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What Happens if CPI Isn’t Released?
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.
Certainty About Uncertainty
I haven’t written recently because it is hard to figure out what to do here. Market action at this point seemingly has little to do with fundamentals, and isn’t even in “risk on/risk off” mode because no one seems to be sure how the government shutdown affects risk (the debt ceiling debate is another issue, which I will discuss later).
I often get comments to the effect that “political uncertainty is a fact of life,” or “the Fed always manipulates markets,” implying that we cannot simply refuse to invest because markets aren’t trading cleanly off of economic fundamentals (which don’t directly translate into market action even in the best of times anyway). This is true, but I always hearken back to the notion that uncertainty implies a smaller bet size (a long time ago I wrote an article in which I discussed the implications of the Kelly Criterion for thinking about how one invests). When the economic signals are clear but the market isn’t pricing them properly, then you have a great edge and the market is giving you good odds, and most of your chips should be on the table. When the economic signals aren’t clear, or when stochastic political events are likely to overwhelm them, then your bet should be small because your edge is lower even if you are getting good odds.
In this case, of course, no matter what market you are talking about it isn’t at all clear how the debate (perhaps calling it a “debate” is generous) about the continuing resolution to fund government operations, the ACA, and the debt ceiling will be resolved.
We can speculate about what various outcomes might mean to the markets, but even here our analysis is fraught with uncertainty. Would an extended shutdown be good for equity markets because it would imply a greater chance of lower ACA costs and a lengthier period of Fed quantitative easing? Or would it be bad because of the short-term impact on growth as government spending is delayed? Would bonds rally because there would be no incremental supply, or sell off because of the implied risk of default? A lengthy government closure might be bad for the dollar because it implies more monetary ease, but might be good because it represents “fiscal discipline” (admittedly, in this case it’s discipline in the fetishistic sense rather than in the self-control sense). The only thing I am certain about is the uncertainty, and that spells a smaller bet.
Retail investors are especially at a disadvantage, because of the huge amount of misinformation that is out there about likely scenarios and the results of various outcomes. This misinformation is often unwittingly disseminated by media outlets, but I suspect it is rarely unwittingly initiated by the original sources.
For example, a recent New York Times blog was pretty good at discussing the possible outcomes, but flunked on at least one aspect when it stated what would happen to the economy as a result of a federal default. I don’t mean to pick on the Times here, and in general it is a good article. But at one point the writer said that a default could cause a spike in Treasury yields (likely true), but then continued “The price tag on a huge range of other debt products is benchmarked to the cost of Treasuries. That means a spike in the federal government’s borrowing costs would translate into pricier mortgages, car loans and corporate borrowing costs.”
Well, that’s wrong. It’s not offensively wrong, but it’s wrong (and I’m pointing it out partly as an example of how even simple stuff is confused right now). The interest rate on any nominal debt instrument consists of several components: the real cost of money, a premium for expected inflation, and a premium for the riskiness of the credit.[1] Normally, with Treasuries we can say the credit spread is effectively zero, so that we refer to the spread that a corporate bond trades over Treasuries as “the” credit spread because that spread minus zero equals that spread. But there is no reason to think that spread would remain constant if the Treasury’s credit was diminished, any more than it would remain constant if the corporate’s credit was diminished. If Treasury rates spiked because the government’s perceived credit spread was no longer zero, then unless that also affected the perceived credit of, say, Caterpillar then there is no theoretical reason that CAT yields should also rise.[2]
In any event, a federal default is not going to happen unless someone in the Administration wants it to happen. The government’s $2.9 trillion in revenues is quite a bit more than is needed to pay the $300bln or so in interest costs per year, so unless the Treasury simply decided to default (see an excellent article here by my friends at TF Market Advisors) it isn’t going to happen. The Treasury has made some mystifying statements about how they don’t have the capability to pay some expenses and not others, but in the worst case someone can sit down and manually wire the money to every holder. So that’s nonsense that is meant to scare us.
So I don’t have any decent “trading opinions” on the basis of the government shutdown. What I do believe is that this is an unmitigated positive for inflation (positive in the sense of pushing it higher), and thus for breakevens and inflation swaps. The longer the government stays shut, the longer quantitative easing will be in force as the Fed attempts to counteract the short-term contraction of economic activity (the fact that monetary policy is ineffective at affecting growth rates never seems to enter their minds); furthermore a long shutdown will more likely to push the dollar lower in my opinion – although, as I said above, I can argue the reverse position as well. On the other hand, if the Republicans cave quickly, as is likely in my view, and the ACA goes into effect, prices for consumer-purchased medical care will rise rapidly. This is less a statement about whether the ACA will push aggregate health care costs higher, although I believe that it will. It’s more an observation that controlled prices in the government-purchased sector will produce higher prices outside of the controls, and it is this latter group that will be sampled for consumer prices (since the price the government purchases at is not a “consumer” price). Since it is the Medical Care subgroup of CPI that has been pressing core CPI to be lower than median CPI, any rebound in Medical Care inflation will push aggregate core inflation higher.
Was that said in a confusing-enough manner?
TIPS should do well while the government is shut, because there is ongoing growth in demand for TIPS while the supply will be drying up. Unlike with the nominal Treasury market, there is no corporate inflation-linked bond sector that can replace the inflation exposure (although there should be) demanded by investors, so TIPS will tend to outperform nominal bonds in the event that both sets of auctions are canceled.
[1] There are other costs, such as the discount to the interest rate that the Treasury pays as a result of the status of Treasuries as superior collateral in repo and similar exchanges, but they are not relevant to this point.
[2] There may be a practical argument that there might be a substitution effect, but that’s also saying that investors would bet the selloff in Treasuries makes them a better risk-adjusted bet than CAT bonds. However, if the Treasury’s credit spread moved permanently higher, it would not affect the equilibrium bond yield of a corporate bond.
