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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.

Inflation Shocks, Inflation Vol Shocks, and 60-40 Returns

Not surprisingly, there has been a lot of debate about the ultimate outcome of the current crisis in terms of causing inflation or disinflation, or even deflation. It is also not surprising that the Keynesians who believe that growth causes inflation have come down heavily on the side of deflation, at least in the initial phase of the crisis. Some nuanced Keynesians wonder about whether there will be a more-lasting supply shock against which the demand-replacement of copious governmental programs will force higher prices. And monetarists almost all see higher inflation after the initial velocity shock fades or at least levels out.

What is somewhat amazing is that there is still so much debate about whether investments in inflation-related markets and securities, such as TIPS and commodities (not just gold), make sense in this environment. A point I find myself making repeatedly is that given where inflation-sensitive markets are priced (inflation swaps price in 1% core inflation for the next 7 years, and commodities markets in many cases are near all-time lows), the potential results are so asymmetrical – heads I win, tails I don’t lose much – that it’s almost malpractice to not include these things in a portfolio. And it’s just crazy that there’s any debate about that. The chart below shows the trailing 10-year annualized real return for various asset classes, as a function of the standard deviation of annuitized real income.[1]

Most of the markets fall along a normal-looking curve in which riskier markets have provided greater returns over time. No guarantee of course – while expectations for future returns ought to be upward-sloping like this, ex post returns need not be – and we can see that from the extreme deviations of EAFE and EM stocks (but not bonds!) and, especially, commodities. Wow! So if you’re just a reversion-to-the-mean kind of person, you know where you ought to be.

Now, that’s true even if we completely ignore the state of play of inflation itself, and of the distribution of inflation risks. Let’s talk first about those risks.  One of the characteristics of the distribution of inflation is that it is asymmetric, with long tails to the upside and fairly truncated tails to the downside. The chart below illustrates this phenomenon with rolling 1-year inflation rates since 1934. Just about two-thirds of outcomes in the US were between 0% and 4% (63% of total observations). Of the remaining 37%, 30% was higher inflation and 7% was deflation…and the tails to the high side were very long.

This phenomenon should manifest in pricing for inflation-linked assets that’s a little higher than implied by a risk-neutral expectation of inflation. That is, if people think that 2% inflation is the most likely outcome, we would expect to see these assets priced for, say, 2.5% because the miss on the high side is potentially a lot worse than a miss on the low side. This makes the current level of pricing of inflation breakevens from TIPS even more remarkable: we are pricing in 1% for the better part of a decade, and so the market is essentially saying there is absolutely no chance of that long upward tail. Or, said another way, if you really think we’ll average 1% inflation for the next decade, you get that tail risk for free.

Finally, there’s the really amazing issue of how traditional asset classes perform with even modest inflation acceleration. Consider the performance of the classic “60-40” mix (60% stocks, 40% bonds) when inflation is stable, compared to when it rises just a little bit. The following table is based on annual data from NYU’s Aswath Damodaran found here.

Note that these are not real returns, which we would expect to be worse when inflation is higher; they are nominal returns. 60-40 is with S&P 500, dividends reinvested and using Baa corporate bonds for the bond component. And they’re not based on the level of inflation. I’ve made the point here many times that equities simply do poorly when inflation is high, and moreover 60-40 correlations tend to be positive (on this latter point see here). But even I was surprised to see the massive performance difference if inflation accelerates even modestly. Regardless of how you see this crisis playing out, these are all important considerations for portfolio construction while there is, and indeed because there is, considerable debate about the path for inflation. Because once there is agreement, these assets won’t be this cheap any more.


[1] Credit Rob Arnott for an observation, more than a decade ago, that an inflation-adjusted annuity for a horizon is the true riskless asset against which returns over that horizon should be measured. The x-axis here is the volatility of the return stream compared with such a (hypothetical) annuity. This is important because it illustrates that TIPS, for example, are lots less volatile in real space – the one we care about – than are Treasuries.

Categories: Investing, Stock Market, TIPS

The Big Bet of 10-year Breakevens at 0.94%

March 11, 2020 6 comments

It is rare for me to write two articles in one day, but one of them was the normal monthly CPI serial and this one is just really important!

I have been tweeting constantly, and telling all of our investors, and anyone else who will listen, that TIPS are being priced at levels that are, to use a technical term, kooky. With current median inflation around 2.9%, 10-year breakevens are being priced at 0.94%. That represents a real yield of about -0.23% for 10-year TIPS, and a nominal yield of about 0.71% for 10-year Treasuries. The difference in these two yields is 0.94%, and is approximately equal to the level of inflation at which you are indifferent to owning an inflation-linked bond and a nominal bond, if you are risk-neutral.

First, a reminder about how TIPS work. (This explanation will be somewhat simplified to abstract from interpolation methods, etc). TIPS, the U.S. Treasury’s version of inflation-linked bonds, are based on what is often called the Canadian model. A TIPS bond has a stated coupon rate, which does not change over the life of the bond and is paid semiannually. However, the principal amount on which the coupon is paid changes over time, so that the stated coupon rate is paid on a different principal amount each period. The bond’s final redemption amount is the greater of the original par amount or the inflation-adjusted principal amount.

Specifically, the principal amount changes each period based on the change in the Consumer Price All Urban Non-Seasonally Adjusted Index (CPURNSA), which is released monthly as part of the Bureau of Labor Statistics’ CPI report. The current principal value of a TIPS bond is equal to the original principal times the Index Ratio for the settlement date; the Index Ratio is the CPI index that applies to the coupon date divided by the CPI index that applied to the issue date.

To illustrate how TIPS work, consider the example of a bond in its final pay period. Suppose that when it was originally issued, the reference CPI for the bond’s dated date (that is, its Base CPI) was 158.43548. The reference CPI for its maturity date, it turns out, is 201.35500. The bond pays a stated 3.375% coupon. The two components to the final payment are as follows:

(1)          Coupon Payment = Rate * DayCount * Stated Par * Index Ratio

= 3.375% * ½ * $1000 * (201.35500/158.43548)

= $21.45

(2)          Principal Redemption = Stated Par * max [1, Index Ratio]

= $1000 * (201.35500/158.43548)

= $1,270.90

Notice that it is fairly easy to see how the construction of TIPS protects the real return of the asset. The Index Ratio of 201.35500/158.43548, or 1.27090, means that since this bond was issued, the total rise in the CPURNSA – that is, the aggregate rise in the price level – has been 27.09%. The coupon received has risen from 3.375% to an effective 4.2892%, a rise of 27.09%, and the bondholder has received a redemption of principal that is 27.09% higher than the original investment. In short, the investment produced a return stream that adjusted upwards (and downwards) with inflation, and then redeemed an amount of money that has the same purchasing power as the original investment. Clearly, this represents a real return very close to the original “real” coupon of 3.375%.

Now, there is an added bonus to the way TIPS are structured, and this is important to know at times when the market is starting to act like it is worried about deflation. No matter what happens to the price level, the bond will never pay back less than the original principal. So, in the example above the principal redemption was $1,270.90 for a bond issued at $1,000. But even if the price level was now 101.355, instead of 201.355, the bond would still pay $1,000 at maturity (plus coupon), even though prices have fallen since issuance. That’s why there is a “max[ ]” operator in the formula in (2) above.

So, back to our story.

If actual inflation comes in above the breakeven rate, then TIPS outperform nominals over the holding period. If actual inflation comes in below the breakeven rate, then TIPS underperform over the holding period. But, because of the floor, there is a limit to how much TIPS can underperform relative to nominals. However, there is no limit to how much TIPS can outperform nominals. This is illustrated below. For illustration, I’ve made the x-axis run from -4% compounded deflation over 10 years to 13% compounded inflation over 10 years. The IRR line for the nominal Treasury bond is obviously flat…it’s a fixed-rate bond. The IRR line for the TIPS bond looks like a call option struck near 0% inflation.

Note that, no matter how far I extend the x-axis to the left…no matter how much deflation we get…you will never beat TIPS by more than about 1% annualized. Never. On the other hand, if we get 3% inflation then you’ll lose by 2% per year. And it gets worse from there.

Because annualizing the effect makes this seem less dramatic, let’s look instead at the aggregate total return of TIPS and Treasuries. For simplicity, I’ve assumed that coupons are reinvested at the current yield to maturity of the 10-year note, which would obviously not be true at high levels of inflation but is in fact the simplifying assumption that the bond yield-to-maturity calculation makes.

So, if you own TIPS in a deflationary environment, you’ll underperform by about 10% over the next decade. Treasuries will return 7.3% nominal; TIPS will return -2.3% nominal. Unfortunate, but not disastrous. But if inflation is 8%, then your return on Treasuries will still be 7.3%, but TIPS will return 103%. Hmmm. Yay, your 10-year nominal Treasuries paid you back, plus 7.3% on top of that. But that $1073 is now worth…$497. Booo.

So the point here is that at these prices you should probably own TIPS even if you think we’re going to have deflation, unless you are really confident that you’re right. You are making a much bigger bet than you think you’re making.

What’s Bad About the Fed Put…and Does Powell Have One?

January 8, 2019 3 comments

Note: Come hear me speak this month at the Taft-Hartley Benefits Summit in Las Vegas January 20-22, 2019. I will be speaking about “Pairing Liability Driven Investing (LDI) and Risk Management Techniques – How to Control Risk.” If you come to the event I’ll buy you a drink. As far as you know.

And now on with our irregularly-scheduled program.


Have we re-set the “Fed put”?

The idea that the Fed is effectively underwriting the level of financial markets is one that originated with Greenspan and which has done enormous damage to markets since the notion first appeared in the late 1990s. Let’s review some history:

The original legislative mandate of the Fed (in 1913) was to “furnish an elastic currency,” and subsequent amendment (most notably in 1977) directed the Federal Open Market Committee to “maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” By directing that the Federal Reserve focus on monetary and credit aggregates, Congress clearly put the operation of monetary policy a step removed from the unhealthy manipulation of market prices.

The Trading Desk at the Federal Reserve Bank of New York conducts open market operations to make temporary as well as permanent additions to and subtractions from these aggregates by repoing, reversing, purchasing, or selling Treasury bonds, notes, and bills, but the price of these purchases has always been of secondary importance (at best) to the quantity, since the purpose is to make minor adjustments in the aggregates.

This operating procedure changed dramatically in the global financial crisis as the Fed made direct purchase of illiquid securities (notably in the case of the Bear Stearns bankruptcy) as well as intervening in other markets to set the price at a level other than the one the free market would have determined. But many observers forget that the original course change happened in the 1990s, when Alan Greenspan was Chairman of the FOMC. Throughout his tenure, Chairman Greenspan expressed opinions and evinced concern about the level of various markets, notably the stock market, and argued that the Fed’s interest in such matters was reasonable since the “wealth effect” impacted economic growth and inflation indirectly. Although he most-famously questioned whether the market was too high and possibly “irrationally exuberant” in 1996, the Greenspan Fed intervened on several occasions in a manner designed to arrest stock market declines. As a direct result of these interventions, investors became convinced that the Federal Reserve would not allow stock prices to decline significantly, a conviction that became known among investors as the “Greenspan Put.”

As with any interference in the price system, the Greenspan Put caused misallocation of resources as market prices did not truly reflect the price at which a willing buyer and a willing seller would exchange ownership of equity risks, since both buyer and seller assumed that the Federal Reserve was underwriting some of those risks. In my first (not very good) book Maestro, My Ass!, I included this chart illustrating one way to think about the inefficiencies created:

The “S” curve is essentially an efficient frontier of portfolios that offer the best returns for a given level of risk. The “D” curves are the portfolio preference curves; they are convex upwards because investors are risk-averse and require ever-increasing amounts of return to assume an extra quantum of risk. The D curve describes all portfolios where the investor is equally satisfied – all higher curves are of course preferred, because the investor would get a higher return for a given level of risk. Ordinarily, this investor would hold the portfolio at E, which is the highest curve he/she can achieve given his/her preferences. The investor would not hold portfolio Q, because that portfolio has more risk than the investor is willing to take for the level of expected return offered, and he/she can achieve a ‘better’ portfolio (higher curve) at E.

But suppose now that the Fed limits the downside risk of markets by providing a ‘put’ which effectively caps the risk at X. Then, this investor will in fact choose portfolio Q, because portfolio Q offers higher return at a similar risk to portfolio E. So the investor ends up owning more risky securities (or what would be risky securities in the absence of the Fed put) than he/she otherwise would, and fewer less-risky securities. More stocks, and fewer bonds, which raises the equilibrium level of equity prices until, essentially, the curve is flat beyond E because at any increment in return, for the same risk, an investor would slide to the right.

So what happened? The chart below shows a simple measure of expected equity real returns which incorporates mean reversion to long-term historical earnings multiples, compared to TIPS real yields (prior to 1997, we use Enduring Investments’ real yield series, which I write about here). Prior to 1987 (when Greenspan took office, and began to promulgate the idea that the Fed would always ride to the rescue), the median spread between equity expected returns and long-term real yields was about 3.38%. That’s not a bad estimate of the equity risk premium, and is pretty close to what theorists think equities ought to offer over time. Since 1997, however – and here it’s especially important to use median since we’ve had multiple booms and busts – the median is essentially zero. That is, the capital market line averages “flat.”

If this makes investors happy (because they’re on a higher indifference curve), then what’s the harm? Well, this put (a free put struck at “X”) is not costless even though the Fed is providing it for free. If the Fed could provide this without any negative consequences, then by all means they ought to because they can make everyone happier for free. But there is, of course, a cost to manipulating free markets (Socialists, take note). In this case the cost appears in misallocation of resources, as companies can finance themselves with overvalued equity…which leads to booms and busts, and the ultimate bearer of this cost is – as it always is – the citizenry.

In my mind, one of the major benefits that Chairman Powell brought to the Chairmanship of the Federal Reserve was that, since he is not an economist by training, he treated economic projections with healthy and reasonable skepticism rather than with the religious faith and conviction of previous Fed Chairs. I was a big fan of Powell (and I haven’t been a big fan of many Chairpersons) because I thought there was a decent chance that he would take the more reasonable position that the Fed should be as neutral as possible and do as little as possible, since after all it turns out that we collectively suck when it comes to our understanding of how the economy works and we are unlikely to improve in most cases on the free market outcome. When stocks started to show some volatility and begin to reprice late last year, his calculated insouciance was absolutely the right attitude – “what Fed put?” he seemed to be saying. Unfortunately, the cost of letting the market re-adjust is to let it fall a significant amount so that there is again an upward slope between E and Q, and moreover let it stay there.

The jury is out on whether Powell does in fact have a price level in mind, or if he merely has a level of volatility in mind – letting the market re-adjust in a calm and gentle way may be acceptable to him, with his desire to intervene only being triggered by a need to calm things rather than to re-inflate prices. I’m hopeful that is the case, and that on Friday he was just trying to slow the descent but not to arrest it. My concern is that while Powell is not an economist, he did have a long career in investment banking, private equity, and venture capital. That might mean that he respects the importance of free markets, but it also might mean that he tends to exaggerate the importance of high valuations. Again, I’m hopeful, and optimistic, on this point. But that translates to being less optimistic on equity prices, until something like the historical risk premium has been restored.

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