Archive
The Cool Kids Don’t Like Bonds Any More
Global stock markets were the boring markets for a change, as today global bond markets took a potentially meaningful step back. In the U.S., 10-year yields rose 15bps (with no economic data to point to), reaching 2.28%. Yesterday I noted that most of the last week’s rise in yields had come from an increase in inflation expectations; that trend corrected today, as TIPS were also hammered. Ten-year TIPS yields rose 12bps, to -0.10%, implying that the 10-year breakeven rose a mere 3bps.
This was not just a U.S. story. The 10-year UK Gilt rose to the highest yield since December, +17bps today. Germany was +13bps today although still in the range; JGBs up to the highest level since December although that’s also only 9bps above the low yield from the last quarter since JGB yields have been effectively ‘pinned’ for a long time.
Although in the U.S. our selloff was largely in real yields today, the underlying pressure here is from prices. I have previously illustrated the fact that core inflation globally has been rising for two years; this is starting slowly to be reflected in yields. The chart below is an eye-opening one of Japanese 5-year breakevens (there is no 10-year breakeven because Japan stopped issuing inflation-linked bonds a few years ago although they may soon resume). It has been rising almost non-stop since mid-2010, from -1.5% in five-year inflation expectations to…a positive number. That’s right, the poster child for deflation now has investors expecting prices to rise (albeit a small amount) over the next five years.
And with that small change, the yen has fallen 8 big figures against the dollar in about a month (see Chart, shown in terms of the number of yen per dollar). Higher inflation in Japan means the Yen is finally losing real purchasing power too, and is no longer essentially a one-way bet versus the dollar.
Here is another chart you don’t see much. This is 10-year Australian breakevens:
Euro 10-year inflation swap rates, despite the tremendous recent troubles, are closer to the highs than the lows of inflation expectations over the last several years:
Twenty basis points, or forty basis points, is nothing to get all in a lather about, yet. But I believe it is significant that global bond markets are all pricing in more inflation over the last few months, and nominal yields today all rose. This is not a global growth story – it’s mostly a global inflation story.
In that context, it was especially odd to see precious metals get battered again today (-3.3%), although the reasoning is easy enough to understand. Precious metals may hedge against a growth Armageddon, or they may hedge against inflation – but it is hard for them to hedge both outcomes at the same time. Betting on Armageddon has never been a good bet, so far (since we’ve had zero Armageddons as of this writing), and being long precious metals in anticipation of that event is never a good idea. That said, there are other reasons to be long precious metals as part of a diversified commodity index, and I continue to be amused and confused by the fact that inflation indications are sprouting up all over, in many markets…but not yet in commodities, which historically produces the highest inflation “beta” in the early stages of an inflation episode. I think the adjustment will eventually come, and it may be swift when it does.
To repeat, a one-day or one-week selloff in bonds, even global in nature, is nothing to get panicky about. But higher inflation, higher interest rates, and higher gasoline prices each singly poses a challenge for increasingly-lofty equity valuations. Collectively, they pose a dangerous threat. Right now, the stock market doesn’t seem to know what is good for it. It reminds me a bit of a rebellious teenager, like James Dean in “Rebel Without A Cause.” No good can come of the drag racing being done in equities right now. That being said, I covered some of my short (through equity options) on Tuesday before the Fed, because this feels like a pom-pom rally and everything is going to feel great until the morning.
So far, I can’t figure out how far away dawn is. The rapid movements in the dollar/yen, the abrupt drop in bonds, the rise in energy prices – these are all bad, but they’re still fairly insignificant moves. It will take more to derail stocks.
It won’t likely come tomorrow from the surveys (Empire Manufacturing, Consensus: 17.5 vs 19.53 last, and the Philly Fed Survey, Consensus: 12.0 vs 10.2 last) or Initial Claims (Consensus: 357k from 362k). But those are also not likely to be very bullish figures for bonds, either. I suspect the crack in stocks will come if investors notice that conditions in rates markets are getting less accommodative (or more attractive as a competing investment!). At 15bps per day, that may not take long but it’s probably not going to be on Thursday!
Model vs. Reality: Reality Wins
The bond market ended Thursday nearly unchanged, although short TIPS did very well because energy markets continued to trend higher. Gasoline rose 0.8% to $3.1136/gallon and NYMEX Crude added 1.5% to $107.83. Precious Metals were also higher. Stocks gained 0.4%. It is hard to believe this can merely be enthusiasm over growth and a “risk on” trade associated with the purported resolution of Greece’s troubles. In fact, I will say that with the almost unanimous acceptance of the notion that “the crisis is over” among the mainstream media makes me very nervous. Apple has recovered its losses from last Thursday, although on a fraction of the volume it had on the selloff, but I am accumulating equity hedges. Implied vols are at a 7-month low, but I don’t think risk is.
That is all I am going to say about market action today, because I want to mention a research publication that crossed my desk today and discuss what it means to a trader who is also an econometrician.
Goldman Sachs Global Economics, Commodities and Strategy Research today produced a piece called “The Top-Down Logic for Our Inflation Forecast.” In it, the economics team explains why they are calling for core inflation to fall to 1.5% in 2012, and 1.3% next year. Their reasoning is the “the combination of labor market slack and anchored inflation expectations should reassert itself in lower core price inflation over time.”
Frequent readers of this column will know that I have rebut the labor market slack hypothesis a number of times, and while I haven’t explicitly rebut the ‘anchored inflation expectations’ argument (mainly because modeling this requires complicated regime-shifting models that make it hard to refute null hypotheses) I am highly critical of them since the evidence in support of the notion that inflation expectations matter is based on measures of inflation expectations that demonstrably fail to measure inflation expectations.
So, you would think that these few paragraphs would be criticizing the forecast of Goldman Sachs. But that’s not really my point. Really, I want to point out the really hysterical part of the note, and observe why sell-side economic analysis is so useless (although some economists at Goldman, to be fair, are quite good). Goldman says “Although the model failed to capture the sharp pick-up in inflation in 2011, our bottom-up analysis suggests that this deviation was chiefly driven by special factors outside of the scope of the model, including pass-through from surging commodity prices and a spike in auto prices.”
Yes, that’s right: if there’s a discrepancy between reality and the model, then obviously it is reality at fault and not the model!
To make the hilarity of this point clear I reproduce below the chart from their piece:
So all the model failed to do is to pick up the most-dramatic rise in core inflation in the last 35 years or so.
To make this fair, here’s my own model (now Enduring Investments’ model) covering the same period. Note that the model forecasts are actually finalized about 12 months ahead.
As I’ve said frequently, the current surge in inflation has not been fully captured by our model (although if we distributed the lags, rather than doing a simple lag, it would probably have done better, as the strange spike in late 2011 suggests). But at least it got the direction right, and began to rise at the right time, and for the right reasons. And, unlike Goldman, I think the reason for the difference is that our model isn’t quite right and is missing or underestimating some effect – so I expect our model will catch up with reality, rather than the other way around as Goldman does.
If an economist is highly confident in the model, then it can be reasonable to expect minor deviations to be mean-reverting. But it’s the model that’s mean-reverting, not reality (it is a model, after all – it isn’t supposed to capture all the nuance of reality). And if there is a significant deviation in reality from the model, then it can make sense for an economist to hew to the model if he’s 100% confident in the model. But then, if he’s 100% confident in a model, he’s an idiot. Which reminds me of this:
Bernanke: Well, this fear of inflation, I think is way overstated. We’ve looked at it very, very carefully. We’ve analyzed it every which way…We’ve been very, very clear that we will not allow inflation to rise above 2% or less…We could raise interest rates in 15 minutes if we have to. So, there really is no problem with raising rates, tightening monetary policy, slowing the economy, reducing inflation, at the appropriate time…
Pelley: You have what degree of confidence in your ability to control this?
Bernanke: One hundred percent.
Aside from the irony that we’re already above 2% (although not in core PCE, which he will claim should be understood), the other commonality (besides utter confidence in the model) between Goldman’s economists and this Princeton economist is that they’re absolutely confident that they have the right model: labor slack and inflation expectations. So far, we have seen from neither one of these sets of economists any deep introspection about whether maybe, perhaps, labor slack and inflation expectations don’t really matter, but things like money supply do.
Incidentally, while our model’s forecast for year-end is 2.10%, if we’re right on the trend but wrong on the starting level (that is, if the effect we missed was around the bottom and isn’t something persistent) then the more-relevant figure is the 0.8% acceleration in y/y core CPI our model expects in 2012. That would put core inflation at a cool 3%. Interestingly, if we remove the dampening effect the high level of private debt has in our model – that is, if we simply hypothesize that the ratio of private/public debt has a discontinuous effect so it either dampens (at high private/public ratios) or does not dampen (at moderate or low private/public ratios), then we also get 3%. That hypothesis, obviously, is difficult to test, which is why it’s important to not be 100% confident or reliant on your model, and to always be skeptical that you may be missing a key dynamic. Life is not linear. The reason that these economists don’t know that is that they’ve never tried to trade a model! If you are an investor who relies on models, a healthy – and continuous – skepticism is your best defense against reality diverging from your model.
I suspect something in between our model’s forecast (2.1%) and our model’s forecast for acceleration (implying 0.8% acceleration) is right, and so 2.7%-2.8% is our official forecast. By the way…not that it matters, if labor slack and inflation expectations are all that matters…but M2 rose $27.9 billion in the latest week and continues to grow at a better-than-10% pace year/year. It first hit that pace exactly half a year ago.
On Friday, New Home Sales for January (Consensus: 315k from 307k) is due out at 10:00ET. More interesting is that a number of regional Fed Presidents are in NY to speak at a conference on monetary policy. The conference begins at 9:00ET, so be prepared for tape bombs all day from San Francisco Fed Williams, St. Louis Fed President Bullard, Philly Fed President Plosser, and NY Fed President Dudley – a former Goldman Sachs economist, by the way. It will be interesting to hear if any of them is interesting in examining his model, or if they all expect reality to conform to the model.
It being Friday, we are supposed to have some rumors about a Greek deal over the weekend, but I am not sure how to play that since we supposedly have a Greek deal already. Perhaps this means that there won’t be such great expectations, and we can all enjoy the weekend for a change.
How To Exceed Expectations (Or At Least Keep Up)
As we wait for something interesting to happen in the markets – or at least for some volume! – I thought I would write about a way that investors can, should they choose to, invest in a security that is directly linked to inflation expectations. Tomorrow there is useful economic data in the form of Retail Sales (Consensus: 0.3%/0.3% ex-auto) and Initial Claims (Consensus: 375k vs 372k last), although this last is subject to huge error bars because the weeks just before and just after the new year are very hard to seasonally adjust. Still, it’s data. Otherwise, the market continues to chop around with little volume and seemingly little conviction. It’s a good time to consider other approaches, so I am going to do that today.
With monetary policymakers in virtually every corner of the globe furious pumping liquidity into the world’s economies, it is no surprise that many asset markets are not cheap. Equities are expensive, although less so than they were last year; nominal bonds are terribly expensive. Inflation-linked bonds generally sport real yields below zero (out to 10 years) and insubstantial real yields beyond that. Commodities look cheap as a whole, but even though commodity indices are as diversified as equity indices many investors have a hard time putting a huge weight in commodities because of the sense that they are “risky.” Corporate inflation-linked bonds are doubly expensive, with real rates quite low and credit spreads tighter than they should be given the economic outlook. How then can an investor protect him/herself from the possibility of inflation moving higher?
I have been an advocate for commodity indices, of course, which tend to do well when real yields are low and in the early stages of inflationary surprises. But there is another way now that retail investors can fairly easily be long inflation expectations.
First, let me explain some basics. When we talk about nominal yields, such as normal Treasuries have, we recognize that they are made up of several parts. If I borrow money from you, you will first assess the real cost of money – how much more stuff do you want to have at the end of the loan, in order to convince you to defer consumption and lend me the money? That is the real interest rate. Second, you will evaluate how much less the dollars you receive from me at the end of the deal are likely to be worth, compared to the dollars you pay me at the beginning of the deal. This is an adjustment for expected inflation. There is a third adjustment, probably, that relates to the uncertainty of the real return when the nominal yield is fixed; this extra premium is called the inflation risk premium.[1] The Fisher equation is approximately:
y=r + i,
where y is the nominal yield, r is real yield, and i is expected inflation plus the risk premium. Because this latter quantity is what you need to realize if you buy an inflation-indexed bond with a real yield of r, in order to break even against a nominal investment that pays a yield of y, this is called breakeven inflation, or BEI.
This background is necessary to understand the following statement: TIPS are not “inflation-protected” in the sense that they do better when inflation rises. TIPS are real rate instruments, whose real price depends only on the real yield to maturity. The nominal value of a TIPS bond depends on the actual inflation realized over time, but this just means that a TIPS bond is immune to inflation. The real return of a TIPS bond depends only on the yield of the bond at purchase, if it is held to maturity.[2]
And so, a TIPS bond is just like a nominal bond in the sense that if its yield rises, its price falls. The Barclays Capital 1-10y TIPS Index returned 9.00% for 2011. That wasn’t because inflation was 9%, but rather it was mostly because real yields fell over the course of the year. The flip side is also true: if real yields rise, then TIPS will decline in value (although as I said, if held to maturity you will receive the real yield the bond sported when you bought it). And guess what will happen when inflation really picks up? You got it: real yields, along with nominal yields, will likely rise. While real yields should rise less than nominal yields in such a circumstance, it will not feel like “inflation protection” if your TIPS lose 9% when inflation is positive 4%.[3]
Now, I’m concerned about inflation, and while I think TIPS will beat nominal bonds handily over the next five years they may both have negative returns. I could simply short nominal bonds (and I have, via the TBF ETF), but if I am wrong – or if the Fed simply holds down nominal yields forever – that won’t produce the outcome I want. I would like to be long “i”, or inflation expectations. An institutional investor can do that by buying inflation swaps, or buying TIPS and shorting nominal bonds. A retail investor can buy a TIPS ETF (such as TIP) and short nominal bonds with a different ETF (such as TBF), but this is clunky, and since the durations may not match up well it requires a fair amount of work to get the right hedge. But there’s another way, which I will discuss in one moment.
Before I do, let me show one or two charts as context for what I have said recently. Quoting again from my week-ago comment,
It is incredible to me that with monetary conditions as accommodative, globally, as they have been in decades, inflation swaps are still nearly as cheap as they have ever been. That’s truly striking. What is the 10-year downside to a long inflation position from these levels? One-half percent per annum? Seventy-five basis points per annum? How low can inflation be over the next 10 years, especially with central banks apparently willing (and even anxious) to produce as much liquidity as is needed?
Let me provide a graphical answer to that question.
The chart below (source: Shiller and BLS) shows compounded 10-year inflation rates since the late 1800s.
Compounded inflation below 2% has been very rare since 1914, and the Fed is clearly leaning one way here.
I have drawn two lines on this chart. The vertical line indicates the date of the formation of the Federal Reserve; the horizontal line shows the current level of 10-year inflation breakevens (Treasury yields minus TIPS yields). Since the formation of the Federal Reserve, you can see that a 10-year period of inflation below 2% has been exquisitely rare, with the exception of the Depression when the Federal Reserve erred and tightened policy. So, if you are buying inflation below 2%, your realistic downside (especially with a Chairman who is acutely aware of the Fed’s failing in the Great Depression) over ten years is probably on the order of 50bps.[4]
The institution of the Federal Reserve created an institution whose purpose is to prevent deflationary depressions, and who has historically pushed prices higher – sometimes gently, and sometimes not so gently – over a long period of time. What may be surprising to see is how oftenwe have experienced periods of high inflation compared to episodes of tame inflation. While this histogram isn’t necessarily the purest way to address that question, since the periods overlap, it gives some sense for how frequent the “tails” of inflation are:
A frequency distribution breakdown of the previous chart (since 1914).
The maximum 10-year inflation rate was 8.8%, with about 30% of all observations above 5%. Note that these are not 1-year inflation numbers, but 10-year compounded inflation. The compounding matters. 2% compounded for 10 years is 21.9%. 8% compounded for 10 years is 115.9%.
This is what you’ll get if you own TIPS for 10 years. You’ll get the real yield of TIPS (currently negative out to 10 years) plus compounded inflation. If you think we can get 6% or 8% inflation, then the fact that the real yield is 0% instead of 1% isn’t that big a deal. But I would like to put on a trade that responds when inflation expectations themselves start to rise.
Deutsche Bank recently issued a pair of PowerShares exchange-traded notes (ETNs) that trade with the symbols INFL and DEFL. Information, and the prospectus, can be found at links here, here, and here. In full disclosure, I have bought some INFL for my own portfolio.
These instruments are an interesting way for retail investors to play for a potential increase in inflation expectations. The notes, which are issued by Deutsche and so are exposed to Deutsche Bank credit,[5] are designed so that they expect to rise $0.10 if inflation expectations rise 0.01% (1 basis point – I am here, and henceforward, speaking of INFL although the inverse holds for DEFL). So a 1bp rise in inflation expectations equals (if the security is at $50, as it is now) a 0.20% rise in the security’s price. Put another way, the buyer of INFL has roughly a 20 modified duration, which is pretty long for a bond-like instrument. The underlying index consists of 5-year, 10-year, and 30-year TIPS and short positions in 5-year Note, 10-year Note, and Ultra Treasury futures, in roughly the proportions TIPS are represented in the bond universe. The ETN also earns a T-Bill return and carries fees of 0.75% per annum.
The securities are supposed to maintain that 1bp=$0.10 relationship even as price rises and falls within some bounds, so that if INFL declines to $30, the modified duration rises to 33.
(Because this would eventually cause modified duration to head towards infinity as the price declines, the securities have a feature that causes the security to split if the price goes above $100 or reverse-split if the price goes below $25; however, the 1bp:$0.10 relationship would remain the same, so that if the price declines below $25 for a few days your modified duration will suddenly decline from 40 to 20; if the price rises above $100 your duration will go from 10 to 20. This is not necessarily a bad feature, since it means you will eventually get longer in a rally, but it isn’t analogous to normal convexity since with normal positive convexity you would get long in a rally, then less-long as price declined again. In this case, if price went to $100 and then reversed, you’d essentially have double the duration on the way down. So I suggest keeping a close eye on the ETN and being sure to adjust your exposure manually from time to time to remain within your risk tolerance. Having your exposure change via a split is also quintessentially unlike a normal equity’s behavior in a split, in which your exposure remains constant even though the number of shares doubles.)
There is a market-maker who presents orderly two-sided markets some $0.12 wide, or roughly 1.2bp on breakevens. That’s not bad at all – professional inflation traders don’t face markets much tighter than that. I don’t know the size commitment of the market-maker and have no direct knowledge of his dedication to maintaining these markets.
Are there warts to the structure? Sure. The weird ‘convexity’ is off-putting, although it can be managed. The float is currently smaller than I’d like (only $4mm each side at issue), although that’s true of any new ETF or ETN and I would expect it to increase over time. The use of futures instead of cash for the nominal position complicates analysis somewhat, although there is probably no easy way around it. There is an additional drag on return that comes from the financing of the long-TIPS position at LIBOR. Ordinarily, you would finance TIPS at the repo rate (about 20-40bps lower over time), and then you would earn a somewhat lower repo rate on the short Treasuries position. By selling futures, the repo rate earned on the bond short is embedded in the futures convergence, which makes it quite difficult to analyze the true total cost of the structure. The long-INFL investor earns T-Bills, plus implied repo on the futures position, minus Libor, minus fees. When T-bills are at zero and LIBOR at 0.20%, that plus the fees make the cost around 0.95% per annum. When T-Bills are at 1% and LIBOR at 1.30%, the net cost is essentially zero (1% + 1% – 1.30% – 0.75%). When T-Bills are at 2%, INFL should appreciate over time although that should be considered against your opportunity cost.[6]
Does Deutsche make money on the structure? Of course. But they make less they would with many structured notes, and these ETNs are, in my opinion, actually a useful way that retail investors can achieve a particular exposure. I don’t expect to hold this position until the ETNs mature, but with breakevens near 2% it is in my opinion a good way to bet on expectations rising over the next few months or years.
.
I appreciate that many of you have suggested to friends and colleagues that they follow this author – thank you very much! I also suspect that people you know may have concerns about inflation or be interested in learning more about inflation and hedging inflation, and that you can help them by introducing them to people who have something to say on the topic. I would appreciate your generous referral of these contacts of yours to our website, and would like to express my appreciation by sending a copy of my book, Maestro, My Ass!, to those of you who point people our way. (Please let your friends know that they should mention you when they fill out the contact form, so that I can know where to send my gift of thanks.) And thanks again.
[1] I say “probably” because although Fisher included the inflation risk premium in his work, it has never been clear to me why the provider of money would demand protection for the uncertainty of his real return while the user of money would not demand protection for the uncertainty of his real cost. To me, it isn’t clear which effect will dominate, and so I suspect it is entirely possible that the “inflation risk premium” can even be negative. We certainly see this phenomenon in some commodities futures curves. Anyway, since we can’t directly observe and separately trade the risk premium, it’s usually folded in with the breakeven.
[2] …unless there is sufficient deflation that the floor on the principal kicks in. This has never happened, but it adds a complexity to TIPS and requires that many statements about TIPS include the phrase “except if…”
[3] This fact leads some managers to make the false claim that “TIPS don’t hedge against inflation.” Of course they do. They hedge almost perfectly against inflation over the horizon from purchase to maturity. However, they do not hedge month-to-month or year-to-year inflation very well if they have a long time to maturity, because the short-term price change of the bond swamps the inflation accretion.
[4] Of course, past results are no guarantee of future returns. Anything can happen. 10-year inflation could go to -10%, or perhaps worse expectations could go to -10% even while inflation was rising, leading to a loss on the trade I’m about to mention. Consult your financial advisor.
[5] However, note that since the ETNs can be delivered in blocks to Deutsche on short notice, it is best thought of as short-term credit even though the notes themselves have a long maturity.
[6] I’m cuffing all of these relationships for the purposes of this column. The point is that right now the structure is about as expensive as it is going to be, and as rates rise INFL should have some positive net carry over time.
