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Do Floating-Rate Notes (FRNs) Protect Against Inflation?
Since the Treasury this week auctioned floating-rate notes (FRNs) for the first time, it seems that it is probably the right time for a brief discussion of whether FRNs protect against inflation.
The short answer is that FRNs protect against inflation slightly more than fixed-rate bonds, but not nearly as well as true TIPS-style bonds. This also goes, incidentally, for CPI-linked floaters that pay back par at maturity.
However, there are a number of advisors who advocate FRNs as an inflation hedge; my purpose here is to illustrate why this is not correct.
There are reasonable-sounding arguments to be made about the utility of FRNs as an inflation hedge. Where central bankers employ a Taylor-Rule-based approach, it is plausible to argue that short rates ought to be made to track inflation fairly explicitly, and even to outperform when inflation is rising as policymakers seek to establish positive real rates. And indeed, history shows this to be the case as LIBOR tracks CPI with some reasonable fidelity (the correlation between month-end 3m Libor and contemporaneous Y/Y CPI is 0.59 since 1985, see chart below, data sourced from Bloomberg).
It bears noting that the correlation of Libor with forward-looking inflation is not as strong, but these are still reasonable correlations for financial markets.
The correlation between inflation and T-Bills has a much longer history, and a higher correlation (0.69) as a result of tracking well through the ‘80s inflation (see chart below, source Bloomberg and Economagic.com).
And, of course, the contemporaneous correlation of CPI to itself, if we are thinking about CPI-linked bonds, is 1.0 although the more-relevant correlation, given the lags involved with the way CPI floaters are structured, of last year’s CPI to next year’s CPI is only 0.63.
Still, these are good correlations, and might lead you to argue that FRNs are likely good hedges for inflation. Simulations of LIBOR-based bonds compared to inflation outcomes also appear to support the conclusion that these bonds are suitable alternatives to inflation-linked bonds (ILBs) like TIPS. I simulated the performance of two 10-year bonds:
Bond 1: Pays 1y Libor+100, 10y swaps at 2.5%.
Bond 2: Pays an annual TIPS-style coupon of 1.5%, with expected inflation at 2.0%.
Note that both bonds have an a priori expected nominal return of 3.5%, and an a priori expected real return of 1.5%.
I generated 250 random paths for inflation and correlated LIBOR outcomes. I took normalized inflation volatility to be 1.0%, in line with current markets for 10-year caps, and normalized LIBOR volatility to be 1.0% (about 6.25bp/day but it doesn’t make sense to be less than inflation, if LIBOR isn’t pegged anyway) with a correlation of 0.7, with means of 2% for expected inflation and 2.5% for expected LIBOR and no memory. For each path, I calculated the IRR of both bonds, and the results of this simulation are shown in the chart below.
You can see that the simulation produced a chart that seems to suggest that the nominal internal rates of return of nominal bonds and of inflation-linked bonds (like TIPS) are highly correlated, with a mean of about 3.5% in each case and a correlation of about 0.7 (which is the same as an r-squared, indicated on the chart, of 0.49).
Plugged into a mean-variance optimization routine, the allocation to one or the other will be largely influenced by the correlation of the particular bond returns with other parts of the investor’s portfolio. It should also be noted that the LIBOR-based bond may be more liquid in some cases than the TIPS-style bond, and that there may be opportunities for credit alpha if the analyst can select issuers that are trading at spreads which more than compensate for expected default losses.
The analysis so far certainly appears to validate the hypothesis that LIBOR bonds are nearly-equivalent inflation hedges, and perhaps even superior in certain ways, to explicitly indexed bonds. The simulation seems to suggest that LIBOR bonds should behave quite similarly to inflation-linked bonds. Since we know that inflation-linked bonds are good inflation hedges, it follows (or does it?) that FRNs are good inflation hedges, and so they are a reasonable substitute for TIPS. Right?
However, we are missing a crucial part of the story. Investors do not, in fact, seek to maximize nominal returns subject to limiting nominal risks, but rather seek to maximize real return subject to limiting real risks.[1]
If we run the same simulation, but this time calculate the Real IRRs, rather than the nominal IRRs, a very different picture emerges. It is summarized in the chart below.
The simulation produced the assumed equivalent average real returns of 1.5% for both the LIBOR bond and the TIPS-style bond. But the real story here is the relative variance. The TIPS-style bond had zero variance around the expected return, while the LIBOR bond had a non-zero variance. When these characteristics are fed into a mean-variance optimizer, the TIPS-style bond is likely to completely dominate the LIBOR bond as long as the investor isn’t risk-seeking. This significantly raises the hurdle for the expected return required if an investor is going to include LIBOR-based bonds in an inflation-aware portfolio.
So what is happening here? The problem is that while the coupons in this case are both roughly inflation-protected, since LIBOR (it is assumed) is highly correlated to inflation, there is a serious difference in the value of the capital returned at the maturity of the bond. In one case, the principal is fully inflation-protected: if there has been 25% inflation, then the inflation-linked bond will return $125 on an initial $100 investment. But the LIBOR-based bond in this case, and in all other cases, returns only $100. That $100 is worth, in real terms, a widely varying amount (I should note that the only reason the real IRR of the LIBOR-based bond is as constrained as it appears to be in this simulation is because I gave the process no memory – that is, I can’t get a 5% compounded inflation rate, but will usually get something close to the 2% assumed figure. So, in reality, the performance in real terms of a LIBOR bond is going to be even more variable than this simulation suggests.
The resolution of the conundrum is, therefore, this: if you have a floating rate annuity, with no terminal value, then that is passably decent protection for an inflation-linked annuity. But as soon as you add the principal paid at maturity, the TIPS-style bond dominates a similar LIBOR bond. “Hooray! I got a 15% coupon! Boo! That means my principal is worth 15% less!”
The moral of the story is that if your advisor doesn’t understand this nuance, they don’t understand how inflation operates on nominal values in an investor’s portfolio. I am sorry if that sounds harsh, but what is even worse than the fact that so many advisors don’t know this is that many of those advisors don’t know that they don’t know it!
[1] N.b. Of course, they seek to maximize after-tax real returns and risks, but since the tax treatments of ILBs and Libor floaters are essentially identical we can abstract from this detail.
A Relatively Good Deal Doesn’t Mean It’s A Good Deal
I suspect that everyone has ‘default activities’ that they automatically turn to when nothing else is working. For example, when I can’t sleep and I’ve tried everything, I go downstairs and have a bowl of cereal. Some folks hit the gym when they’re frustrated. Others go shopping when they’re depressed.
And apparently, some people buy stocks when they’re not turned on by anything else.
There wasn’t any outrageously positive news today that sent the S&P +0.8% on the day. Initial Claims (371k) was slightly higher than expected (but I advocate ignoring that release in late December and most of January). The dollar dropped sharply against the Euro. I initially thought that this was because the President nominated as Treasury Secretary someone with no financial markets experience at all but a solid resumé of hard-nosed negotiations with Congress, but the Euro gained against all major currencies so it was perhaps due more to the fact that ECB President Draghi didn’t ease further at the policy meeting held today (though they were not expected to). Bloomberg blamed a better-than-expected rise in Chinese exports, but the miss was well within the usual variance for a volatile number so that seems unlikely to me.
I am not entirely kidding about the frustration that “there’s nothing else to invest in.” I was just working today on a chart for a keynote presentation I have been asked to give at the Inside Indexing conference in Boston in April (See the link here, although most of the information on the site is still the 2012 data). I have previously run this chart, showing Enduring Investments’ projected 10-year annualized real returns and risks (this is as of year-end 2012).
The slope of that line indicates that the current tradeoff of risk for return is 2.7:1. That is, for a 1% higher expected annualized real return, you will have to accept a 2.7% increase in the annualized standard deviation of annuitized real returns (the “right” measure of risk, as it measures the variance in the long-term real purchasing power of the investment). Now, here’s the chart as of April 23, 2003, using all the same methodology:
The slope of the line back then was 9.1:1. That is, in 2003 you needed to take more than three times as much risk to add 1% in expected real return to your portfolio.
But notice something else also that is very important. The change in the slope of the line didn’t come because expected equity or commodity index returns got better. Indeed, those two asset classes have roughly the same forward expected returns as they did back then, although slightly different risks the way we figure it. What happened is that the expected real returns to Treasuries, TIPS, and Corporate Bonds all fell precipitously.
Of course, this comes as no surprise to anyone, because we’ve all watched the Fed push interest rates down so far that we need extra decimal places. But I think comparing these charts you can understand a fundamental verity: people are not buying stocks because they expect awesome returns going forward (hopefully, anyway, because they’re not going to get them). They’re buying stocks because there’s less reward to buying less-risky asset classes. Which is, after all, what the Fed was trying to do (this is called the “portfolio balance channel” in monetary policymaker parlance: force people to take more risk than they want, because it’s a relatively good deal even if it’s not a good deal in an absolute sense).
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A few other notes about today’s news:
Inflation markets were abuzz today, with inflation-linked bonds outpacing their nominal counterparts in many countries, because the UK’s ONS announced that it has decided not to change the RPI that applies to Gilt linkers (inflation-linked bonds, like TIPS). The ONS (similar to our BLS) has been studying how to make certain important technical corrections to the way the RPI is calculated to make it more accurate; these changes would have had the effect of lowering the RPI significantly. As a consequence, these bonds have been trading at higher real yields, reflecting the fact that if the ONS chose to change the RPI formulation, the yield on the bond would have to be higher to compensate investors for that change if the same value was to be delivered. That is, instead of a yield of (for example) 1% added to expected inflation of 2.5%, the yield would rise to 1.5% to reflect the expectation that measured inflation would be at 2.0%. Many investors thought it was very likely that the ONS would choose one of several options for restating RPI that would have had such a deleterious effect on the bonds.
In the event, the ONS made the wise decision that it would be unfair to change the terms of the bonds retroactively by making a significant change to the RPI, so they will release a second index called the RPIJ, which will now be the benchmark index and featured in ONS releases. But they will also continue to calculate the RPI and the existing bonds will continue to track RPI.
This is a great relief to inflation-linked bondholders the world over, because it sets a very important precedent. The U.S. Treasury has long said that if the BLS made a material change to the way CPI was calculated, it would plan to continue paying on the basis of the old-formulation CPI (if it was still available) or a suitable alternative, but many investors from time to time have worried about whether they would do that in practice. It will be harder to do so with the ONS precedent.
Because investors had thought the ONS was leaning the other way, Gilt linkers rallied a bunch. For example, the UKTI 1.25%-11/2055 rallied 10 points on the day (the yield fell by about 20bps), which is an enormous move at the long end. The 5-year linker (Nov 2017) yield fell 35bps. This is likely to have a spillover effect in US TIPS, since the latter now look much better on a relative value basis than they did previously. Anyone who was long UK linkers yesterday is probably considering 30 year TIPS at a pickup of 42bps.
Finally, in Fed news Esther George, the President of the Kansas City Fed (replacing Thomas Hoenig) was on the tape today. “Fed’s George Says Low Rates Risk Stoking Inflation Surge,” said Bloomberg. No kidding? (See here for Market News’ coverage of the same speech). At the very least, said George, the asset purchases will “almost certainly increase the risk of complicating the FOMC’s exit strategy.” Neither of those statements ought to be the least bit surprising or controversial, but it’s unusual to hear a Fed official state these things so bluntly. But she may have crossed the line with this one, which might get her ostracized at the next FOMC meeting:
Like others, I am concerned about the high rate of unemployment, but I recognize that monetary policy, by contributing to financial imbalances and instability, can just as easily aggravate unemployment as heal it.
Keep speaking truth to power, Ms. George!
Incredible Inflation Bond Bargain
The economic data continues to drip weaker. Today’s Chicago Fed index was the lowest since 2009, and while the Dallas Fed index rose, it remains negative. These aren’t major indicators, but the general tone of data recently has been weak and nothing recently stands out as positive…except for Existing Home Sales, which raises other issues as noted last week. A friend in the southwest U.S. describes the local housing market in Phoenix as “definitely bubblicious” and passed along this link, describing how rental properties in Phoenix are seeing aggressive bidding from would-be renters.
Now, economic activity is also not exactly falling off a cliff, and some Americans insist that the economy is doing just great (these seem to be the Obama voters but I can’t tell which way the causation runs – are they Obama voters because they think the economy is doing well, or do they think the economy is doing well because they are Obama voters and that’s the story?). But to listen to Fed speakers, you would think economic collapse is imminent. Last week, Minnesota Fed President Kocherlakota[1] advocated keeping monetary policy extraordinarily accommodative until the unemployment rate gets down to 5.5% or until the medium-term outlook for inflation rises above 2.25% (on core PCE). Today, San Francisco Fed President Williams said that he expects the Fed to end asset purchases “before late 2014” (which, for those of you scoring at home, would imply the Fed has about a trillion dollars to go) and shouldn’t raise rates until mid-2015. I wonder what it is that Fed officials are forced to check at the door: their brains, or their optimism?
No wonder that inflation-linked bonds are so expensive these days!
Which brings me, actually, to the main topic I wanted to discuss today. A reader asked me the other day about I-series savings bonds from the U.S. Treasury. For those of you who aren’t familiar with them, I-bonds are like regular savings bonds except that they pay a real interest rate. That is, instead of getting a fixed coupon, you get a fixed coupon plus inflation, which is added to the principal and compounded until the bond is redeemed. You can buy them on Treasury Direct and keep them in electronic form, and in fact that’s the best way to buy them. You can buy up to $10,000 per Social Security number per year.
And that limit turns out to be a good thing, because if it weren’t for that limit hedge funds would be going nuts on series I bonds right now. Because the people who created I bonds never contemplated a negative real interest rate, or else thought the marketing angle of selling bonds at a negative real interest rate would be too bad, the fixed part of the I bond coupon is floored at 0%. This is significant, since the market rate for a 5-year TIPS bond right now is -1.59%. The coupon rate on the I-bond is set for the next six months of new sales (the fixed coupon stays the same for the life of any given bond) every May and November, and typically is set very close to the 5-year TIPS rate (see chart below, source Treasury Direct and Bloomberg).
Notice, though, that at the far right-hand part of the chart the last few I-bonds issued have had coupons of 0%, since the actual TIPS rate has been considerably below that. And that means that if you are going to buy TIPS, then before you spend a single dollar on the April-2017 TIPS you should buy your full $10,000 limit on I-bonds, because you save 1.59% compounded for at least 5 years. That’s an extra 8.2% total return on your money over that period![2]
Occasionally, there can be good deals when the TIPS market moves between the setting of a coupon and the next coupon set. When the current series coupon was set at zero, back in May 2012, the advantage was only about 125bps and it’s now 159bps. But the current advantage is in good measure structural, rather than due to timing. As a consequence of that structural mistake (not allowing a negative real coupon), combined with the TIPS market’s rally since May, the current spread is actually the highest ever seen for the program (see chart below, source Treasury Direct and Bloomberg).
I don’t regularly recommend specific trade ideas in this (public) space, for a whole host of regulatory reasons, but I can say this: look into series I-bonds unless you (a) don’t care about inflation, (b) feel like you need to take lots more risk, (c) feel comfortable that if you wait long enough, you’ll get a better investment opportunity in inflation-linked bonds, or (d) have so much money that $10,000 per member of your household, per year, simply isn’t meaningful.
And if it’s case (d), then please write because I need more friends like you!
[1] Kocherlakota is described by some as a hawk, but he can most accurately be described as ‘confused.’ He once explained that the Fed might have to raise interest rates, even if inflation expectations were low, to force them higher, getting the causality exactly backward.
[2] Note that if you do not intend to hold the I-bond for at least 5 years, there is a penalty associated with early redemption – you lose some interest accrual. Even with that, it’s not a terrible deal given how cheap these are now, and most investors should have some inflation protection in their portfolios to diversify the risk of all of those investments (equities, nominal bonds) that do poorly in inflationary environments. So, for the buy-and-hold part of your portfolio, these are terrific.
TIPS Are No Longer Cheap, But Still Preferable
TIPS have gone from being rich on an absolute basis, but cheap against nominal bonds, to (still) rich on an absolute basis, but fair versus nominal bonds as nominal yields have risen. That statement is based, however, on a static equilibrium – given where nominal yields are now, after a 40bp selloff since July, real yields have fallen slightly (see chart, source Bloomberg – nominal yields in yellow, real yields in white) and are about right.
I have previously documented this move, pointing out the rise in breakevens and/or inflation swaps. However, because I was traveling I didn’t write anything following Friday’s skyrocketing breakevens, which followed through on Monday to within a couple of basis points of all-time highs (see chart, source Bloomberg).
That leap seemed exceptionally surprising to some, given the weakness of core CPI on Friday. But inflation expectations on Friday were still reacting to the Fed’s open-ended QE move, which had moved 10-year breakevens to near 2.50% on Thursday. After sleeping on it, many investors realized what we realized immediately: there is nothing deflationary about buying bonds without limit, using money printed for the purpose. The Fed professes to be concerned about the negative tail risk to growth (which they can do nothing about), and ignores the positive tail risk to inflation (which they could do something about, if they chose). It is not at all surprising that breakevens leapt.
As I said, these recent gyrations have moved TIPS to being approximately fair value relative to nominal bonds, given the yield of nominal bonds. But the further question is whether those nominal yields are themselves at fair value, or are on the way to higher or lower levels.
A reasonable question to interpose here is this: is this as good as it gets for bonds? What could be better than unlimited Fed buying? Well…I suppose unlimited buying in Treasuries, as opposed to mortgages, would be better, but with 10-year yields at 1.81% one would think that both a considerable amount of buying and a considerable amount of bad economic news is priced in. To be sure, the news continues to be bad; Friday’s -10.41 print in the Empire Manufacturing Survey was the lowest since the dip in 2008-09. Lower than the “cash for clunkers” hangover in 2010. Lower than the post-Japanese-tsunami drag in 2011.
But consider this: in the throes of a much worse crisis (especially demographically), and with the Japanese central bank making only timid efforts to resist deflation – and certainly not buying every bond in sight, as the Fed is – the average yield of 10-year Japanese government bonds (JGBs) from 1997-2007 was 1.51% (see chart, source Bloomberg).
Even if you take the crisis-on-a-crisis period of post-2008 for Japan, the average 10-year yield is about 1.15% – and that’s with deflation in full bloom and the central bank until the last year or so doing little to fight it.
In Japan, core inflation is at -0.6% over the last 12 months, and 10-year yields are at 0.81%. Our core inflation is 1.3% higher and our nominal yields only 1% higher. There is a lot of disinflation and/or Fed buying that is already in the price. I am not saying that we ought to be selling nominal bonds here; I’ve gotten burned on that call in the past, and anyway we are in the middle of the strongest bullish seasonal period of the year for bonds. But the Fed just added to the length of the possible “high inflation tail” outcome – and I fail to see what the offsetting bullish tail is. I can’t imagine why anyone would buy nominal bonds at these levels, given what the Fed and their pals at other central banks are doing.
But if nominal yields do rise further, this means that TIPS yields will eventually start to rise as well. I still prefer TIPS to nominals, and I still want to be long breakeven inflation, but admittedly it is a more difficult trade at these levels than it was back on August 7th, when I first noted that our Fisher model indicated a short position in TIPS and a long position in breakevens.
I say this, going into a TIPS auction tomorrow with 10-year TIPS yields near all-time lows and 10-year breakevens as I noted near all-time highs. It’s not going to feel like a bargain for anyone, but a year from now, it may seem like it.
Now, make no mistake: the core inflation print on Friday of +0.052% was a definite surprise on the weak side. But it wasn’t quite as weak as it looked. In fact, thanks to Housing and Transportation, 62% of the CPI major subgroups saw their year-on-year rates of change rise, while only 38% (Food/Beverages, Apparel, Recreation, Education/Communication, and Medical Care) saw those rates decline. Much of the weakness in core inflation came from apparel (which is interesting and worth watching to see if it continues) and large moves in used cars and airline fares. Moreover, as I observed last week, the year-ago comparisons get much easier for the next four months, so that the current 1.9% core inflation print is likely to be the lowest for this year. If it’s not, then we’ll need to re-assess what is going on, but for now nothing has changed about my forecast. Do note that the Cleveland Fed’s Median CPI was unchanged again up at a 2.3% y/y rate of change, reinforcing the fact that the core decline over the last few months has been driven by some outlier price movements rather than by a shift in the central moment of the distribution.
What If There Was No Cash?
Bonds, stocks, inflation-linked bonds, commodities, real estate, MLPs, hedge funds, and cash. That is essentially the asset class universe we face as investors. Now, before reading further, think about what you would do with your investments if it were no longer possible to invest in cash, or if some aspect of “cash” made it inadvisable to hold. What would you do with your wealth that is currently sitting in money market funds?
You would clearly invest in riskier assets, since (with the exception of inflation-linked bonds held to your investing horizon) there isn’t a less-risky asset than cash in most cases. You may choose to buy a short-duration bond fund, or you might trickle some extra funds into stocks you feel are undervalued or into commodity indices that I feel are undervalued.
The reason this is a relevant thought-experiment is that the New York Fed, in a little-covered report issued last week, has recommended that investors in money market funds be prohibited from withdrawing 100% of their funds without significant advance notice. The staff of the New York Fed recommended that 5% of an investor’s balance in a money market fund be stuck for thirty days, in order to “protect smaller investors” from the sort of runs on money funds that caused investors in the Primary Reserve Fund to lose the awesome sum of 1% of their money when Lehman obligations went bust in the worst credit crisis in a century. Furthermore, they “suggest a rule that would subordinate a portion of a redeeming shareholders MBR [what the Fed calls the “minimum balance at risk”], so that the redeemer’s MBR absorbs losses before those of non-redeemers.” In other words, if you hear that your money fund is 100% invested in Lehman 2.0 as it teeters on the edge of bankruptcy, you get to choose between taking 95% of your money out now and potentially losing the rest before anyone else loses money, or leaving it all in the fund – in which case you’ll get the second loss, but all of your money is at risk.
Clearly, the New York Fed’s suggestion is a solution in search of a problem given the historical rarity of losses and of the insignificance of those losses, but it is chilling for a couple of reasons. Reason number one is that it pretty much eliminates the main reason for holding a money market fund, which is ready access to cash. People aren’t holding assets earning 0.01%, with 2.2% inflation eating away the real value every year, because they like the return. If you tell investors that they need to have 5% of their principal at risk, and that they may have to choose a gamble between a high-likelihood loss that would be capped at 5% and a lower-likelihood loss that is capped at 100%, the rational investors will simply leave. They may invest in short bond funds, commodity funds, or equity funds where there is much more risk, but at least their money is available with no advance notice. While this development is in a sense bullish for all other assets since it pushes potentially trillions of dollars out the risk spectrum, it isn’t clear to me that our biggest societal problem is that investors aren’t taking enough risk.
Reason number two that I hate this idea is that one destination for money market fund cash will be bank deposits. However, savings deposits are time deposits, and technically can be subject to similar sequestration. Some of the money will go into checking accounts, where it will doubtless burn a hole in many investors’ pockets. The biggest question about the inflation challenge that has been rising over the last year or two is, “how fast will velocity rise, when it rises?” If the Fed effectively forces money into checking accounts, among other things, the velocity of money will surely rise and the pace of the rebound in velocity will become that much more difficult to predict than it already is.
Speaking of velocity, Friday’s GDP figures allow us to make preliminary estimates about what M2 velocity was in Q2. The velocity of the transactional money supply last quarter fell slightly, to 1.5766 (Bloomberg calculation that closely matches my own). The pace of decline is slowing. The quarterly decline was -0.5%.
It doesn’t make a lot of sense to focus too much on quarterly wiggles, but since the big risk here is that velocity abruptly begins to rise (contributing to, rather than blunting, the rise in transactional money in terms of generating inflation) it is worth keeping in the front of our minds. Of course, velocity is a plug number so this doesn’t tell us anything we didn’t already know: we deduce it from the M, the P, and the Q. The trick is in knowing when V is turning and has turned, and as I have said before (see here, for example) there are some reasons for concern on that score.
Going back to the NY Fed study that I discussed above, here is another thought to ponder. Remember that the biggest single objection that the Fed has made against dropping the interest on excess reserves (IOER) charge is that it might damage the money market fund industry by making it impossible to preserve “the buck” if there are no instruments with yields that exceed the cost of operating the fund. And yet, this proposal puts those very same money funds precisely in the crosshairs. Personally, I think it would be just fine to have good-as-cash funds that didn’t guarantee a $1 price and indeed had a negative yield over time, so I don’t think dropping short yields would kill good-as-cash funds even if they weren’t technically money market funds because they traded on price. But changing the contract so that investors can’t get their money back immediately – that’s much worse, in my view; moreover, I don’t know why the reasoning couldn’t be extended to bond funds which are, after all, just as vulnerable to runs. That slippery slope makes me nervous.
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Price action on Thursday and Friday in bonds and stocks was surely frustrating to observers of the macroeconomy. Weak economic data on Thursday and uninspiring data on Friday didn’t prevent 10-year nominal bond yields from rising 15bps (to 1.55%), real 10-year note yields yields from rising 7bps (to -0.61%), and equity prices rising 3.6% (basis the S&P). ECB President Draghi’s apparent determination to support the Euro with every tool at his disposal is mainly to credit for the mid-week about-face. The question that the markets have to consider, and Mr. Draghi as well, is the question of what that toolkit actually contains. There is some evidence that the Bundesbank doesn’t believe Mr. Draghi has quite the authority he thinks he does, and this weekend Draghi and the Bundesbank President are meeting to discuss their differences.
I think that equity markets are overvalued and are over-anticipating QE3 (although I agree that it is coming soon). There isn’t much going for stocks other than QE3, although if the Fed starts taking potshots at low-risk investing alternatives it will help them. I can come up with arguments for extending this rally further, but they all depend on a bunch of faith and a little luck. I am trimming what small equity investments I have, and raising cash allocations. Since the VIX is also quite low considering the kaleidoscope of large risks, I may also buy puts on the S&P.
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!
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.
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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.
New Year’s Revolutions
If it’s January 3rd, it must be time to buy with both hands, right?
Markets leapt higher today, led by commodities. In December, managers evidently pursued a policy of buying what had worked (bonds, inflation-linked bonds) and selling what had not worked (commodities), but with a new year and a new P&L statement the money is springing back to where the opportunities are. And, while equities are not completely unattractive – they rallied today probably because that’s just what they do on Jan 3rd – in my view commodity indices are the most attractive, as I pointed out in my article “Long-Term Portfolio Projections Update” late in December.
To be sure, the increasing volume of saber-rattling in Iran helped put a bid in energy products. The Iranian regime warned U.S. warships to stay away from the Straits of Hormuz while Iran was conducting exercises, saying that they “will not repeat its warning,”while the U.S. responded that “deployment of U.S. military assets in the Persian Gulf region will continue as it has for decades.” Oil prices leapt more than $4/bbl to the highest WTI closing level since May of last year. But it would be a mistake to think that the movement in commodity indices was all about Hormuz. Agriculture was up more than 2%, Energy up 3%, Precious Metals up 4%, and Industrials and Livestock up more than 0.7%. No commodity in the DJ-UBS index declined.
Manufacturing data was decent, both the ISM (which rose to 53.9 from 52.7) as well as purchasing managers’ indices from Italy, France, Germany, and the UK, which all exceeded – albeit slightly – expectations.
Let us not forget that all of these PMIs, with the exception of the US, are also below 50. And let us also not be tricked into thinking that strong equity markets indicate that all is well with the world. This morning, a spokesman for Greece went on television to say that if Greece and the Euro Zone don’t reach an agreement on the second tranche of the bailout (some €130bln, due in March) quickly, the country will fail. Specifically, Greece would leave the Euro:
“The bailout agreement needs to be signed,” he said. “Otherwise, we will be out of the markets, out of the euro. The situation will be much worse.”
Strikingly, investors ignored this suicide threat today, but I wonder if they can continue to ignore it interminably. If everyone truly believes what the banks are saying, that a Euro breakup would be the end of organized cellular life on this planet, then Greece basically can get whatever it wants. Frankly, right now Greece and Iran share strikingly similar positions. Both can probably do what they are threatening, and so there are three questions for economic or military policymakers. (1) Do we really think the consequences are so devastating as they say? (2) Will Greece/Iran be willing to accept the consequences of their own actions, if they choose that path? And (3) given the answers to those two questions, can we bear the risk of finding out? With Iran, the answers are probably ‘no,’ ‘maybe,’ and ‘yes,’ but I am not as sure of the answers to the same three questions with Greece. Moreover, my answers would very likely be different from those of economic policymakers in Europe!
And, speaking of policymakers, the main economic event for Tuesday was the release of the FOMC minutes from the December meeting. There were some interesting tidbits in these minutes, which isn’t always true. Bond investors blanched at this phrase:
With regard to the forward guidance to be included in the statement to be released following the meeting, several members noted that the reference to mid-2013 might need to be adjusted before long.
However, it isn’t clear from the minutes exactly what that means. It may mean that, as bond investors feared, the Fed will ‘adjust’ the reference by shortening it, but this seems unlikely in the context (and because it would weaken the credibility of Fed communications if ‘at least’ turned out to mean ‘at least, maybe’). It probably means that the FOMC figures they need to eventually change to a more-vague goal, or roll the guarantee forward in some way, lest they converge on mid-2013 and be confronted with the same decision at a period of much more significance. This is one of the reasons it was dumb to make the guarantee in the first place, but policymakers apparently didn’t fully think through the ‘exit’ step.
The Fed in early December remained quite cheerful about inflation:
Inflation continued to decrease relative to earlier in the year. Indeed, the PCE price index edged down in October… Consumer prices excluding food and energy also continued to rise at a more modest pace in October than earlier in the year.
Recall that October’s figure on inflation, which the FOMC had at the time, had been a downside surprise. This may have contributed to the Committee’s optimism. But subsequent data on November prices, after the FOMC meeting was completed, showed an upside surprise in core inflation. (I discuss the release in “The Inflation Trend Is Not Yet ‘Tamed’”.)
The FOMC was more than happy to extrapolate the stabilizing and decline in headline inflation, and the brief stabilization in core. This is bad science even though it passes for okay economics in some schools: since new data can only cause a rejecting of existing hypotheses, there is no reasonable way that a one- or two-month slowing in core inflation should have caused the FOMC such elation:
Most participants anticipated that inflation would continue to moderate…Indeed, some expressed the concern that, with the persistence of considerable resource slack, inflation might run below mandate-consistent levels for some time.
Fortunately, some intelligent people were in the room too, and pointed out the incongruity of expecting resource slack to lower inflation when it clearly hasn’t done that in the last couple of years:
However, a couple of participants noted that the rate of inflation over the past year had not fallen as much as would be expected if the gap in resource utilization were large, suggesting that the level of potential output was lower than some current estimates.
Policymakers saw a lot of risk from global financial strains, and “a number” of them saw that there may be a need to ease further. Again, all of this happened before the ‘surprising’ continuation in the core inflation uptrend was made evident, so the doves may be more hawkish now. Somehow, I doubt it though.
There was also much-anticipated development in the Fed’s “communication strategy” (I can remember when they didn’t really feel they needed communication, much less a strategy). The plan at present seems to be for Members of the FOMC to publish their projections of the Fed Funds rate along with their projections of growth and inflation in the four-times-annually “Summary of Economic Projections” (SEP). This is also a bad idea, but it’s going to happen despite the adroit observation of some participants:
Some participants expressed concern that publishing information about participants’ individual policy projections could confuse the public; for example, they saw an appreciable risk that the public could mistakenly interpret participants’ projections of the target federal funds rate as signaling the Committee’s intention to follow a specific policy path rather than as indicating members’ conditional projections for the federal funds rate given their expectations regarding future economic developments.
Yes, that’s just one way in which giving this additional information has more downside than upside, but it continues a long-standing trend at the Fed towards “openness,” which is perceived to be a good but no one ever seems to actually analyze the costs and benefits. (As an aside, it illustrates the power of words. If instead of saying ‘the Fed increased its commitment to openness’ I said ‘the Fed decided to show how well or poorly it forecasts by leaking those forecasts’, we wouldn’t automatically agree that is a good thing. But the current policy is only different in that a ‘leak’ is awkward and potentially damaging information that was not supposed to be released, and this is awkward and potentially damaging information that is supposed to be released.)
On Wednesday, there is only light data being released as the ADP report has been moved to Thursday. For all the fury of today’s 1.6% rally in stocks, it was the worst NYSE composite volume for the first trading day of the year in at least a decade. Last year, 166 trading days saw less than 1bln shares traded on the NYSE. The year before, there had been 113 such trading days; in 2009 only 35. In 2011, it wasn’t until February 14th that we had a day with volume as light as it was today. That probably means that volume will grow over the next few days. But it’s just not a great way to start off a year reaching to higher prices. Now, in 2011 stocks rallied for the first six weeks of the year, hitting a high for the first quarter in … hey, look at that!…the week of February 14th.
