost never FALL.
  • But they can slow, and with incomes sketchy housing inflation probably SHOULD slow. If it doesn’t, that’s a real sign that the rising monetary tide is raising all assets. (And goods and services). FWIW, wages also aren’t slowing. Atlanta Fed wages are +3.8% y/y.
  • (There’s interesting stuff around the disconnect between wages and the unemployment rate right now, but I’ll save that for a blog post another time. Not really a CPI-day thing.)
  • Consensus today is for 0.2% on core CPI, but a soft 0.2% with y/y falling to 1.1%. I think there’s lots of upside to that if Used Cars pops, but a little downside if shelter is weak again. I’m in the “probably higher” camp.
  • Good luck! And if you’re curious about what an inflation guy does when it’s not CPI day, stop by Enduring Investments: http://enduringinvestments.com
  • Oh, yes.
  • I don’t think we need to worry much about the rounding this month. Core +0.6% m/m; y/y to 1.6% when it was expected to drop to 1.1%.
  • FWIW, that was rounded down. +0.62% m/m on core. Repeat: rounded down. I will have to check but that is the biggest monthly figure in decades.
  • I think I soiled myself.
  • There are going to be a lot of crazy charts like this one this month. This is the last 12 core CPI prints.

  • y/y core rose from 1.19% to 1.57%, in one month. Core goods were -1.10% y/y; now they are -0.5%. Core services were 1.90%; now they’re 2.3%.
  • Take that Keynesians. WHERE’S YOUR OUTPUT GAP MODEL NOW? …but I shouldn’t celebrate. All of those degrees…and poor Nomura forecasting outright deflation…
  • Now interestingly, Used Cars and Trucks was up, 2.33% m/m, but that’s not the big jump yet. (!)

  • Lodging Away from Home, another COVID-casualty, was +1.2% m/m. Same as last month. But the y/y is still -13.26% (was -13.92%).
  • Primary rents rebounded some, +0.19% vs +0.12% last month, and OER as well +0.21% from +0.09%. Those are m/m numbers, and the y/y are still softening though: 3.12% for primary rents and 2.80% for OER, down from 3.22%/2.84%. But not collapsing.
  • OK, I said I was going to be interested in core-ex-housing. It jumped from 0.35% y/y to +1.01% y/y. Now, that’s only the highest since March but again: the deflation dragon, if not slain, is pretty sick.
  • Apparel was +1.08% m/m, but y/y is still -6.4% (was -7.2%). Like the other belly-flop categories, there’s still a lot of recovery to come.
  • So how are the doctors doing? Medical Care was +0.41% m/m, but that actually dropped the y/y slightly to 5.02% from 5.08%. However, that’s mostly because Pharma remains weak.
  • CPI for Medicinal Drugs was flat again. +0.02% this month; -0.01% last month. The y/y is down to 1.1%.

  • But Physicians’ Services up to 2.58% y/y (up 0.67% this month)

  • And hospital services hanging out at around 5% y/y. Look, like many services these are all becoming more labor-intensive and that means…more expensive. Some of that might come back, some day.

  • Totally forgot airfares: +5.4% m/m after +2.6% m/m last month. But still down a lot from the peak. Here’s the y/y figure.

  • And a quick check of the markets: 10-year breakevens +3.5bps, kinda surprised it’s not more. 5y breakevens +5bps. Some of this might just be time for price discovery. I know when I was a CPI swaps dealer, it took some time before we knew wth was the right price.
  • BTW that core increase was the biggest monthly increase since 1991. That predates TIPS by 6 years.
  • Now, college tuition and fees rose to 2.09% y/y from 1.74% y/y. That’s interesting, as that serious ought to be declining next month. And for tuitions, that’s a largeish m/m change. Interesting.
  • Let’s see. Biggest m/m declines: misc personal goods (-41.7% annualized) and meats, poultry, fish & eggs (-36.9%, but it had been up a lot too).
  • The list of gains annualizing more than 10% has 14 categories. Includes motor vehicle insurance, car/truck rental, public transportation, used cars/trucks, communication, jewelry, footwear, lodging away from home…
  • Now, those who live by Median CPI ought to also die by Median CPI. I’ll convert you all, eventually. Median this month will be something like +0.21%, because it ignores the upside long tails like it did the downside ones. y/y will actually decline to 2.56%
  • The message there is just that the underlying trends are pretty stable. But it’s not insignificant that the tails shifted to the right side from the left side. As I’ve said before, that’s sort of what infl looks like in practice, just as disinflation has one-offs to the left.
  • Health insurance y/y is a little softer, down to 18.7% y/y from 19.4%. So we got that going for us.

  • This is the distribution of y/y changes in the CPI. There’s still a big left tail anchor which is why core is below median. But this is a much more balanced distribution than it has been in a while.

  • And here’s the weight of categories going up by more than 2.5% y/y. The weight is the highest since July 2008.

  • That doesn’t look very deflationary to me.
  • Putting together the four-pieces charts and then I’ll wrap up.
  • Piece 1 – food and energy. With all of the wild swings, it’s net-net kinda boring.

  • Piece 2, core goods. This was the piece that was getting a wind behind it because of trade frictions when the crisis hit. Big bounce this month. Much of that is autos, but as I pointed out early: the BIG jump in car prices hasn’t hit the data yet.

  • Piece 3, core services less rent of shelter. Also a big recovery, and some of this is airfares. Some also is medical care. But there are a number of other categories contributing here. Still kind of trendless last 5y, overall.

  • Piece 4, the biggest and slowest piece, and looks scary. Until you remember this includes hotels (lodging away from home). If you take that out, shelter has decelerated some but not a lot, and certainly not in a disturbing way like this appears. Don’t project this!

  • OK to sum up. I saw someone call this a “noisy” report. Well, only in the sense of clanging cymbals. The data here all swung in one direction – but there really weren’t a lot of surprises, per se. The only surprise was the synchony of the surprises to one side.
  • As I said up top, we still have a couple of +0.3% boosts (maybe +0.2% if we’re ahead of mode) coming from used cars. And a lot of the beaten-down categories haven’t really recovered (apparel, etc) fully.
  • THAT’S what’s surprising. This wasn’t the left tail snapping back, much. This was a much broader advance than the decline had been. The decline had been 4 categories: lodging AFH, used cars, airfares, apparel. Way more here.
  • There are lots of bumps ahead, including the question of whether home prices and rents decelerate when and if incomes decline. We aren’t seeing that yet. And with M2 growing at 23% per year, it’s hard to believe asset prices can decline very much. Including housing.
  • The fun thing to think about is: what is happening at the Fed today? Are they clapping wildly, that they succeeded in pushing prices up? Or are they somber, wondering if they might have overdone it? Or are they focusing on median CPI and saying, meh?
  • My guess is that there’s a bit of nervousness. The Fed wants to overshoot 2%, but they don’t want to put it at 6%. I’ve said for a long time: creating inflation is easy. Creating A LITTLE inflation is hard.
  • Well, that was fun. Thanks for tuning in. I’ll put a summary on my blog relatively shortly. Again, if today’s number makes you think ‘hey, maybe we should talk to an inflation guy and see if he can help us’, stop by our website: https://enduringinvestments.com Have a nice day.

I don’t know whether to be exhausted or energized. I think I’ll go with energized, because this is not likely to be the last surprise in inflation prints. We are entering a period, not only of higher inflation (probably), but also much higher inflation volatility. That’s important, because a key underpinning of the valuation argument for stocks and bonds is that inflation is not only low, it’s low and stable and therefore can be ignored in calculations. But if inflation is volatile, and especially if it’s high and volatile, then  companies and investors need to include it in their calculus. And if the inflation factor ends up becoming significant again, after more than a decade of irrelevance, then it means that (a) stocks and bonds will become increasingly correlated and (b) stock and bond valuations will be lower.

Now, I don’t know if the markets really understand what’s going on. In fact, this number was so outside of expectations I think that investors just dismissed it as a one-off, like April’s number. But it’s not. This was not just a snapback of the depressed categories; indeed, most of the categories that were depressed because of Covid (lodging away from home, airfares, e.g.) are still depressed although they’ve rebounded a little. This was much broader than that. But investors have pushed 10-year breakevens up only 3-4bps, to 1.66%. Stocks are soaring, and 10-year nominal yields are a mere 3.5bps higher. Commodities are flat. Gold, after a bloodbath yesterday, is flat today. The only way those reactions make sense is if investors are missing the significance.

When the unemployment rate shoots higher, then you can understand a positive market reaction because investors have come to count on the Fed supporting markets in that circumstance. But that reasoning doesn’t make sense here. Nothing about a 7.2% annualized rate of inflation (0.6% * 12) would make the Fed eager to add more liquidity. Ergo, it must be that investors just don’t care about the inflation numbers, or they think this is a random miss.

They should care. This isn’t a one-standard-deviation miss; it’s the biggest monthly print in thirty years and there was no big outlier. While it doesn’t guarantee that inflation is heading higher, the question is whether this print is consistent with our a priori model of the world.

If you’re a Keynesian, the answer is absolutely not. So economists who are output-gap focused are going to say that this number doesn’t matter; it’s ‘quirky’ or ‘noisy’ or ‘measurement error’; the output gap is going to drag down inflation. Maybe that’s why investors are nonchalant about this…because they’re being told by the bow-tie set to look through it.

But if you’re a monetarist, this is entirely consistent with your a priori model. The only surprising thing about this is that it is happening so soon. I was thinking we would see inflation rise starting in Q4 and it would get messy in 2021. I might have to move up the timetable. Because this number is entirely consistent with my model, I’m much less sanguine. This might be only the first shot over the bow… Indeed, over the next several months I can say that since we are confident that used car prices are going to add a lot to core inflation, we will probably have at least one or two more prints of 0.4%-0.5% on core over the next three months. If we get 0.4%, 0.2%, 0.4%, then in three months core CPI will be back to 2.25% y/y, and that with unemployment still in the high-single or low-double-digits. And it could actually be worse than that. Without home prices collapsing, it’s hard to see it being much better than that and absolutely no way to see how prices (or even the inflation rate) could be lower than that unless something really, really weird happens.

Well, 2020 is the year of really, really weird so I suppose I will never say never. But inflation hedges remain super cheap; if you’ve been waiting to scoop them up I can’t see any argument for waiting any more.

Low Real Yields – You Can’t Avoid Them

July 29, 2020 7 comments

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.

Trust Masters, not Models

June 25, 2020 4 comments

Normally, when I write about markets, I try to point at models but there is a lot of guesswork and gut-work in analysis. When times are sort of normal, then models can be a big part of what drives your thinking. But times have not been ‘normal’ for a very long time, and this is part of what drives big policy errors (and big forecasting errors): if you are out of the ‘normal’ range, then to make a forecast or comment usefully on what is going on you need to have a good feel for what the model is actually trying to capture. You need to know where the model goes wrong.

When I was a rates options trader – stop me if I’ve told this story before – I found that I preferred to use a simple Black-Scholes pricing model instead of some fancy recombining-trinomial-tree-with-heteroskedastic-volatility-model. That was because even though Black Scholes doesn’t match up super well with reality, I at least had a good feel for where it fell short. For example, the whole reason we have a volatility smile is because real-world returns have fat tails, but pricing models like Black Scholes are based on the normal distribution. When the smile flattens, it means returns are becoming more like they’re being drawn from a normal distribution; when it steepens it means that the tails are becoming fatter. So that’s easy to understand.

If you understand why an option model works, then it’s easier to think about how to price something esoteric like an option on an inflation swap (which can trade at a negative rate, but actually isn’t a rates product at all but rather is a way of trading a forward price), and not mess it up. But if you just apply and try to calibrate a bad model – especially if it’s really complicated – then you get potentially really bad outcomes. And that is, of course, exactly where we are today.

We haven’t been ‘normal’, I guess, for a couple of decades. Central banks, and in particular the Federal Reserve, have dealt in the markets with a heavier and heavier hand. Nowadays, the Fed not only has expanded its balance sheet by trillions in a very short period of time, but it has expanded the range of markets it is involved in from Treasuries to mortgages to ETFs and now individual corporate bonds. And, since the whole point of this is because the Fed wants to make sure the stock market stays elevated (they are preternaturally terrified at the notion of a wealth effect from a market crash, even though historically the wealth effect has been surprisingly small) I suspect it is only a matter of time before they directly intervene in equity markets.[1] C’est la vie. There is no normal any more.

But at least the ‘normal’ we have had over the last decade was just modestly outside of the prior normal. Things didn’t work right according to the ‘traditional’ way of thinking about things; momentum became ascendant in a way we’ve never seen before and value almost irrelevant. We are now, though, working on a whole different part of the number line. This means that economists will continue to be surprised at almost everything they see, and it means that any model you look at needs to be informed by a good intuition about how the hell it works.

So, for example, let’s consider the money supply. Over the last 13 weeks, M2 is up at a 63% annualized rate. With two weeks left in the quarter, it looks like we will end up with something like a 10.25%-10.50% growth in the money supply for the quarter. The Q2 average money supply, compared to Q1 (important in looking at the MV=PQ equation), is going to be about 13.85% higher. That’s not annualized! Remember, the old record in M2 growth for a year was a bit above 13%, in 1976.

The current NY Fed Nowcast for 2nd Quarter GDP – keeping in mind that no one has any idea, this is as good a guess as any – is -19.03%. I really like the .03 part. That’s sporty. That would mean q/q growth of -4.75%.

If we want the price deflator to come in around 1.75% (+0.44% q/q), which is where it was for the year ended in Q1, then that means money velocity needs to fall about 16% for the quarter. (1-4.75%)*(1+0.44%)/(1+13.85%)-1 = -15.97%. If money velocity falls less, and that GDP estimate is correct, then inflation comes in higher. If money velocity falls more, then inflation comes in lower. If GDP growth is actually better than -19% annualized, then inflation is lower; if GDP is worse, then inflation is higher. We don’t need to worry much about the M2 numbers themselves, as they’re almost baked in the cake at this point.

The biggest amount that money velocity has ever fallen q/q is about 5%. But clearly, these are different times! We’ve also never seen a 19% decline in growth.

Weirdly, our model has M2 money velocity for Q2 at 1.159, which would be a 15.6% decline in money velocity. Let me stress that that is a total coincidence, and I put almost zero weight on that point estimate. Contributing to that sharp decline, in our model, is the small decline in interest rates from Q1, the increase in the non-M1 part of M2, the small increase in global negative-yielding debt, and (most importantly) a large increase in precautionary demand for cash balances due to economic uncertainty. (This is why it’s hard to get velocity to stay down at this level. The current low levels depend on low interest rates, which will probably persist, but also on dramatic precautionary savings, which are unlikely to). Small changes in money velocity will have big effects on inflation: if our model estimate for velocity was right, we’d see annualized inflation for Q2 at 4.3% or so. Here’s how confident I am in our model: for Q3, it is seeing unchanged velocity (approximately), which with money trends and the GDP Nowcast figures from the NY Fed would imply that y/y inflation would rise to 6.22%, about 17.5% annualized for the quarter. Not going to happen.

Here’s where knowing a bit about the underlying process and assumptions really matters. Velocity is effectively a plug number, in that bureaucrats are good at measuring money and pretty good at measuring GDP and prices, but really bad at measuring velocity directly. So velocity is solved for. And our model (along with every other model, probably) treats the response of money velocity to the input variables as more or less instantaneous. For small changes in these variables – movements in money growth from 4% to 6%, or GDP from 2% to 0% – the assumption about instantaneity is pretty irrelevant. The economy adjusts prices easily to small changes in conditions. But that’s not true at all for big changes. On the available evidence, many prices (if not most) accelerated a bit in Q2, which surprised almost everyone including us. But no matter what the model says, prices are not going to drop 5% in a quarter, or rise 5% in a quarter, for the entire consumption basket. Price changes take time – heck, rents don’t change every month, and it takes time to rotate through the sample. Also, manufacturers don’t tend to make large changes in prices overnight, preferring to drip it in and see consumer response. But here’s the point: the model doesn’t know this. So I suspect we will see money velocity this quarter around 1.14-1.17…not because I believe our model but because I think prices will accelerate by a little bit and I think the real uncertainty surrounds the forecast of GDP. Over time, velocity and inflation will converge with our model, but it will take time.

For what it’s worth, I think that GDP growth will be a little lower than the NY Fed thinks, for a different model reason: the model assumes that changes in various economic data can be mapped to changes in GDP. But that assumes a fairly stable price level…what they’re really mapping this data onto is the nominal price level, and assuming that the price level doesn’t change enough to matter. So I think some of the dollar improvement in durable goods sales, for example, reflects rising prices and not growth, which would be manifested in a slightly lower GDP change and a slightly higher GDP deflator change.

What does this mean and why does it matter?

For one thing…and you already knew this…models are currently trash. They mean almost nothing by themselves. You should ignore it all. I give very little credence to the NY Fed’s forecast. I am pretty sure Q2 GDP growth will have a minus sign, but I couldn’t tell you between -15% and -25% and neither can they. Which is why the -19 POINT OH-THREE is so sporty. But by the same token, you should listen more to the model-builder, and to people who understand what’s going on behind the models, and to people who are taking measurements directly rather than taking them from models. Because this is going back to the art of forecasting, and away from the science. We are over-quanted in this world, and we are over-committed to models, and we are overconfident in models, and we are over-reliant on models. They have a place, just as the autopilot has a place when conditions are placid. When things get rough, you want a real pilot holding the controls.[2]

There used to be a couple of guys in Boston who were auto mechanics and had a radio show. People would call up and describe the noises their cars made, and the guys would ask whether it made the noise only turning left, or both directions, and whether it got worse when it was humid, and other things that sounded crazy to you and me. And then they would diagnose the problem, sight-unseen. Those are the people you want to take your car to. They’re the ones who understand how it really works, and they don’t need to hook your car up to a computer to tell you what the problem is. I took my car to them, and they really were geniuses at it. So look for those people in market space: the ones who can tell by the sound of the squeal what is really going on under the hood. They won’t always be right, but they will have the best guesses…especially when something unusual happens.


[1] Ironically, I think that something else they are considering would have a much bigger effect on equity markets than if they directly bought equities, but I don’t want to talk about that in this space because it also has big implications for inflation-related markets and would create some really delicious relative value trades that I don’t want to discuss here.

[2] Although I didn’t think I’d remark on this in today’s comment: this is also why the Trump Administration’s move today to loosen the Volcker Rule to let banks take more risks with their capital is very timely. There is a lot of bumpy flight ahead of us and we should want seasoned traders making the markets with actual capital behind them, not robots looking to scalp an eighth.

Categories: Analogy, Investing, Trading

The Flip Side of Financialization of Commodities

Recently, a paper by Ilia Bouchouev (“From risk bearing to propheteering”) was published that had some very thought-provoking analysis. The paper traced the development of the use of futures and concluded that while futures markets in the past (specifically, he was considering energy markets but notes the idea started with agricultural commodities) tended towards backwardation – in which contracts for distant delivery dates trade at lower prices than those for nearer delivery dates – this is no longer as true. While others have noticed that futures markets do not seem to provide as much ‘roll return’ as in the past, Mr. Bouchouev suggested that this is not a random occurrence but rather a consequence of financialization. (My discussion of his fairly brief paper will not really do it justice – so go and read the original from the Journal of Quantitative Finance here).

Let me first take a step backward and explain why commodities markets tend towards backwardation, at least in theory. The idea is that a producer of a commodity, such as a farmer growing corn, has an affirmative need to hedge his future production to ensure that his realized product price adequately compensates him for producing the commodity in the first place. If it costs a farmer $3 per bushel to grow corn, and he expects to sell it for $5 per bushel, then he will plant a crop. But if prices subsequently fall to $2 per bushel, he has lost money. Accordingly, it behooves him when planting to hedge against a decline in corn prices by selling futures, locking in his margin. The farmer is willing to do this at a price that is lower than his true expectation, and possibly lower than the current spot price (although, technical note: Keynes’ ‘Theory of Normal Backwardation’ refers to the difference between his expected forward price and the price at which he is willing to sell futures, so that futures prices are expected to be downwardly biased forecasts of prices in the future, and not that they are expected to be actually lower than spot ‘normally’). He is willing to do this in order to induce speculators to take the other side of the trade; they will do so because they expect, on average, to realize a gain by buying futures and selling in the future spot market at a higher price.

Unfortunately, no one has ever been able to convincingly prove normal backwardation for individual commodities, because there is no way to get into the collective mind of market participants to know what they really expect the spot price to be in the future. Some evidence has been found (Till 2000) that a risk premium may exist for difficult-to-store commodities (agricultural commodities, for example), where we may expect producers to be the most interested in locking in an appropriate profit, but on the whole the evidence has been somewhat weak that futures are biased estimators of forward prices. In my view, that’s at least partly because the consumer of the product (say, Nabisco) also has a reason to hedge their future purchases of the good, so it isn’t a one-sided affair. That being said, owners of long futures positions have several other sources of return that are significant and persistent,[1] and so commodity futures indices over a long period of time have had returns and risks that are similar to those found in equity indices but deriving from very different sources. As a consequence, since the mid-2000s institutional investment into commodity indices has been significant compared to the prior level of interest, even as actual commodity returns have disappointed over the last 5-10 years. Which brings us back to Mr. Bouchouev’s story again.

He makes the provocative point that part of the reason commodity returns have been poorer in recent years is because markets have tended more toward contango (higher prices for distant contracts than for those nearer to expiry) than backwardation, and moreover that that is a consequence of the arrival of these institutional investors – the ‘financialization’ of commodities futures markets, in other words. After all, if Keynes was right and the tendency of anxious producers to be more aggressive than patient speculators caused futures to be downwardly biased, then it stands to reason that introducing more price-insensitive, institutional long-only buyers into the equation might tilt that scale in the other direction. His argument is appealing, and I think he may be right although as I said, commodities are still an important asset class – it’s just that the sources of returns has changed over time. (Right now, for what it’s worth, I think the potential return to spot commodities themselves, which are ordinarily a negative, are presently a strong positive given how badly beaten-down they have become over time).

All of that prelude, though, is to point out a wonderful corollary. If it is the case that futures prices are no longer biased lower by as much as they once were, then it means that hedgers are now getting the benefit of markets where they don’t have to surrender as much expectation to hedge. That is, where an oil producer might in the past have had to commit to selling next year’s oil $1 lower than where he expected to be able to sell it if he took the risk and waited, he may now be able to sell it $1 higher thanks to those institutions who are buying long-only indices.

And that, in turn, will likely lead to futures curves being extended further into the future (or, equivalently, the effective liquidity for existing markets will be extended further out). For example, over the last decade there have been several new commodities indices that systematically buy further out the curve to reduce the cost of contango. In doing so, they’re pushing the contango further out, and also providing bids for hedgers to be able to better sell against. So Mr. Bouchouev’s story is a good one, and for those of us who care about the financial markets liquidity ecosystem it’s a beautiful one. Because it isn’t the end of the story. Chapter 1 was producers, putting curves into backwardation to provide an inducement to draw out speculators to be the other side of the hedge. Chapter 2 is Bouchouev’s tale, in which financial buyers push futures markets towards contango, which in turn provides an inducement to draw out speculators on the other side, or for hedgers to hedge more of their production. In Chapter 3, also according to Bouchouev, the market balances with hedgers reacting to economic uncertainty, and speculators fill in the gaps. Of course, in Chapter 4 the Fed comes in and wrecks the market altogether… but let’s enjoy this while we can.


[1] …and beyond the scope of this article. Interested parties may refer to History of Commodities as the Original Real Return Asset Class, by Michael Ashton and Bob Greer, which is Chapter 4 in Inflation Risks and Products, 2008, by Incisive Media. You can contact me for a copy if you are unable to find it.

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