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What Happens if CPI Isn’t Released?

September 27, 2023 Leave a comment

One thing I’ve stopped worrying very much about is a government shutdown. It could even be a good thing, given the bloated deficit, except for the fact that the government basically keeps spending anyway. The federal government employs about 4.5mm workers, and no more than 800k have every been furloughed – moreover, many of those furloughed workers often receive back pay. Social Security gets paid, Treasuries get paid, and the wheel keeps turning. That’s not a guarantee, of course – it’s possible that an extended shutdown could cause Treasuries interest to not be paid, but we all know that before that happens, the Fed would just print the money and make sure the checks go out. At worst, there could be a one-day technical default, if important people had given the heads-up to insiders to get really long CDS.

But my cynicism is getting the better of me so let’s turn to what could happen in a shutdown that impacts the inflation markets: in the past, some data releases of federal agencies have been delayed (or their quality impacted), and if the delay was long enough then it could affect TIPS. Lots of people are asking about this, so I thought I’d lay out what would happen and how.

First of all, the quality of the CPI data could potentially be impacted. That has happened in the past, because data collection agents are not ‘essential workers’ so if the government shuts down, a lot of the data collection stops. This is less of a problem than it has been in the past, though, because a lot more of the data is collected electronically than in the past. For example, the new cars sample is no longer collected by hand but is sourced from J.D. Power. Prescription drugs data is partly supplied by one large firm that didn’t want to allow data collectors to collect data in store. A similar story applies to apparel. Many of these ‘big data’ changes are discussed in this BLS white paper, but the point is that these changes also mean that the quality of the data won’t be impacted as much as would be the case if data collection was entirely done by hand as it once was.

The bigger potential problem is that the CPI report could be delayed.[1] The NSA CPI is used almost exclusively as the index in inflation swaps, and is the index that determines escalation of TIPS principals. Other subindices are used in contract arrangements (for example, in long-term airplane purchase contracts), but those applications are generally less urgent.

If the BLS is unable to release the CPI on October 12th, what happens? The first thing to know is that the September CPI (which is what is released in October) is only relevant to swap payments and TIPS accruals in November and December. For each day in November, the inflation index is interpolated between the August and September prints; for each day in December, the inflation index is interpolated between the September and October prints. Ergo, missing the September print would make it impossible to settle inflation swaps payments – but more importantly, every TIPS trade that settles in November or December would be impossible to settle because the invoice price couldn’t be calculated.

Fortunately, the Treasury thought about that a very long time ago. Title 31 of the Code of Federal Regulations (CFR) spells out what would happen if the BLS didn’t report a CPI by the end of October (it also spells out what happens if the BLS makes a large change to the CPI, or stops calculating it). In a nutshell, the Treasury would use the August CPI index, inflated by the decompounded year-over-year inflation rate from August 2022-August 2023:

I’ll do the math for you. If the CPI isn’t released, the figure for September will be 307.94834, which is +0.3004% on the month. While that sounds very convenient, since economists are forecasting a +0.3% m/m change for this data point, remember that the economists’ +0.3% is seasonally adjusted while the +0.3004% change is NSA. The difference is that 0.3004% NSA is about 0.50% SA this month.

Naturally, this wouldn’t matter very much in the long run; once the October CPI was released at the proper level the artificial change from Sep-Oct would wash out the artificial change for Aug-Sep.

Except, that is, for one pain-in-the-ass way, and that is the second part of the code snippet shown above: the Treasury would never adjust the official number back to match the BLS back-dated release of September CPI. Forever after, if you ran the sequence of monthly Treasury CPI Index numbers and the BLS CPI numbers, they would be exactly the same except for the one data point. The economic significance of that approaches zero, but the Inflation-Guy-Irritation figure on that approaches infinity.

So let’s hope cooler heads prevail.


[1] How likely is this? Kalshi has a market for this as well as markets on the probability of a government shutdown and the length of a government shutdown. As of this writing, Kalshi traders are saying there is an 18% chance that the CPI data will not be released in October.

Season(al)’s Greetings

As we move into 2023, one of my New Year’s resolutions is to write more frequently on the blog and post podcasts more frequently. I have a list of topics that is certainly long enough. When I was writing commentary for Bankers Trust, and for Barclays, and for Natixis, I wrote every day and somehow I never ran out of words…

Sometimes, as with today’s article, I am going to refer to pictures and observations that I have previously made on the private/subscription Twitter channel. You can subscribe to the Private Twitter feed at https://inflationguy.blog/shop/ . Not only that, but as of January 2023 I have marked the price down from $99 to only $69, which is a 30% nominal decline in the subscription price – and a 35% or so real decline. (Those of you who subscribed at the $99 price unfortunately will have to cancel and re-subscribe to get the lower price because there’s no way for me to edit a recurring subscription’s price, which annoys me as much as it annoys you but I suppose it’s to keep unscrupulous sellers from raising the price without your permission).

Today I want to present some oldie-but-goodie charts that I developed years ago to look at the seasonality of inflation breakevens. In updating the charts, what was amazing is that…the seasonality hasn’t changed much. Fairly consistently, breakevens rise in the early part of the year, and then decline from May to October. It’s not a guarantee,[1] but it is a pretty consistent tendency. The chart below shows, in black, the percentage of the time (1999-2021, so 22 years of history) in which 10-year breakevens increased in the 60 days following that date. So, on January 3rd, the number was about 70% which means that in 70% of those years, breakevens were higher 60 days after January 3rd than on January 3rd. The average increase (including years in which it decreased) is in red, and shows about 10bps on average. That doesn’t sound like much, but it’s an average of over 22 years. Buying breakevens early in the year is typically a good idea.

The next chart steps back and shows the average for the full year, properly de-trending the data so that any drift over time falls out (since breakevens have gone basically nowhere for a quarter-century, this doesn’t do much but it’s the right way). So, breakevens start the year below the level that will subsequently be the average, and by May they’re well above that level. Ergo, it has historically been good to be long into the first part of May. And then I guess you sell in May and go away, to coin a phrase.

None of this is guaranteed, as I said, but seasonal patterns which are consistent are valuable tools. The way I look at seasonals is that I want to see a move of some decent economic value, but mainly I want to see the consistency. And personally I won’t do a trade just to take advantage of the seasonal trend, but if I want to sell and the market shows a strong tendency to rally then I might consider “flat” the same as selling in that environment. Conversely, a market which has a strong tendency to rally when I want to buy is likely to make me be more aggressive getting in rather than trying to steal a tick on the bid/offer by hanging out on the bid. If you’re bearish on breakevens, then I don’t think you should be a buyer just because it’s a good time of the year to buy. But between the low level of breakevens, and the seasonal trend itself…I would be cautious about being aggressively short.


[1] …and some of it is an artifact: in the early part of the year, a breakeven buyer often has negative carry from bad inflation prints in November and December; as that carry passes, breakevens rise. But this only explains part of the early-season seasonality, not the whole thing.

Categories: TIPS, Trading Tags: ,

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.

Fair is Fair, and TIPS are There (Almost)

September 30, 2022 6 comments

For a very long time, I have been writing in our Quarterly Inflation Outlook that TIPS were “relatively cheap, but absolutely expensive.” By that I meant that TIPS real yields at -1%, -2%, etc were not exciting (implying as they did that a buyer would have long-term real wealth destruction), but that compared with nominal Treasury yields of 1%, 1.5%, or 2% any investor in fixed income should have vastly preferred TIPS.

I have repeatedly said – as far back as 2016 – that with breakevens below 1.5% there wasn’t even a decent strategic case to own nominal bonds rather than inflation-linked bonds (ILBs) except to defease specific nominal liabilities and that at times those low breakevens meant that owning nominals instead of ILB amounted to a really big bet (as I said in this article from March 2020). Those are relative concepts.

But 10-year real yields were below zero, and as low as -1.2%, for most of 2020, 2021, and the first half of 2022. And 10-year real yields have been below +1% almost continuously since 2011. When real yields were below zero or just fractionally positive, it meant that TIPS were absolutely expensive. That wasn’t just a TIPS problem of course: low real yields were the most obvious in TIPS, but you couldn’t avoid them by trafficking in other asset classes because they were a characteristic of the environment we were in. Everything was absolutely expensive, but TIPS were at least relatively cheap.

More recently, our models indicated TIPS getting quantitatively fair on a relative basis, which is historically unusual (see chart, source Enduring Investments); they even got somewhat rich a couple of months ago and that’s historically unheard of.[1] Real and nominal yields were still low, but at least it was a fair horse race between which ones to hold. And if you’d bought TIPS when I said there was “a big bet” being made against them, and sold them when we said they were fair, you crushed a nominal portfolio’s return. (As an aside, the rich/cheap chart and value is available every day on my private Twitter feed. Sign up for that private feed here: https://inflationguy.blog/shop/ I keep adding more charts etc, in addition to the main event, my live CPI report coverage each month).

As of today, 10-year TIPS yields are all the way up to 1.67%, the highest they’ve been since 2010. I explained back in June why the equilibrium risk-free real interest rate is approximately 2.25%, so TIPS are getting to the neighborhood of long-term fair values in an absolute sense. TIPS have no risk in real space, when held to maturity, so if you can get an annual 2%ish real increase in wealth with no risk, that’s a good deal. And inflation-linked bond yields in developed markets basically never yield more than 4% or 4.5%, so the higher the yield goes the less your potential mark-to-market downside. A 5-yr or 10-yr TIPS yield of 4% is back-up-the-truck stuff if you see it. At those real yields, with no risk, other asset classes simply can’t compete. At 1% breakevens there was no reason to own nominal bonds rather than TIPS; at 4% real yield there would be no reason to own stocks rather than TIPS.

But that sort of yield is of course very rare and we won’t see it unless nominal yields get up to double-digit land. At the current level, with TIPS at fair or slightly-cheap relative value and approaching fair absolute value, it is worth accumulating TIPS as a long-term hold.

It has been an astonishingly long time since I could make that statement. And TIPS may well get cheaper from here. I hope they do! But in the meantime, you can do a lot worse than guarantee yourself that your wealth will increase 18% more over the next decade than the price level rises.[2]


[1] I have written previously though about the value of long inflation tails, and how that value is NOT reflected in TIPS so that even when our model says TIPS are fair, they’re still very cheap if that tail option is reasonably valued. But that isn’t included here.

[2] (1+1.67%)^10 – 1 = 18%.

Categories: Bond Market, CPI, TIPS Tags:

A Guess at the Value of Long Inflation Tails

December 7, 2021 1 comment

In my last post, “You Have Not Missed It,” I promised the following:

“There is one final point that I will explain in more detail in another post. Breakevens also should embed some premium because the tails to inflation are to the upside. When you estimate the value of that tail, it’s actually fairly large.”

So, as promised, here is that explanation.

Viewing the forward inflation curve as a forecast of expected inflation (whether using “breakevens” or, more accurately, inflation swaps) is biased in a particular way. Or, at least, it should be. The “breakeven” inflation rate is the rate at which a long-only investor over the ensuing period would be roughly as well off with a nominal bond (which pays a real rate plus a premium for expected inflation) and an inflation-indexed bond (which pays a real rate, plus actual inflation realized over the period). Obviously the inflation-indexed bond is safer in real space, so arguably nominal bonds should also offer a risk premium to induce a buyer to take inflation risk.[1] Ordinarily, though, we ignore this risk and just consider breakeven inflation to be the difference between real and nominal yields. Inflation swaps are cleaner, in that if inflation is higher than the stated fixed rate, the fixed-rate payer on the swap ‘wins’ and receives a cash flow at the end, whereas if inflation turns out to be lower than the stated fixed rate, it is the fixed-rate receiver who wins. So from here on, I will talk in terms of inflation swaps, which also abstract from various bond-financing issues of the breakeven…but the reader should understand that the concept applies to other measures of expected inflation as well.

Now, suppose that you expect 10-year inflation to come in at 2% per annum. Suppose that in the inflation swap market, the 10-year rate is 2% ‘choice’ – that is, you may either buy inflation at 2% or sell inflation at 2%. Since you expect inflation to be 2%, are you indifferent about whether you should buy or sell?

The answer is no. In this case you should be much more eager to buy 2% than to sell 2%, given that your point estimate is 2%. The reason why is that the distribution of inflation outcomes is not symmetrical: you are much more likely to observe a miss far above your expectation than to observe a miss far below your expectation. Therefore, the expected value of that miss is in your favor if you buy the inflation swap (pay fixed and receive inflation) at 2%. There is, in other words, an embedded option here that means the swap market should trade above where most people expect inflation to be.

We can roughly quantify at least the order of magnitude of this effect. Consider the distribution below. This chart (Source: Enduring Investments) shows the difference, from 1956 until 2011, of 10-year inflation expectations[2] compared with subsequent 10-year actual inflation results. The blue line is at 0% – at that point, actual inflation turned out to be right where a priori expectations had it. The chart obviously only covers until 2011 since that is the last year from which we have a completed 10-year period. Recognize that I am not charting the levels of inflation, but the level of inflation relative to the original expectation.

Notice that the chart has a cluster of outcomes (and in fact, the most-probable outcomes) just to the left of zero, where expectations exceeded the actual outcome by a little bit, but that there are very few long tails to the left. However, misses to the right, where the actual outcome was above the beginning-of-period expectations, were sometimes quite large. The median point (where half of the misses are to the left, and half are to the right) is 0.21%. But this is not a symmetric distribution, so if we randomly sample points from this distribution, we find that the average of that sample is 0.59%.

So, if you buy the inflation swap at 2% when your expectations are at 2%, on average you’ll win by 59bps, at least historically. Of course, past results are no indication of future returns, and a Fed economist would argue that we have much better control of inflation now than we ever have in the past (Ha ha. I crack myself up.). And inflation volatility markets, when they can be found, don’t trade at such high implied volatilities. Noted, although the wild swings in growth and the deficit and the money supply, not to mention recent realized outcomes, might make more cynical observers question whether we should be so confident in that view right at the moment.

Moreover, a counterargument is that at the present time an investor also has the advantage of investing when expectations are fairly low, so the downside tails are not as likely. The worst outcome of that whole 1956-2011 period was an 8.75% undershoot of inflation versus expectations. This happened in the 10 years following September 1981, when expectations were for 10-year inflation of 12.70% and actual inflation was 3.95%. But with expectations at 2.50%, is it really feasible to get a -6.25% compounded inflation rate? That would imply a 50% fall in the price level (and, I should note, it would mean that investors in TIPS would win hugely in real space since they get back no worse than nominal par. But that doesn’t help the swap buyer).

To be a little more fair, then, the following chart considers only the periods where inflation expectations were 5% per annum or less at the beginning of the period. That truncates only 10% of the distribution, but as you might expect the vast majority of the truncation is on the left-hand side. This is fair because it’s naturally harder to miss far below your expectations when your expectations are very low to begin with.[3]

The value of the expected miss in this contingent view is 1.13%. So, in order for the market to be priced fairly if general expectations are for 2.5% average CPI inflation the 10-year inflation swap would have to be around 3.63%. Again, even allowing for the “policymakers are smarter now” argument (an argument quite lacking, I would argue, in empirical evidence) I would feel comfortable saying that 10-year inflation swaps, and breakevens, should embed at least a 50bps or so ‘option premium’ relative to expectations.

I don’t believe that they do. Indeed, consider that the buyer of 10-year TIPS (with breakevens at 2.50%) not only wins if 10-year inflation is above 2.50% but the average win historically (conditioned on breakevens being below 5% to start, and by construction only considering wins) has been about 2.07% per annum – a massive outperformance. Not only that, but any losses are essentially guaranteed to be small because the tails on the left-hand side are truncated: if inflation is negative (that is, if the loss would have been greater than 2.50%) it is limited by the fact that the Treasury guarantees the nominal principal.

As an aside, we do consider this sort of option in other contexts. In the Eurodollar futures market, for example, we recognize that the person who is short the Eurodollar contract (and therefore gets a positive mark-to-market when interest rates rise) is in a better situation than the long (who gets the positive mark-to-market when interest rates fall), because the short gets to invest wins at higher interest rates and borrow losses at lower interest rates, while the long must borrow to cover losses when interest rates are higher, and but gets to invest wins when interest rates are lower. As a result, Eurodollar futures trade lower than the forwards implied from the swap curve, since the buyer needs to be induced by a better-than-expected price. And there are other such examples. But I am pretty sure I have never seen an example of an embedded option like this that is priced so differently relative to history than the embedded options in the inflation market!


[1] However, since this risk is symmetric – the seller of the bond also has risk in real space, but in the opposite direction – it isn’t immediately obvious why one side should get an inducement over the other. So I will leave the ‘risk premium’ aside.

[2] For long-term inflation expectations back before the advent of TIPS, I used the Enduring model relating real yields to nominal yields, about which I’ve written previously. You can find a brief discussion of this and an illustration of the model at this link: https://inflationguy.blog/2016/12/23/a-very-long-history-of-real-interest-rates/

[3] The author’s wife has been known to make something like this observation from time to time.

Categories: Options, Theory, TIPS Tags: , ,

You Have Not Missed It

November 18, 2021 8 comments

Recently, 10-year inflation breakevens reached 2.78% – matching the all-time highs (since TIPS were issued in 1997) from 2005. If you think about breakevens in the same way you think about TSLA, then it may seem to you that this is a very bad time to buy inflation. No one who bought 10-year inflation at 2.78% or in that neighborhood has ever had a mark-to-market gain.[1] Heck, for a couple of decades it has been a fairly automatic trade to dump 10-year breakevens once they got a bit over 2.50%. Moreover, with y/y inflation at 6.2% – even if it goes a little higher still before it ebbs – it certainly seems like the worst is behind us, right?

I hear from a lot of investors who are afraid that they “missed the trade.” The first spike happened so quickly that not many people outside of the inflation geeks had time to get on board. And we’re only just now figuring out (well, it’s only just now becoming common knowledge) that the “transitory” effects have lasted and are lasting a lot longer than we were told to expect. These tactical traders feel like they missed a once-in-a-generation, if not a once-in-a-lifetime, trade in inflation, which is now over.

Relax. You have not missed it.

Okay, perhaps you should have bought inflation when 10-year breakevens were at 0.94%. At that level, the market was making a huge bet that inflation was forever dead. There was almost no risk in buying inflation at that level, as I pointed out at the time. That was the right trade, and the easy trade, and I know you’re committed to buying those levels the next time you see them. Unfortunately, you won’t. Those levels won’t be seen again for decades, if ever. The only way they could happen is because there was no natural bid for inflation risk, no one who was worried about it. No matter what happens to inflation from here, lots of people have learned that it’s something you ought to be worried about, especially if you can hedge it essentially for free as you could 19 months ago.

But that doesn’t mean you oughtn’t buy longer-term inflation even though the current levels are high. The chart below shows 10-year inflation breakevens, in white, versus contemporaneous core CPI in blue.

Obviously, I’m comparing a 10-year forward-looking rate to a 1-year backward-looking rate, but my point isn’t that there are good times and bad times to buy breakevens based on what has recently happened. In fact, my point is almost the opposite. My point is that historically, it has paid to ignore what has recently happened, and focus on whether or not breakevens are a bargain relative to the equilibrium level. Over the period since TIPS were first issued, core CPI has ranged from 1% to 3%, and averaged almost exactly 2%. That’s the blue line. The question then, is not whether breakevens are a good deal here if inflation is going to go back to a sedate 1%-3% range for the next decade; in that circumstance they certainly aren’t. On the other hand, they aren’t a disastrous trade in that case, but certainly not a very good one. The real question, though, is whether the equilibrium range going forward really is going to be centered around 2%. Because if instead it is going to be centered around 3%, then you’re buying breakevens below the midpoint of that future range (and you get great near-term carry in the bargain).

There are a number of reasons that I think we have moved into a new post-2% regime. A lot of those reasons were already hinted at prior to the current crisis and the ensuing irresponsible policy response. For example, one following wind that the global economy enjoyed from 1993 or so until the mid-2010s was a gradual increase in globalization. The movement of production to lower-production-cost countries, especially in an era of cheap transportation and low tariffs, was a net gain to society in the classic Ricardian sense, and allowed all economies to have a better growth/inflation mix. However, that impulse was already starting to wane prior to Trump, and in the last 5 years the globalization arrow has clearly reversed in no small part because of intentional policy decisions to do so. That’s just one example of how the cycle, in my view, was already reversing.

Since the policy response to COVID, however, the inflation idyll has been decisively shattered. Manufacturers in many industries have been forced to shift strategies about passing through costs – strategies that are very hard to restore to the old way. The high inflation prints, especially in the context of product shortages, have emboldened labor in ways we haven’t seen for some time. Increased unionization is likely to follow an increase in the level and volatility of inflation, which naturally will help institutionalize levels of inflation that are not outrageous in the grand scheme of things but which are still damaging compared to the Way Things Were.

Thus, I think we are out of the 2-percent-as-the-center-of-the-distribution era, and into an era where the middle is more like 3%. The bad part is that inflation regimes don’t usually stay stable except at low levels, so that we are going to have higher inflation volatility, and there’s a decent chance that equilibrium level bleeds higher over time.

That’s the bet with 10-year breakevens. In the short-term, some of the “transitory” factors are going to ebb (prices won’t fall, but their rates of change will), although other factors will emerge too. The inflation derivatives market is pricing in headline inflation over 7% in the next few months, but that will likely be the peak. But rents are going to be pushing up, and core and median inflation are not going to go back to 2% very soon. I’ve seen some forecasts that by late 2022, core will be around 1.5%. I think that’s wrong by 200bps.

There is one final point that I will explain in more detail in another post. Breakevens also should embed some premium because the tails to inflation are to the upside. When you estimate the value of that tail, it’s actually fairly large. But for now, let me just assure you: the train has left the station, but it is still making stops. There’s time to get on board.


[1] Sticklers will note that this isn’t quite true. In 2005, headline inflation reached 4.7%, so an owner of breakevens might actually have had a net profit on income and inflation accretion, at least for a while, even though breakevens retreated from there. But it still wouldn’t have been a great trade and you would have had to be nimble to make any money at all.

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 7 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.

Summary of My Post-CPI Tweets (March 2020)

March 11, 2020 1 comment

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy. Or, sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments (updated site coming soon). Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • CPI day, coronavirus edition! Meaning that no matter what this month’s number is, next month’s number will be more “infected” and lots more interesting.
  • The consensus today is for core CPI to be a ‘soft’ +0.2%, with y/y core coming in at 2.3%.
  • Last month’s CPI figure was above expectations, but following a couple of weak months. Economists’ forecasts suggest they think the strength, not the weakness, was the outlier. I’m not so sure.
  • In last month’s CPI, core goods were weak, especially Used Cars and Pharmaceuticals. Both of those effects look to have recently reversed…altho question in both cases is whether it will be captured in the Feb number. Black Book figures have turned higher.
  • Important to note is the easy comparison of today’s CPI print to Feb 2019, which was only +0.127% core. So even a slightly strong 0.2% m/m could cause an uptick to 2.4% rounded on the y/y core.
  • Going forward, I’m really interested in housing, which has been resilient – if 10-year inflation markets are “right” at 1.0%, then Housing will have to collapse. I don’t see that.
  • And I think we are all more aware now that our supply chain of pharmaceuticals, specifically APIs, runs through China; efforts to bring back some drug manufacturing to the US will put upward pressure there.
  • That’s probably not this month’s story, but the Big Story to watch I think.
  • That’s all for now. 5 minutes to go…good luck with the number.
  • Well, core was +0.2% and the y/y was 2.4%, so that implies a strong core. But core figures being really slow to post to Bloomberg. That’s why the unnatural pause from me..
  • Weirdly getting entire breakdown except for core index level. Not sure if it’s a Bloomberg or a BLS issue but we’ll proceed. In any event looks like it was above 0.2% on core, and rounded down.
  • …and as I type that it comes in at +0.22%. That puts y/y core at 2.37%. That’s not QUITE the high for the cycle, but pretty close.
  • here is y/y core. I don’t see deflation yet, do you?

  • Last 12…the Oct and Dec figures looking more like the outliers.

  • Context for that. Here is the median CPI (which doesn’t come out until later) vs the 10y CPI swap rate. Clearly, market participants expect something big and negative.

  • Candidates for big and negative? It would have to be housing. But Owners’ Equivalent Rent this month was +0.246%. That’s softer than last month and the y/y fell to 3.28% from 3.35%…but not exactly weak.
  • Primary rents were unchanged y/y at 3.76%. Lodging Away from Home – to be sure, we ought to soon see that drop on the COVID-19 effect, was +2.03% m/m, but that only puts y/y at +0.78% from -0.21%. Lodging AFH hasn’t been a driver of inflation prints.
  • Now, possibly interesting, except that this is now a really volatile number, was the +0.43% jump in Apparel. China effect? Prob not yet. But y/y rose to -0.91% from -2.24% as recently as Oct. But the new survey method has made this volatile.
  • On Medical care – Pharma was -0.43% m/m, but that kept the y/y at 1.85% (was 1.80%). Last month Pharma was negative too. I’ll come back to drugs in a moment but Doctors’ Services rose to +0.83% y/y from +0.70% and Hospital Svcs to 4.28% from 3.84%.
  • Hospital Services y/y.

  • Recall 1 reason I’ve been expecting rise in Med Care is b/c insurance costs in the CPI have been soaring. But b/c of the way BLS measures insurance, as a residual, my hypothesis was that this was just proxying for stuff they hadn’t caught yet. But insurance STILL soaring!

  • So if I am right about the proxying effect, the recent rise in medical care pieces still leaves more to go.
  • I haven’t mentioned used cars yet. M/M used cars were +0.39%, moving y/y to -1.33% from -1.97%. The dip seems to be over. Recent surveys in last few weeks especially have seen surge in used car buying. Might be b/c auto manufacturing is having supply chain issues, or not.

  • Core CPI ex-housing rose to 1.70% y/y. That’s the highest level since Feb 2013. Again, I refer you to 10-year inflation breakevens, DOWN this morning to 0.99%. Just not seeing anything that even suggests a turn lower. Housing solid, and ex-housing at the highs.
  • …that doesn’t mean inflation can’t fall, and headline inflation in the near term is going to drop HARD because of energy, but to sell 10-year inflation at 1% you have to believe in more than an energy effect. Oil can’t fall 30% every month.
  • Again to sort of make the point that last month…while stronger than expected…was actually dragged LOWER by core goods: y/y core services stayed at 3.1%; y/y core goods rose to 0.0% vs -0.3% last month (but +0.1% month before).
  • One element of core goods is pharma. In the news recently b/c China supplies something like 90% of our APIs that go into drugs. This index has become lots more VOLATILE in recent yrs. Does that have anythng to do w/ the China part of supply chain becoming more important?

  • So biggest declining core categories this month: car/truck rental, misc personal goods, jewelry and watches. All down more than 10% annualized. Gainers: Lodging AFH, Women’s/Girls’ Apparel, Dairy (??), Personal Care Products. (Dairy not core, but unusual).
  • As if i didn’t already have enough reasons to give up ice cream. Here’s Dairy inflation, y/y. Come on, man.

  • Here is a little stealth inflation for you, although I suspect this will turn around. Here is y/y airfares, up at 2.35% y/y.

  • Why is that stealth inflation? Because airfares usually have a decent relationship to jet fuel. Except recently, they’ve been reluctant to fall. This is thru Feb since this is Feb CPI. Last point in red.

  • But here is jet fuel futures. This isn’t in CPI because consumers don’t buy jet fuel. Notice it was already declining in January and February before falling off a cliff this month. We OUGHT to be seeing this in airfares. Not yet, but soon.

  • last subcomponent pic today. This is college tuition & fees, y/y. This is going to start heading up unless the stock market starts to recover. When endowments take a beating, they share the pain.

  • Median CPI this month looks like it ought to be up around 0.26%ish. If that’s right, y/y median will be steady at 2.88% y/y.
  • Let’s see, why don’t we do the four pieces charts and then wrap up. Didn’t realize I’d been yammering for an hour.
  • Piece 1 is food & energy. Guess what: this is about to roll over, and hard. But it isn’t core, so it moves around a ton. We look through this volatility. Note the y axis scale!

  • Piece 2 is core goods. Back to roughly flat. Close to our model, but I’m still amazed this hasn’t seen more of an upswing yet with trade frictions. But I am pretty sure it will with COVID-19, because that’s a major supply shock and this is where it will tend to hit.

  • Still, of more concern is core services less rent-of-shelter. Significant weight here to medical care services, which as I showed earlier (see hospital services chart) is in a steady rise. Pharma shows up in core goods. The rest of medical shows up here.

  • Last but not least, rent of shelter. Solid as a rock. By the way, 10-year breakevens are down another 8bps today, to 0.95%. This makes zero sense. 1y CPI swaps? Different story. But 10y is nonsense.

  • Wrapping up: another stronger-than-expected number. I said last month that core CPI will be above 2.5% by summer, and we are still on track for that. COVID-19 might eventually pull prices lower if it becomes more demand shock than supply shock. We’re nowhere close to that now.
  • Of course, that doesn’t change the Fed’s decision. They’ll ease, aggressively. And the Federal government will spend like crazy. Folks, welcome to MMT. This is exactly what the MMT prescription is: deficit spend, and print money to cover it. We’ll see how it works out.
  • That’s all for today. Thanks for tuning in.

Nothing really further to add to this string of tweets. None of this stops the Fed from easing aggressively, but it wouldn’t have changed their decision much anyway because the Fed pretty much ignores inflation. But it should affect investment decisions. Really incredible to me is the way inflation bonds are underperforming so dramatically when they were already cheap and inflation is still rising. You have to be massively bearish, looking for a global collapse of monumental proportions, to want to sell 10-year inflation below 1% when housing is above 3% and ex-housing is at 7-year highs, and when the government is implementing MMT (effectively) and businesses are going to be under tremendous pressure to shorten supply chains and produce in higher-cost areas that are geographically safer/closer. It’s really hard to understand the TIPS market at the moment. (Some people say that it is always hard to understand the TIPS market!)

Categories: CPI, TIPS, Tweet Summary

Summary of My Post-CPI Tweets (October 2019)

October 10, 2019 Leave a comment

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy. Or, sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments or Enduring Intellectual Properties (updated sites coming soon). Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • CPI day! Want to start today with a Happy Birthday to @btzucker , good friend and inflation trader extraordinaire at Barclays. And he does NOT look like he is 55.
  • We are coming off not one not two but THREE surprisingly-high core CPI prints that each rounded up to 0.3%. The question today is, will we make it four?
  • Last month, the big headliners were core goods, which jumped to 0.8% y/y – the highest in 6 years or so – and the fact that core ex-housing rose to 1.7%, also the highest in 6 years.
  • Core goods may have some downward pressure from Used Cars this month, as recent surveys have shown some softness there and we have had two strong m/m prints in the CPI, but core goods also has upward tariffs pressure, and pharma recently has been recovering some.
  • (The monetarist in me also wants to point out that we have M2 growth accelerating and near 6% y/y, and it’s also accelerating in Europe…but I also expect that declining interest rates are going to drag on money velocity. Neither of those is useful for forecasting 1 month tho)
  • Now, one thing I am NOT paying much attention to is yesterday’s soggy PPI report. There’s just not a lot of information in the broad PPI, with respect to informing a CPI forecast. I mostly ignore PPI!
  • The consensus forecast for today calls for a soft 0.2%. I don’t really object to that forecast. We are due for something other than 0.3%. But I would be surprised if we got something VERY soft. I think those 0.3%s are real.
  • Unless we get less than 0.12%, though, we won’t see core CPI decline below 2.4% (rounded). And if we get 0.222% or above, we will see it round UP to 2.5%. That’s because we are dropping off one more softish number, from Sep 2018, in the y/y.
  • Median, as a reminder, is 2.92%, the highest since late 2008. It’s going to take a lot to get back to a deflation scare, even if inflation markets are currently pricing a fairly rapid pivot lower in inflation. I don’t think they’re right. Good luck today.
  • Obviously a pretty soft CPI figure. 0.13% on core, 2.36% y/y.

  • This is not going to help the new 5yr TIPS when the auction is announced later. But let’s look at the breakdown. Core goods fell to 0.7% from 0.8%, and core services stable at 2.9%.
  • As expected, CPI-Used Cars and Trucks was soft. -1.63% m/m in fact. That actually raises the y/y slightly though, to 2.61% from 2.08%. There’s more softness ahead.

  • OER (+0.27%) and Primary rents (+0.35%) were both higher this month and the y/y increased to 3.40% and 3.83% respectively. So why was m/m so soft? Used cars is worth -0.05% or so, but we need more to offset the strong housing.
  • (Lodging away from home also rebounded this month, +2.09% m/m vs -2.08% last month).
  • Big drop in Pharma, which is surprising: -0.79% m/m, dropping y/y back to -0.31%. That’s still well off the lows of -1.64% a few months ago.
  • Core ex-shelter dropped to 1.55% y/y from 1.70% y/y. That’s still higher than it has been for a couple of years.
  • Apparel dropped -0.38% on the month. The new methodology is turning out to be more volatile than the old methodology, which is fine if apparel prices are really that volatile. I’m not sure they are. y/y for apparel back to -0.32%.
  • Yeah, apparel is just reflecting the strong dollar, but I’m still surprised that we haven’t seen more trade-tension effect.

  • So, Physicians’ services accelerated to 0.93% y/y from 0.71%. And Hospital Services roughly unchanged. Pharma as I said was down (in prescription, flat on non-prescription). Health Insurance still +18.8% y/y (was 18.6% last month).
  • A reminder that “health insurance” is a residual, and you’re likely not seeing that kind of rise in your premiums. But I suspect it means that there are other uncaptured effects that should be allocated into different medical care buckets, or perhaps this leads those movements.
  • So even with that pharma softness, overall Medical care (8.7% of the CPI) was exactly unchanged at 3.46% y/y.
  • College Tuition and Fees decelerated to 2.44% from 2.51%. But that’s mostly seasonal adjustment – really, there’s only 1 College Tuition hike every year, and it just gets smeared over 12 months. Tuition is still outpacing core, but by less.
  • Largest drops in core m/m were Women’s/Girls’ apparel(-18.7% annualized), Used Cars & Trucks(-17.9%), Infants’/Toddlers’ apparel(-13.4%), Misc Personal Goods(-12.1%), and Jewelry/Watches (-11.9%). Biggest gainers: Lodging away from home(+28.1%) & Men’s/Boys’ Apparel.(+25.5%)
  • Here’s the thing. Median? It’s a little hard to tell because the median categories look like the regional housing indices, but I think it won’t be lower than +0.25% unless my seasonal is way off. And that will put y/y Median CPI at 3%.

  • The big difference between the monthly median and core figures is because the core is an average, and this month that average has a lot of tail categories on the low side while the middle didn’t move much.
  • That’s why, when you look at the core CPI this month, there’s nothing that really jumps out (other than used cars) as being impactful. You have moves by volatile components, but small ones like jewelry and watches or Personal Care Products.
  • Here is OER, in housing, versus our forecast. There’s no real slowdown happening here yet, and that’s going to keep core elevated for a while unless non-housing just collapses. And there’s no sign of that – core ex-housing, as I noted, is still around 1.4%.

  • So, this is a fun chart. In white is the median CPI, nearing the highs from the mid-90s, early 2000s, and late 2000s. Now compare to the 5y Treasury yield in purple. Last time Median was near this level, 5s were 3-4%.

  • Another fun chart. Inflation swaps vs Median CPI. Not sure I’ve ever seen a wider spread. Boy are investors bearish on inflation.

  • Here is the distribution of inflation rates, by low-level components. You can see the long tails to the downside that are keeping core lower than where “most” prices are going. So inflation swaps aren’t as wrong as median makes them look…if the tails persist. Not sure?

  • So four pieces: food & energy, about 21% of CPI.

  • Core goods, about 19%. Backed off some, but still an important story.

  • Core services less rent of shelter. About 27% of CPI. And right now, meandering. Real question is whether rise in health care inflation is going to pass through eventually to other components or if it is transitory. If the former, there’s a big potential upside here.

  • And rent of shelter, about 33% of CPI. As noted, this ought to decelerate some, but no real indication it’s about to collapse. And you can’t get MUCH lower inflation unless it rolls over fairly hard.

  • Really, the summary today is that there isn’t anything that looks like a sea change here. Most prices continue to accelerate. Now, next month the comparison is harder as Oct 2018 core was +0.196%. Month after was +0.235%. So some harder comps coming for core.
  • That said, I continue to think that we’ll see steady to higher inflation for the balance of this year with an interim peak coming probably Q1-Q2 of next year. But the ensuing trough won’t be much of a trough, and the next peak will be higher.
  • That’s all for today. Thanks for tuning in.

I don’t think there is anything in this report that should change any minds. The Fed ought to be giving inflation more credit and be more hesitant to be cutting rates, but they are focused on the wrong indicator (core PCE) and, after all, don’t really want to be the guys spoiling the party. I think they’ll be slow, but we’re entering a recession (if we’re not already in one) and since the Federal Reserve utterly believes that growth causes inflation, they will tend to ignore a continued rise in inflation as being transitory. Since they said it was transitory when it dipped a couple of years ago – and it really was – they will be perceived as having some credibility…but back then, there really was some reason to think that the dip was transitory (the weird cell phone inflation glitch, among them), and there’s no real sign right now that this increase in inflation is transitory.

Yes, I think inflation will peak in the first half of 2020, but I’m not looking for a massive deceleration from there. Indeed, given how low core PCE is relative to better measures of inflation, it’s entirely possible that it barely declines while things like Median and Sticky decelerate some. Again, I’m not looking for inflation or, for that matter, anything that would validate the very low inflation expectations embedded in market prices. The inflation swaps market is pricing something like 1.5% core inflation for the next 8 years. Core inflation is currently almost a full percentage point higher, and unlikely to decline to that level any time soon! And breakevens are even lower, so that if you think core inflation is going to average at least 1.25% for the next 10 years, you should own inflation-linked bonds rather than nominal Treasuries. I know that everyone hates TIPS right now, and everyone will tell you you’re crazy because “inflation isn’t going to go up.” If they’re right, you don’t lose anything, or very little; if they’re wrong, you have the last laugh. And much better performance.

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