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Is Inflation Dead…Again?
I am not the first person to point out that the stock market, at outlandish multiples, is not behaving consistently with commodities markets that are flashing imminent depression. If we insist on anthropomorphizing the markets, it really makes no sense at all unless we posit that “the market” suffers from a split personality disorder of some kind. But that sort of thing happens all the time, in little ways.
But here is something that seems very weird to me. Prices of short-dated inflation swaps in the interbank market suggest that NSA headline inflation is going to rise less than 0.9% for the entire balance of 2023 (a 1.45% annualized rate). And actually, most of that rise will be in the next 2 months. The market is pricing that between June’s CPI print and December’s CPI print the overall price level will rise 0.23%…less than ½% annualized!
Now, eagle-eyed readers will notice that there was also a flat portion of 2022, covering roughly the same period. Headline inflation between June and December last year rose only 0.16%, leading to disappointing coupons on iBonds and producing proclamations that inflation was nearly beaten. Here’s the thing, though. The second half of 2022 it made perfect sense that headline inflation was mostly unchanged. Oil prices dropped from $120/bbl the first week of June, to $75 by mid-December. Nationwide, average unleaded gasoline prices dropped from $5 to $3.25 during that time period.
A comparable percentage decline would mean that gasoline would need to drop to $2.32 from the current $3.58 average price at the pump. To be sure, the gasoline futures market is in much steeper backwardation than normal, with about 44c in the curve from now until December compared with 28c from June to December 2024.[1] So that can’t be the whole source of this insouciance about inflation. If gasoline does decline that much, the inflation curve will be right…but there’s an easier way to trade that, and that’s to sell Nov or Dec RBOB gasoline futures.
So the flatness must be coming from elsewhere. It can’t be from piped gas, which has recently been a measurable lag, because Natural Gas prices have already crashed back to levels somewhat below the norm of the last 10 years. Prices of foodstuffs could fall back more, which would help food-at-home if it happened, but food-away-from-home tracks wages so it’s hard to get this huge of an effect from food.
Ergo…this really must be core. Except there, the only market where you can sort of trade core inflation rather than backing into it, the Kalshi exchange, has the current prices of m/m core at 0.35% in May, 0.32% in June, 0.57% in July, 0.45% in August, 0.35% in September, 0.18% in October, and 0.22% in November. (To be sure, those markets especially for later months are still fairly illiquid but getting better). That’s not drastically different from the 0.41% average over the last six months.
Markets, of course, trade where risk clears and not necessarily where “the market thinks” the price should be. I find it hard to understand though who it is who would have such an exposure to lower short-term prices that they would need to aggressively sell short-term inflation…unless it is large institutional owners of TIPS who are making a tactical view that near-term prints would be bad. Sure seems like a big punt, if so.
Naturally, it’s possible that inflation will suddenly flatline from here. I just don’t feel like that’s the ‘fair bet’. That is after all a key function of markets: offer attractive bets to people who don’t have a natural bias in the market in question, to offset the flows of those people who are willing to pay to reduce their risk in a particular direction. (This should not be taken to suggest that I don’t have a natural bias in the market; I do.)
There’s another reason that this matters right now. Recently, markets have also been starting to price the possibility that the Federal Reserve could continue to hike interest rates, despite fairly clear signals from the Chairman after the last meeting that a ‘pause’ was in the offing. That certainly makes sense to me, since 25bps or 50bps makes almost no difference and after one of the most-aggressive hiking cycles in history, putting rates at approximately long-term neutral at the short end, it would seem to be prudent to at least look around. If, in looking around, the Fed were to notice that the balance of the market is suggesting that inflation has a chance of going instantly and completely inert, it would seem to be even stranger to think that the FOMC is about to fire up the rate-hike machine again for another few hikes.
[1] N.b. – June to December on the futures curve isn’t the exact right comparison since prices at the pump lag wholesale futures prices, but it gives you an idea.
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.
Oil Be Home For Christmas
As a general rule, don’t trade on pre-holiday thin-liquidity sessions. There can be amazing-seeming opportunities, but price can still get shoved in your face by whoever it is who feels like pushing markets around.
A prime example today is the energy market, where front-month oil prices are down nearly 4% at this writing. Recently, energy futures have been regularly jammed lower overnight in low-liquidity conditions and then have recovered during the day. There is a structural shortage of energy globally at the moment, and inventories are low…but sentiment is also very poor and as I’ve shown before, open interest has been in a downtrend for years – aggregate open interest in NYMEX Crude hasn’t been lower since 2012.
So, it’s a market ripe for pushing around and the day before Thanksgiving is probably not the day to take a stand by getting long even when the reasons given for the selloff are nonsense. Today, the story is again about the price cap on Russian oil that is being implemented soon by the US and EU. Market participants seem to struggle with Econ 101 here. A price cap has one of two effects in the market under consideration: if the price cap is set above the market-clearing price, it has no effect. If the price cap is set below the market-clearing price, it leads to shortages as suppliers – in this case, Russia – won’t supply as much oil (if any) to the capped market when there are other uncapped markets (say, China and India). There is probably an area near the price cap where the cost of switching to delivering oil in other markets is higher than the gain from switching deliveries, but that’s only in round 1 of the game theoretic outcome.[1]
In this case, since only the price from one supplier is capped, the result should be higher prices in the markets than otherwise since once price exceeds the cap, one supplier is lost. The chart below shows the classic outcome. Below the cap, the supply curve is normal. Above the cap, the supply curve is left-shifted.
This leads, at least in a frictionless market (which this isn’t), to prices being discontinuous around the cap. As demand shifts from left to right, prices behave normally and rise as they normally would, until abruptly jumping higher once the capped producer is removed. In any case, price is more volatile than it would otherwise be…but, and this is important, it is never lower in a market where some or all of the suppliers are capped, than it is in an uncapped market. At best, prices are the same if the caps aren’t in play. At worst, a combination of shortages and higher prices obtain.
Speaking of shortages…it seems that people are growing calmer about the chances of a bad energy outcome over the winter in Europe. This seems, to me, to be related to the fact that inventories of gas are reasonably flush thanks to conservation efforts and vigorous efforts to replace lost Russian pipeline supply (see Chart, source Gas Infrastructure Europe via Bloomberg).
That’s great, but the problem is that since the pipelines are not flowing Europe needs more gas going into the winter than they otherwise would have – because it’s not being replenished by pipeline during the winter, either. We certainly hope that Europe doesn’t run out of heat this winter, but the level of gas inventories is not exciting.
Putting downward pressure on both of these markets, but especially Crude, is the idea that the world will enter a global recession in 2023. As I’ve been saying since early this year, that’s virtually a sure thing: we’ve never seen interest rates and energy prices rise this much and not had a recession. But I have thought that the recession would be relatively mild, a ‘garden variety’ recession compared to the last three we’ve had (the tech bubble implosion, the global financial crisis, and the COVID recession). What worries me a bit is that the consensus is now moving to that conclusion. It seems that most forecasts are for a mild recession (although predictably, economists are all over the map on inflation depending on the degree to which they understand that inflation is a monetary phenomenon and not a growth phenomenon). I’m still in that camp, but that concerns me, because the consensus is usually wrong.
[1] In round 2, after oil delivery from Russia is switched to the uncapped markets, the available price in the capped market will need to be appreciably above the market clearing price in the uncapped market in order to cause the switch back.
Tight Spreads’ Cost: Orderly Markets
In this article I am taking a brief break from writing about inflation. There have been lots of great stories and anecdotes recently about inflation. I loved the Wall Street Journal article about how “Inflation and Other Woes Are Eating Your Girl Scout Cookies”, and we have seen several contributions from former Treasury Secretary Larry Summers that are worth reading. One was an opinion piece in the Washington Post (“Opinion: The stock market liked the Fed’s plan to raise interest rates. It’s wrong.”) and one was a very good NBER working paper on “The Coming Rise in Residential Inflation,” in which he confirms and extends the normal way inflation people forecast rents and comes up with even higher numbers than I’ve been working with for a while. Incidentally, if you haven’t seen these stories before now, consider installing the Inflation Guy mobile app. I don’t curate every single inflation story; just the ones worth curating.
Moreover, the Fed increasingly sounds like they want to be aggressive with rates. That’s half the battle, though on the more important half (the balance sheet reduction) they don’t yet have a plan. I should note that saying hawkish things on half the plan isn’t really all that hawkish, especially when your notion of “pushing rates above neutral” means 3%: a level well below inflation. But it’s progress that these folks have finally realized that inflation is a real phenomenon and not just due to port congestion. They still don’t seem to see the role of money growth in causing that phenomenon, but it’s nice we’re making baby steps.
As I said, though, in this article I’m going to talk about market structure, and the deal with the devil we have made to seek ever-tighter-spreads at a cost of orderly markets.
Since the 1970s, the cost of trading equities has moved from a bid/offer spread of a half point or a quarter point ($0.50 or $0.25 per share), on round lots, plus large brokerage fees, to sub-penny spreads on any size trade, often with zero brokerage costs. The cost of bond execution has similarly declined, as has the cost of futures and swaps brokerage. Volumes, across all markets, have responded to the decrease in costs. Some of this improvement in the median cost of trading has come from increased transparency, and a lot from increased competition.
Those improvements have not come without a cost, but at most times the cost is less apparent. The way the stock market used to be structured was around a number of market-making firms whose job it was to maintain orderly markets – including the distasteful task of being the buyer when everyone else is selling. What this means for the profit of a market-maker is that they generally made steady, small profits (a quarter of a point on every share, day in and day out) and occasionally lost huge amounts in market panics. It’s a classic “short gamma” position of picking up nickels before the bulldozer, and well-understood by the market-makers to be so. But that was the deal: you let the market-maker take his spread as an insurance premium, and collect on that premium when a calamity hits. Primary dealers in the government bond markets worked the same way: in exchange for the privilege of building an auction book (and being able to bid on the auction with that knowledge) and making spreads as a market-maker most of the time, it was understood that they were supposed to work to keep markets liquid in the bad times.
Then, we decided that we didn’t like paying all of these insurance premiums, which we called the “cost of trading” but could also be considered “the cost of providing continuous liquidity in bad times.” So stock prices were decimalized, which immediately started narrowing spreads. Electronic trading made the deal even worse because anyone could jump in front of the market-maker and be the bid or the offer, meaning that the market-maker wasn’t earning the spread. In many cases, there wasn’t any spread left to earn.
There is a parallel to something else I’ve written about recently, and that’s the trend over the years to lower and lower costs, and longer and longer supply chains, in manufacturing. Such a system is lower cost, but the price of that cost-savings is fragility. A long, international supply chain gets snarled much more easily and much worse than a short, domestic one. That cost/fragility tradeoff is the bargain that manufacturers made, although not thoughtfully.
Similarly, the price of the cost-savings from sub-penny equity spreads is fragility in the market-making system. It is difficult to find dealers who will accept the responsibilities of being the buyer or seller of last resort, and maintaining orderly markets, when that cost is not counterbalanced by an increase in profit opportunities during placid times.
As with international trade, we have begun to see the downside of this tradeoff when trading risks increase. Not that this is the first time, but it seems these days that liquidity conditions get sketchier more quickly now than they used to. Of course, we saw this as recently as March 2020, when trading in credit got so bad that the Fed had to step in and backstop corporate bond ETFs by buying corporate bonds and ETFs under the Secondary Market Corporate Credit Facility.[1] Recently, the Nickel market basically broke when prices went vertical and the resulting margin calls would have put some LME brokers out of business (conveniently, the LME decided to just cancel the trades that they didn’t like, which means those brokers are still in business but probably won’t have a market to broker). Prices went vertical partly because there are fewer highly-capitalized market-maker shops to stand in the middle and make orderly markets. Also recently, the European Federation of Energy Traders pleaded for “emergency funding mechanisms” so that they can continue to trade energy markets that have had greatly increased volatility recently.[2]
Now, the disturbing thing is that we are starting to see declines in liquidity even in fairly unremarkable periods. The last seven months’ worth of volatility in interest rate markets was higher than we’d seen in some years, but not exactly unprecedented. This month, 10-year Treasury yields are up 57bps. In 2002, 10-year yields fell 170 bps between May and October, in something close to a straight line driven by mortgage convexity. In about 6 weeks from May to June in 2003, yields dropped 81bps and then immediately reversed 129bps higher over the ensuing 6 weeks (same reason, different direction). I mention those two episodes because I was making markets in rates options and remember them not-very-fondly.
But these recent 57bps have been a lot more stressful on the market with fewer strong hands responsible for maintaining order. The chart below shows the BofA MOVE index, which measures normalized implied volatility on 1-month Treasury options. Recently, that index reached its second-highest level since the Global Financial Crisis. The highest prior level was in the March 2020 shutdown crash…understandable… and during the GFC banks were undercapitalized and in risk of failure. What’s the reason now?
We also see it in various market ecosystems. For example, there are roughly two dozen “Lead Market Makers” in the ETF ecosystem. In order to launch an ETF, you need to find someone to be the LMM. The function of the LMM is to make markets in virtually all conditions. But it is exquisitely hard to get an LMM signed up nowadays because the math for them works out badly. If your fund is very small, they make a decent spread but on tiny volume so it’s not very lucrative. As soon as your fund gets large, everyone else jumps in front of your markets, because they can and there’s money there to be made, so the LMM either makes no spread at all or makes a very small spread. Of course, those other Johnny-come-latelies will scatter the first time there is volatility, leaving the LMM there all alone to make orderly markets. So the market-making itself is a bad deal for the LMM in almost all circumstances. Their models are only tenable if they are able to make money on the relationship with the ETF issuer in other ways – being a broker for fund rebalancing, etc. This means that fewer good ETFs come to market than otherwise would. I have lamented this elsewhere. And the root cause and ultimate result are the same: we’ve engineered a very low-cost, high fragility system for investors to deal in.
The bottom line is that as any insurance agent can tell you people really hate paying for insurance. But no one expects insurance companies to provide insurance without being paid at least a fair premium. What would happen if we did? Well, then we wouldn’t have any insurance. Financially speaking right now, we don’t have much insurance because it’s too costly to stand in the middle. That looks like a win, until something catches on fire.
[1] For the Fed to buy corporate bonds was long held to be impermissible, since the Federal Reserve Act listed the assets the Fed was authorized to buy and that list did not include corporates and equities. Clearly, this was meant to follow Bagehot’s dictum that a central bank, to avert panic, “should lend early and freely, to solvent firms, against good collateral, and at ‘high rates’”, but thanks to clever lawyers who note that the Act does not explicitly prohibit the Fed from buying these things the Fed has in recent years decided that since it wants to, what could go wrong?
[2] A sad aside is that the movement to remove “pricey, greedy market-makers” and replace them with bailouts provided by central bank or treasury is the opposite of what Dodd-Frank was supposedly trying to do in ensuring that systemically-important institutions were adequately capitalized. They’re adequately capitalized now, but they don’t provide the market-braking function they used to because that’s ‘speculative activity’ that penalizes capital severely.
Trust Masters, not Models
Normally, when I write about markets, I try to point at models but there is a lot of guesswork and gut-work in analysis. When times are sort of normal, then models can be a big part of what drives your thinking. But times have not been ‘normal’ for a very long time, and this is part of what drives big policy errors (and big forecasting errors): if you are out of the ‘normal’ range, then to make a forecast or comment usefully on what is going on you need to have a good feel for what the model is actually trying to capture. You need to know where the model goes wrong.
When I was a rates options trader – stop me if I’ve told this story before – I found that I preferred to use a simple Black-Scholes pricing model instead of some fancy recombining-trinomial-tree-with-heteroskedastic-volatility-model. That was because even though Black Scholes doesn’t match up super well with reality, I at least had a good feel for where it fell short. For example, the whole reason we have a volatility smile is because real-world returns have fat tails, but pricing models like Black Scholes are based on the normal distribution. When the smile flattens, it means returns are becoming more like they’re being drawn from a normal distribution; when it steepens it means that the tails are becoming fatter. So that’s easy to understand.
If you understand why an option model works, then it’s easier to think about how to price something esoteric like an option on an inflation swap (which can trade at a negative rate, but actually isn’t a rates product at all but rather is a way of trading a forward price), and not mess it up. But if you just apply and try to calibrate a bad model – especially if it’s really complicated – then you get potentially really bad outcomes. And that is, of course, exactly where we are today.
We haven’t been ‘normal’, I guess, for a couple of decades. Central banks, and in particular the Federal Reserve, have dealt in the markets with a heavier and heavier hand. Nowadays, the Fed not only has expanded its balance sheet by trillions in a very short period of time, but it has expanded the range of markets it is involved in from Treasuries to mortgages to ETFs and now individual corporate bonds. And, since the whole point of this is because the Fed wants to make sure the stock market stays elevated (they are preternaturally terrified at the notion of a wealth effect from a market crash, even though historically the wealth effect has been surprisingly small) I suspect it is only a matter of time before they directly intervene in equity markets.[1] C’est la vie. There is no normal any more.
But at least the ‘normal’ we have had over the last decade was just modestly outside of the prior normal. Things didn’t work right according to the ‘traditional’ way of thinking about things; momentum became ascendant in a way we’ve never seen before and value almost irrelevant. We are now, though, working on a whole different part of the number line. This means that economists will continue to be surprised at almost everything they see, and it means that any model you look at needs to be informed by a good intuition about how the hell it works.
So, for example, let’s consider the money supply. Over the last 13 weeks, M2 is up at a 63% annualized rate. With two weeks left in the quarter, it looks like we will end up with something like a 10.25%-10.50% growth in the money supply for the quarter. The Q2 average money supply, compared to Q1 (important in looking at the MV=PQ equation), is going to be about 13.85% higher. That’s not annualized! Remember, the old record in M2 growth for a year was a bit above 13%, in 1976.
The current NY Fed Nowcast for 2nd Quarter GDP – keeping in mind that no one has any idea, this is as good a guess as any – is -19.03%. I really like the .03 part. That’s sporty. That would mean q/q growth of -4.75%.
If we want the price deflator to come in around 1.75% (+0.44% q/q), which is where it was for the year ended in Q1, then that means money velocity needs to fall about 16% for the quarter. (1-4.75%)*(1+0.44%)/(1+13.85%)-1 = -15.97%. If money velocity falls less, and that GDP estimate is correct, then inflation comes in higher. If money velocity falls more, then inflation comes in lower. If GDP growth is actually better than -19% annualized, then inflation is lower; if GDP is worse, then inflation is higher. We don’t need to worry much about the M2 numbers themselves, as they’re almost baked in the cake at this point.
The biggest amount that money velocity has ever fallen q/q is about 5%. But clearly, these are different times! We’ve also never seen a 19% decline in growth.
Weirdly, our model has M2 money velocity for Q2 at 1.159, which would be a 15.6% decline in money velocity. Let me stress that that is a total coincidence, and I put almost zero weight on that point estimate. Contributing to that sharp decline, in our model, is the small decline in interest rates from Q1, the increase in the non-M1 part of M2, the small increase in global negative-yielding debt, and (most importantly) a large increase in precautionary demand for cash balances due to economic uncertainty. (This is why it’s hard to get velocity to stay down at this level. The current low levels depend on low interest rates, which will probably persist, but also on dramatic precautionary savings, which are unlikely to). Small changes in money velocity will have big effects on inflation: if our model estimate for velocity was right, we’d see annualized inflation for Q2 at 4.3% or so. Here’s how confident I am in our model: for Q3, it is seeing unchanged velocity (approximately), which with money trends and the GDP Nowcast figures from the NY Fed would imply that y/y inflation would rise to 6.22%, about 17.5% annualized for the quarter. Not going to happen.
Here’s where knowing a bit about the underlying process and assumptions really matters. Velocity is effectively a plug number, in that bureaucrats are good at measuring money and pretty good at measuring GDP and prices, but really bad at measuring velocity directly. So velocity is solved for. And our model (along with every other model, probably) treats the response of money velocity to the input variables as more or less instantaneous. For small changes in these variables – movements in money growth from 4% to 6%, or GDP from 2% to 0% – the assumption about instantaneity is pretty irrelevant. The economy adjusts prices easily to small changes in conditions. But that’s not true at all for big changes. On the available evidence, many prices (if not most) accelerated a bit in Q2, which surprised almost everyone including us. But no matter what the model says, prices are not going to drop 5% in a quarter, or rise 5% in a quarter, for the entire consumption basket. Price changes take time – heck, rents don’t change every month, and it takes time to rotate through the sample. Also, manufacturers don’t tend to make large changes in prices overnight, preferring to drip it in and see consumer response. But here’s the point: the model doesn’t know this. So I suspect we will see money velocity this quarter around 1.14-1.17…not because I believe our model but because I think prices will accelerate by a little bit and I think the real uncertainty surrounds the forecast of GDP. Over time, velocity and inflation will converge with our model, but it will take time.
For what it’s worth, I think that GDP growth will be a little lower than the NY Fed thinks, for a different model reason: the model assumes that changes in various economic data can be mapped to changes in GDP. But that assumes a fairly stable price level…what they’re really mapping this data onto is the nominal price level, and assuming that the price level doesn’t change enough to matter. So I think some of the dollar improvement in durable goods sales, for example, reflects rising prices and not growth, which would be manifested in a slightly lower GDP change and a slightly higher GDP deflator change.
What does this mean and why does it matter?
For one thing…and you already knew this…models are currently trash. They mean almost nothing by themselves. You should ignore it all. I give very little credence to the NY Fed’s forecast. I am pretty sure Q2 GDP growth will have a minus sign, but I couldn’t tell you between -15% and -25% and neither can they. Which is why the -19 POINT OH-THREE is so sporty. But by the same token, you should listen more to the model-builder, and to people who understand what’s going on behind the models, and to people who are taking measurements directly rather than taking them from models. Because this is going back to the art of forecasting, and away from the science. We are over-quanted in this world, and we are over-committed to models, and we are overconfident in models, and we are over-reliant on models. They have a place, just as the autopilot has a place when conditions are placid. When things get rough, you want a real pilot holding the controls.[2]
There used to be a couple of guys in Boston who were auto mechanics and had a radio show. People would call up and describe the noises their cars made, and the guys would ask whether it made the noise only turning left, or both directions, and whether it got worse when it was humid, and other things that sounded crazy to you and me. And then they would diagnose the problem, sight-unseen. Those are the people you want to take your car to. They’re the ones who understand how it really works, and they don’t need to hook your car up to a computer to tell you what the problem is. I took my car to them, and they really were geniuses at it. So look for those people in market space: the ones who can tell by the sound of the squeal what is really going on under the hood. They won’t always be right, but they will have the best guesses…especially when something unusual happens.
[1] Ironically, I think that something else they are considering would have a much bigger effect on equity markets than if they directly bought equities, but I don’t want to talk about that in this space because it also has big implications for inflation-related markets and would create some really delicious relative value trades that I don’t want to discuss here.
[2] Although I didn’t think I’d remark on this in today’s comment: this is also why the Trump Administration’s move today to loosen the Volcker Rule to let banks take more risks with their capital is very timely. There is a lot of bumpy flight ahead of us and we should want seasoned traders making the markets with actual capital behind them, not robots looking to scalp an eighth.
You Haven’t Missed It
A question I always enjoy hearing in the context of markets is, “Have I missed it?” That simple question betrays everything about the questioner’s assumptions and about the balance of fear and greed. It is a question which, normally, can be answered “no” almost without any thought to the situation, if the questioner is a ‘normal’ investor (that is, not a natural contrarian, of which there are few).
That is because if you are asking the question, it means you are far more concerned with missing the bus than you are concerned about the bus missing you.
It usually means you are chasing returns and are not terribly concerned about the risks; that, in turn – keeping in mind our assumption that you are not naturally contrary to the market’s animal spirits, so we can reasonably aggregate your impulses – means that the market move or correction is probably underappreciated and you are likely to have more “chances” before the greed/fear balance is restored.
Lately I have heard this question arise in two contexts. The first was related to the stock market “correction,” and on at least two separate occasions (you can probably find them on the chart) I have heard folks alarmed that they missed getting in on the correction. It’s possible, but if you’re worried about it…probably not. The volume on the bounces has diminished as the market moves away from the low points, which suggests that people concerned about missing the “bottom” are getting in but rather quickly are assuming they’ve “missed it.” I’d expect to see more volume, and another wave of concern, if stocks exceed the recent consolidation highs; otherwise, I expect we will chop around until earnings season is over and then, without a further bullish catalyst, the market will proceed to give people another opportunity to “buy the dip.”
The other time I have heard the angst over missing the market is in the context of inflation. In this, normal investors fall into two categories. They’re either watching 10-year inflation breakevens now 100bps off the 2016 lows and 50bps off the 2017 lows and at 4-year highs (see chart, source Bloomberg) and thinking ‘the market is no longer cheap’, or they just noticed the well-telegraphed rise in core inflation from 1.7% to 2.1% over the last several months and figuring that the rise in inflation is mostly over, now that the figure is around the Fed’s target and back at the top of the 9-year range.
Here again, the rule is “you didn’t miss it.” Yes, you may have missed buying TIPS 100bps cheap to fair (which they were, and we pointed it out in our 2015Q3 Quarterly Inflation Outlook to clients), but breakevens at 2.17% with median inflation at 2.48% and rising (see chart, source Bloomberg), and still 25bps below where breakevens averaged in the 5 years leading up to the Global Financial Crisis, says you aren’t buying expensive levels. Vis a vis commodities: I’ve written about this recently but the expectations for future real returns are still quite good. More to the point, inflation is one of those circumstances where the bus really can hit you, and concern should be less about whether you’ve missed the gain and more about whether you need the protection (people don’t usually lament that they missed buying fire insurance cheaper, if they need fire insurance!).
(In one way, these two ‘did I miss it’ moments are also opposites. People are afraid of missing the pullback in stocks because ‘the economy still looks pretty strong,’ but they’re afraid they missed the inflation rally because ‘the economy is going to slow soon and the Fed is tightening and will keep inflation under control.’ Ironically, those are both wrong.)
My market view is this:
- For some time, TIPS have been very cheap to nominal bonds, but rich on an absolute Negative real yields do not a bargain make, even if they look better than other alternatives when lots of asset classes are even more expensive. But as real yields now approach 1% (70bps in 5y TIPS, 80bps in 10y TIPS), and with TIPS still about 35bps cheap to nominal bonds, they are beginning to be palatable to hold on their own right. And that’s without my macro view, which is that over the next decade, one way or the other, inflation protection will become an investment theme that people tout as a ‘new focus’ even though it’s really just an old focus that everyone has forgotten. But the days of <1% inflation are over, and we aren’t going to see very much <2% either. We may not see 4% often, or for long, but at 3% inflation is something that people need to take into account in optimizing a portfolio. I think we’re at that inflection point, but if not then we will be in a year or two. And TIPS are a key, and liquid, component of smart real assets portfolios.
- Stocks have been outrageously expensive with very poor forward return expectations for a long time. However, these value issues have been overwhelmed by strong momentum (that, honestly, I never gave enough credit to) and the currently in-vogue view that momentum is somehow better than value. But perennially strong momentum is no longer a foregone conclusion. Momentum has stalled in the stock market – the S&P has broken the 50-day, 100-day, and (a couple of times, though only briefly so far) 200-day moving averages. The 50-day has now crossed below the 100-day. And the longer that the market chops sideways the weaker the momentum talisman becomes. Eventually, the value anchor will take over. There may be more chop to come but as I said above, I think another leg down is likely to come after earnings season.
And so, in neither case have you “missed it.”
Kicking Tails
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Like many people, I find that poker strategy is a good analogy for risk-taking in investing. Poker strategy isn’t as much about what cards you are dealt as it is about how you play the cards you are dealt. As it is with markets, you can’t control the flop – but you can still correctly play the cards that are out there.[1] Now, in poker we sometimes discover that someone at the table has amassed a large pile of chips by just being lucky and not because they actually understand poker strategy. Those are good people to play against, because luck is fickle. The people who started trading stocks in the last nine years, and have amassed a pile of chips by simply buying every dip, are these people.
All of this is prologue to the observation I have made from time to time about the optimal sizing of investment ‘bets’ under conditions of uncertainty. I wrote a column about this back in 2010 (here I link to the abbreviated re-blog of that column) called “Tales of Tails,” which talks about the Kelly Criterion and the sizing of optimal bets given the current “edge” and “odds” faced by the bettor. I like the column and look back at it myself with some regularity, but here is the two-sentence summary: lower prices imply putting more chips on the table, while higher volatility implies taking chips off of the table. In most cases, the lower edge implied by higher volatility outweighs the better odds from lower prices, which means that it isn’t cowardly to scale back bets on a pullback but correct to do so.
When you hear about trading desks having to cut back bets because the risk control officers are taking into account the higher VAR, they are doing half of this. They’re not really taking into account the better odds associated with lower prices, but they do understand that higher volatility implies that bets should be smaller.
In the current circumstance, the question merely boils down to this. How much have your odds improved with the recent 10% decline in equity prices? Probably, only a little bit. In the chart below, which is a copy of the chart in the article linked to above, you are moving in the direction from brown-to-purple-to-blue, but not very far. But the probability of winning is moving left.
Note that in this picture, a Kelly bet that is less than zero implies taking the other side of the bet, or eschewing a bet if that isn’t possible. If you think the chance that the market will go up (edge) is less than 50-50 you need better payoffs on a rally than on a selloff (odds). If not, then you’ll want to be short. (In the context of recent sports bets: prior to the game, the Patriots were given a better chance of winning so to take the Eagles at a negative edge, you needed solid odds in your favor).
Now if, on the other hand, you think the market selloff has taken us to “good support levels” so that there is little downside risk – and you think you can get out if the market breaks those support levels – and much more upside risk, then you are getting good odds and a positive edge and probably want to bet aggressively. But that is to some extent ignoring the message of higher implied volatility, which says that a much wider range of outcomes is possible (and higher implied volatility moves the delta of an in-the-money option closer to 0.5).
This is why sizing bets well in the first place, and adjusting position sizes quickly with changes in market conditions, is very important. Prior to the selloff, the market’s level suggested quite poor odds such that even the low volatility permitted limited bets – probably a lot more limited than many investors had in place, after many years of seeing bad bets pay off.
[1] I suspect that Bridge might be as good an analogy, or even better, but I don’t know how to play Bridge. Someday I should learn.
The Limits to Trusting the Robots
After another day on Thursday of stocks starting to look mildly tired – but only mildly – only to rally back to a new closing high, it hardly seems unusual any more. I have to keep pinching myself, reminding myself that this is historically abnormal. Actually, very abnormal. If the S&P 500 Total Return Index ends this month with a gain, it will be the second time in history that has happened. The other time was in 1936, as stocks bounced back from a deep bear market (at the end of those 12 months, in March 1936, stocks were still 54% off the 1929 highs). A rally this month would also mean that stocks have gained for 19 out of the last 20 months, the longest streak with just one miss since…1936 again.
But we aren’t rebounding from ‘oversold.’ This seems to be a different situation.
What is going on is confounding the wise and the foolish alike. Every dip is bought; the measures of market constancy (noted above, for example) are at all-time highs and the measures of market volatility such as the VIX are at all-time lows. It is de rigeur at this point to sneer “what could go wrong?” and you may assume I have indeed so sneered. But I also am curious about whether there is some kind of feedback loop at work that could cause this to go on far longer than it “should.”
To be sure, it shouldn’t. By many measures, equities are at or near all time measures of richness. The ones that are not at all-time highs are still in the top decile. Buying equities (or for that matter, bonds) at these levels ought to be a recipe for a capitalistic disaster. And yet, value guys are getting carried out left and right.
Does the elimination (with extreme prejudice) of value traders have any implications?
There has been lots of research about market composition: models, for example, that examine how “noise” and “signal” traders come together to create markets that exhibit the sorts of characteristics that normal markets do. Studies of what proportion of “speculators” you need, compared to “hedgers,” to make markets efficient or to cause them to have bubbles form.
So my question is, what if the combination of “buy the dip” micro-time-frame value guys, combine with the “risk parity” guys, represents a stable system?
Suppose equity volatility starts to rise. Then the risk-parity guys will start to sell equities, which will push prices lower and tend to push volatility higher. But then the short-term value guys step in to ‘buy the dip.’ To be clear, these are not traditional value investors, but rather more like the “speculators” in the hedger/speculator formulation of the market. These are people who buy something that has gone down, because it has gone down and is therefore cheaper, as opposed to the people who sell something that has gone down, because the fact that it has gone down means that it is more likely to go down further. In options-land, the folks buying the dip are pursuing a short-volatility strategy while the folks selling are pursuing a long-volatility strategy.[1]
Once the market has been stabilized by the buy-the-dip folks, who might be for example hedging a long options position (say, volatility arbitrage guys who are long actual options and short the VIX), then volatility starts to decline again, bringing the risk-parity guys back into equities and, along with the indexed long-only money that is seeking beta regardless of price, pushing the market higher. Whereupon the buy-the-dip guys get out with their scalped profit but leaving prices higher, and volatility lower, than it started (this last condition is necessary because otherwise it ends up being a zero-sum game. If prices keep going higher and implied volatility lower, it need not be zero-sum, which means both sides are being rewarded, which means that we would see more and more risk-parity guys – which we do – and more and more delta-hedging-buy-the-dip guys – which we do).
Obviously this sort of thing happens. My question though is, what if these different activities tend to offset in a convergent rather than divergent way, so that the system is stable? If this is what is happening then traditional value has no meaning, and equities can ascend arbitrary heights of valuation and implied volatility can decline arbitrarily low.
Options traders see this sort of stability in micro all the time. If there is lots of open interest in options around, say, the 110 strike on the bond contract, and the Street (or, more generally, the sophisticated and leveraged delta-hedgers) is long those options, then what tends to happen is that if the bond contract happens to be near 110 when expiry nears it will often oscillate around that strike in ever-declining swings. If I am long 110 straddles and the market rallies to 110-04, suddenly because of my gamma position I find myself long the market since my calls are in the money and my puts are not. If I sell my delta at 110-04, then I have locked in a small profit that helps to offset the large time decay that is going to make my options lose all of their remaining time value in a short while.[2] So, if the active traders are all long options at this strike, what happens is that when the bond goes to 110-04, all of the active folks sell to try and scalp their time decay, pushing the bond back down. When it goes to 99-28, they all buy. Then, the next time up, the bond gets to 110-03 and the folks who missed delta-hedging the last time say “okay, this time I will get this hedge off” and sell, so the oscillation is smaller. Sometimes it gets really hard to have any chance of covering time decay at all because this process results in the market stabilizing right at 110-00 right up until expiration. And that stabilization happens because of the traders hedging long-volatility positions in a low-volatility environment.
But for the options trader, that process has an end – options expiration. In the market process I am describing where risk-parity flows are being offset by buy-the-dip traders…is there an end, or can that process continue ad infinitum or at least, “much longer than you think it can?”
Spoiler alert: it already has continued much longer than I thought it could.
There is, however, a limit. These oscillations have to reach some de minimus level or it isn’t worth it to the buy-the-dip guys to buy the dip, and it isn’t worth reallocation of risk-parity strategies. This level is much lower now than it has been in the past, thanks to the spread of automated trading systems (i.e., robots) that make the delta-hedging process (or its analog in this system) so efficient that it requires less actual volatility to be profitable. But there is a limit. And the limit is reach two ways, in fact, because the minimum oscillation needed is a function of the capital to be deployed in the hedging process. I can hedge a 1-lot with a 2 penny oscillation in a stock. But I can’t get in and out of a million shares that way. So, as the amount of capital deployed in these strategies goes up, it actually raises the potential floor for volatility, below which these strategies aren’t profitable (at least in the long run). However, there could still be an equilibrium in which the capital deployed in these strategies, the volatility, and the market drift are all balanced, and that equilibrium could well be at still-lower volatility and still-higher market prices and still-larger allocations to risk-parity etc.
It seems like a good question to ask, the day after the 30th anniversary of the first time that the robots went crazy, “how does this stable system break down?” And, as a related question, “is the system self-stabilizing when perturbed, or does it de-stabilize?”
Some systems are self-stabilizing with small perturbations and destabilizing with larger perturbations. Think of a marble rolling around in a bowl. A small push up the side of the bowl will result in the marble eventually returning to the bottom of the bowl; a large push will result in the marble leaving the bowl entirely. I think we are in that sort of system. We have seen mild events, such as the shock of Brexit or Trump’s electoral victory, result in mild volatility that eventually dampened and left stocks at a higher level. I wonder if, as more money is employed in risk parity, the same size perturbation might eventually be divergent – as volatility rises, risk parity sells, and if the amount of dip-buyers is too small relative to the risk parity sellers, then the dip-buyers don’t stabilize the rout and eventually become sellers themselves.
If that’s the secret…if it’s the ratio of risk-parity money to dip-buyer money that matters in order to keep this a stable, symbiotic relationship, then there are two ways that the system can lose stability.
The first is that risk parity strategies can attract too much money. Risk parity is a liquidity-consumer, as they tend to be sellers when volatility is rising and buyers when volatility is falling. Moreover, they tend to be sellers of all assets when correlations are rising, and buyers of all assets when correlations are falling. And while total risk-parity fund flows are hard to track, there is little doubt that money is flowing to these strategies. For example one such fund, the Columbia Adaptive Risk Allocation Fund (CRAZX), has seen fairly dramatic increases in total assets over the last year or so (see chart, source Bloomberg. Hat tip to Peter Tchir whose Forbes article in May suggested this metric).
The second way that ratio can lose stability is that the money allocated to buy-the-dip strategies declines. This is even harder to track, but I suspect it is related to two things: the frequency and size of reasonable dips to buy, and the value of buying the dip (if you buy the dip, and the market keeps going down, then you probably don’t think you did well). Here are two charts, with the data sourced from Bloomberg (Enduring Intellectual Properties calculations).
The former chart suggests that dip-buyers may be getting bored as there are fewer dips to buy (90% of the time over the last 180 days, the S&P 500 has been within 2% of its high). The latter chart suggests that the return to buying the dip has been low recently, but in general has been reasonably stable. This is essentially a measure of realized volatility. In principle, though, forward expectations about the range should be highly correlated to current implied volatility so the low level of the VIX implies that buying the dip shouldn’t give a large return to the upside. So in this last chart, I am trying to combine these two items into one index to give an overall view of the attractiveness of dip buying. This is the VIX, minus the 10th percentile of dips to buy.
I don’t know if this number by itself means a whole lot, but it does seem generally correct: the combination of fewer dips and lower volatility means dip-buying should become less popular.
But if dip-buying becomes less popular, and risk-parity implies more selling on dips…well, that is how you can get instability.
[1] This is not inconsistent with how risk parity is described in this excellent paper by Artemis Capital Management (h/t JN) – risk parity itself is a short volatility strategy; to hedge the delta of a risk parity strategy you sell when markets are going down and buy when markets are going up, replicating a synthetic long volatility position to offset.
[2] If this is making your eyes glaze over, skip ahead. It’s hard to explain this dynamic briefly unless I assume some level of options knowledge in the reader. But I know many of my readers don’t have that requisite knowledge. For those who do, I think this may resonate however so I’m plunging forward.
Hard to Sugar-Coat Nonsense Like This
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One of the things that fascinates me about markets – and one of the reasons I think “Irrational Exuberance”, now in its third edition, is one of the best books on markets that there is – is how ‘storytelling’ takes the place of rational analysis so easily. Moreover, almost as fascinating is how easily those stories are received uncritically. Consider this blurb on Bloomberg from Wednesday (name of the consultant removed so as not to embarrass him):
Sugar: Talk in market is that climate change has pushed back arrival of winter in Brazil and extended the high-risk period for frost beyond July, [name removed], risk management consultant for [company name removed] in Miami, says by telephone.
Sugar futures have recently been bouncing after a long decline. From February through June, October Sugar dropped from 20.40 cents/lb to 12.74¢; since the end of June, that contract has rallied back to 14.50¢ (as of Wednesday), a 14% rally after a 38% decline. There are all sorts of reasons this is happening, or may be happening. So let’s think about ‘climate change’ as an explanation.
There are several layers here but it boils down to this: the consultant is saying (attributing it to “talk in the market,” but even relaying this gem seems like gross negligence) that the rally in the last few weeks is due to a change in the timing of the arrival of winter…a change which, even if you believe the craziest global warming scaremongers, could not possibly have been large enough over the last decade to be measurable against the backdrop of other natural oscillations. Put another way, in late June “the market” thought the price of sugar ought to be about 12.74¢/lb. Then, “the market” suddenly realized that global warming is increasing the risk to the sugar crop. Despite the fact that this change – if it is happening at all – is occurring over a time frame of decades and centuries, and isn’t exactly suffering from a lack of media coverage, the sugar traders just heard the news this month.
Obviously, that’s ridiculous. What is fascinating is that, as I said, in this story there are at least 4 credulous parties: the consultant, the author of the blurb, the editor of the story, and at least part of the readership. Surely, it is a sign of the absolute death of critical thinking that only habitual skeptics are likely to notice and object to such nonsense?
Behavioral economists attribute these stories to the need to make sense of seemingly-random occurrences in our universe. In ancient times, primitive peoples told stories about how one god stole the sun every night and hid it away until the morning, to explain what “night” is. Attributing the daily light/dark cycle to a deity doesn’t really help explain the phenomenon in any way that is likely to be useful, but it is comforting. Similarly, traders who are short sugar (as the chart below, source Floating Path, shows based on June 27th data) may be comforted to believe that it is global warming, and not unusually short positioning, that is causing the rally in sugar.
As all parents know, too much sugar (or at least, being short it) isn’t good for your sleep. But perhaps a nice story will help…
Inflation Trading is Not for the Weak
I was prepared today to write a column about horse racing and value investing…that will have to wait until tomorrow…when this article was sent to me by about a dozen people:
Deutsche Bank Said to Face Possible $60 Million Derivative Loss
The article was sent my way because the loss was tied to a trade that used US dollar inflation derivatives, and since that’s a market I basically started back in 2003 folks figured I might want to know. And I do.
The inflation derivatives market is not huge. The chart below shows rolling 12-month inflation derivative volumes (source: BGC Partners) through last September, which was the last time I went looking for the data for a presentation. Total interbank volumes are around $10-15bln per month; customer volumes are not included here but are not insignificant (any more).
Most inflation books, especially these Volcker Rule days, are run pretty close to the vest. Most of these volumes will be set against customer flows, or against bond breakevens, or against other positions on the inflation curve. Net risk positions for any derivative book, especially these days, are pretty small…which is why Deutsche is investigating whether risk limits were breached in this case. In principle this should be easy to figure out, since DB and every other bank has risk control specialists whose job it is to monitor these risks.
But inflation risks are complex. Our firm breaks fixed-income risks down into six basis risks that add up to the net risk of a bond. For a TIPS bond, there is just one risk; for a corporate bond there will be six. Our risk schematic starts from real rate risks and builds up – unlike in most risk systems, which start with nominal risks and try to force real bonds to fit. Inflation-linked derivatives also have commodity deltas implied, since they are tied to headline inflation and headline inflation is tied largely to energy prices. Geez, I could write a book on this – it would be a combination of “Inflation Risks and Products”[1] and, in this case, “Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports.”
Suffice it to say that even really sharp investors don’t always quite get it when it comes to inflation. In early 2014, a prestigious investment management firm took a multi-billion-dollar bath on a “risk-parity” product that hadn’t truly understood how to figure out the risks of TIPS. How much more difficult, then, is it for risk control officers, many of whom have shiny new Ph.D.s and very little direct market experience? A fast-talking trader who knows something about the product can, if he is unscrupulous, persuade risk control that he is not really taking risks that he knows, or ought to know, he is taking.
In short, I am sympathetic with the risk control guys in this case. They were probably outgunned by a slick operator pushing the limits of his limits. It’s almost assuredly the case: the market, as large as it is, is too small in the Volcker Rule era to allow the accumulation of a prudent position of large enough size to cause this sort of loss – especially in the recent period of exceptionally low market volatility.
This, then, is an object lesson: if you’re running inflation risk, and you think it’s pretty much like running nominal rate risk – you’re wrong, and you should get help before your firm’s name is the one in the Bloomberg article.[2]
Tomorrow, we can talk about horse racing.
[1] In which I co-wrote a chapter, on commodities actually, with Bob Greer.
[2] To be fair, in this case the problem was the combination of ignorance and what appears to be malfeasance. If you’re careful with your control structures and only hire high-quality people of sterling reputation, you shouldn’t have a problem with the second part of this formula.
