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Inflation Market Valuations and Tactics in the New Year
There is so much to talk about, since it has been such a long time since I posted, that it is a little hard to know where to begin. So let’s begin 2025 with a few quick notes about inflation markets and markets generally. I wouldn’t call this an outlook, per se…I am trying to resist making that year-end/year-beginning offering to the jinx gods…but an update with some observations. As an aside, later today I’m planning to post a new Inflation Guy Podcast (this is a Podbean link but it’s available anywhere you get your podcasts) with some comments on the trajectory of inflation (as opposed to markets), and how that may be affected by things such as the massive California wildfires.
I will begin with a content warning: this note is much denser than most of my columns. If you’re a retail investor and/or only interested in developments in inflation rather than inflation instruments, then you might skip this one. I’ll talk more about expectations for inflation, of course, in other posts. But that’s not today’s post.
Let’s start by looking at 10-year real yields. The blue line in the chart below is 10-year TIPS yields; the black line (because it’s topical) is 10-year UK Gilt linker (real) yields. TIPS yields are up to 2.25%. Normally, when they get to around 2% I think of them as roughly fair in an absolute sense, because long-term risk-free real yields ought to in principle look something like long-term real economic growth. Instructive in the chart below is that as far as nominal UK yields have risen, inflation-linked yields are still well below US real yields.[1]
That’s partly a clientele effect, since there are many forced holders of UK linkers. But still, while US real yields ran up from -1% to +2.25% once inflation started (that is, TIPS declined in a mark-to-market sense when inflation went up – very, very important to understand if you think of TIPS as an inflation hedge. They are, but only at maturity), Gilt real yields went from -3% to +1.19%. The selloff was 100bps worse. Yikes.
The next chart shows my quantitative measure of relative cheapness (negative indicates richness, because I’m a bond guy). I said before that TIPS are now roughly fair in an absolute sense; relative to nominal bonds, they’re also roughly fair to slightly cheap. That’s the blue line. You can see that TIPS for most of the past decade were pretty cheap relative to nominals (even while they were absolutely rich because of negative real yields), but since people started caring a bit about inflation they’ve gone back to being mostly fair. However, Gilt linkers have been massively rich for a long time – again, because of the forced-holders problem. But they are starting to get cheaper. That 100bps greater selloff I mentioned above happens to show up here as 100bps cheapening relative to nominals, and relative to TIPS!
Today’s column is supposed to be mostly about US markets, but I can’t help myself. I ought to also point out that breakeven inflation in the UK is roughly 100bps higher than it is in the US, even though core inflation in the UK is 3.6% and in the US it’s 3.5%. So, possibly, part of the relative richness of UK linkers – since I’m looking at each country’s linkers in relation to its own nominal bonds – is actually cheapness of UK nominals, compared to the actual inflation there. Or maybe it’s the richness of US nominals, compared to the actual inflation here. (This is why relative value trading is so useful and important – we don’t need to have an opinion about which of these two things is true. Are US nominals too rich, maybe because they can be financed cheaply in repo markets at ‘special’ rates? Or are UK nominals too cheap, maybe because the UK budget situation is perceived to be somehow even more precarious than our own? I don’t know.)
Sorry about the digression there to the UK. I just got excited. The inflation markets and inflation in Japan are also really interesting right now, especially as wage growth is surging and the yen is bordering on collapsing…yet 10-year inflation in Japan is quoted around 1.5%. If you can get someone to transact. Maybe I’ll talk about Japan another time.
US markets. First, note the weird shape of the US CPI swaps curve.
I have several issues here, with one of them being the overall optimism that inflation is definitely going back to be close to target, despite any real sign that is going to happen. It borders on religious conviction, frankly. But also, we have a weird implied path where inflation droops, then spikes near the 10-year point, and then declines. To be sure, I’m committing a chart crime here with the y-axis; if you stepped back this would look almost flat. But this is more than enough for a hedgie to be interested, usually. What is really happening is that if we had a core inflation swaps curve (I do, but you don’t) it would show a gentle decline out to 8 years. It’s steep on the CPI swaps curve because the energy curves imply that energy inflation will drag core inflation lower for years.
Of course, they won’t but you can hedge the energy. Out to about 5-8 years, probably. And that’s probably why we have that little dip in the CPI curve – it’s really an energy thing.
So I’ve said that 2.25% real yields on TIPS are fairly attractive. About as attractive as they’ve been for some time, actually. But be aware of a couple of things. One is that the bond market as a whole is under pressure and probably will stay under pressure for a bit as investors worry about financing the government in a world where the trade deficit is probably going to be coming down (implying that domestic savings will have to go up, and the only good way to make that happen is with higher yields). Real yields could go higher, and probably will at some point. But you should recognize that seasonality works in favor of the TIPS buyer right now.
Breakevens have a strong tendency to rise in the early part of the year. In 22 of the last 26 years, 10-year breakevens have risen in the 60 days following January 8th. To be sure, some of that is because TIPS bear flat-to-negative accretions in the early part of the year because CPI in December almost always declines on an NSA basis, so the rise in price/decline in real yields that helps widen breakevens is partly reflecting a change in the source of total return in TIPS during those months to being more price and less yield.[2] The point being that buying nominal bonds in the beginning of the year, up until about May, runs into difficult seasonal patterns but this is not true with TIPS. Indeed, it means that if you’re buying fixed income at all in Q1, it probably should be TIPS.
Finally, I really should say something about equities here. I think it’s always important to realize that TIPS yields are a direct competitor with equities. Nominal yields are not, necessarily, because 7% nominal yields in a world where prices (and earnings) are going up at 9% are much worse than 5% nominal yields in a world where prices (and earnings) are going up at 3%. Equity earnings do tend to rise with inflation (but stocks are a poor inflation hedge because multiples also tend to contract significantly when there is inflation, so you need to hold equities for a long, long time for them to be a good inflation hedge), and since they do it means that inflation-linked yields are a more-fair comparison. Real yields at 2.25% are neither rich nor cheap in the grand scheme of things. But equities are, once you discount expected earnings growth for expected inflation. I calculate the expected long-term S&P real return assuming that the current multiple of long-term average earnings (the Shiller PE) reverts 2/3 of the way to its mean over 10 years. By making it 10 years, and not demanding full reversion, I lessen the impact of apparent overvaluation on expected returns. But high returns do, historically, tend to precede low returns! In any event, you can debate my approach but below you can see my point.
This first chart shows 10-year TIPS yields set against my calculated expected 10-year annualized real returns from the S&P 500. Granted, the S&P 500 is cheaper outside of the Magnificent 7. But you can see that while stocks and TIPS cheapened together in the inflation spike of 2022, equities have ‘forgotten’ that they should be priced for higher real yields…resulting in the chart below, which I call the “Real Equity Risk Premium” of expected equity returns minus TIPS real yields.
Some of you will say “that’s a trend. Let’s get on that and buy stocks.” To me, that sounds like the fellow falling out a window on the 29th floor and declaring as he passes the 6th floor ‘so far, so good.’ The point of the chart is that when you buy stocks now, you should be expecting to lose money, in real terms, over the next decade. Maybe you’ll average 3% and inflation will be 4%, for example. But TIPS will guarantee you will make 2.25% after inflation. As this spread gets more and more tilted against stocks, it gets harder and harder to explain why anyone would choose equity risk over TIPS risk, other than as a diversifier.
[1] This is not wholly unique to the UK. US 10y inflation bonds have higher real yields than linkers in Australia, Italy, Israel, Canada, France, the UK, Germany, and Spain.
[2] This is wonky stuff. If the expected forward price level doesn’t change, then the breakeven needs to go up because we are starting from lower and lower current price levels due to the (short) lag between the reporting of CPI and its realization in the carry of TIPS. If you don’t understand this because you’re not a rates strategist, don’t worry about it and take my word for it.
Fair is Fair, and TIPS are There (Almost)
For a very long time, I have been writing in our Quarterly Inflation Outlook that TIPS were “relatively cheap, but absolutely expensive.” By that I meant that TIPS real yields at -1%, -2%, etc were not exciting (implying as they did that a buyer would have long-term real wealth destruction), but that compared with nominal Treasury yields of 1%, 1.5%, or 2% any investor in fixed income should have vastly preferred TIPS.
I have repeatedly said – as far back as 2016 – that with breakevens below 1.5% there wasn’t even a decent strategic case to own nominal bonds rather than inflation-linked bonds (ILBs) except to defease specific nominal liabilities and that at times those low breakevens meant that owning nominals instead of ILB amounted to a really big bet (as I said in this article from March 2020). Those are relative concepts.
But 10-year real yields were below zero, and as low as -1.2%, for most of 2020, 2021, and the first half of 2022. And 10-year real yields have been below +1% almost continuously since 2011. When real yields were below zero or just fractionally positive, it meant that TIPS were absolutely expensive. That wasn’t just a TIPS problem of course: low real yields were the most obvious in TIPS, but you couldn’t avoid them by trafficking in other asset classes because they were a characteristic of the environment we were in. Everything was absolutely expensive, but TIPS were at least relatively cheap.
More recently, our models indicated TIPS getting quantitatively fair on a relative basis, which is historically unusual (see chart, source Enduring Investments); they even got somewhat rich a couple of months ago and that’s historically unheard of.[1] Real and nominal yields were still low, but at least it was a fair horse race between which ones to hold. And if you’d bought TIPS when I said there was “a big bet” being made against them, and sold them when we said they were fair, you crushed a nominal portfolio’s return. (As an aside, the rich/cheap chart and value is available every day on my private Twitter feed. Sign up for that private feed here: https://inflationguy.blog/shop/ I keep adding more charts etc, in addition to the main event, my live CPI report coverage each month).
As of today, 10-year TIPS yields are all the way up to 1.67%, the highest they’ve been since 2010. I explained back in June why the equilibrium risk-free real interest rate is approximately 2.25%, so TIPS are getting to the neighborhood of long-term fair values in an absolute sense. TIPS have no risk in real space, when held to maturity, so if you can get an annual 2%ish real increase in wealth with no risk, that’s a good deal. And inflation-linked bond yields in developed markets basically never yield more than 4% or 4.5%, so the higher the yield goes the less your potential mark-to-market downside. A 5-yr or 10-yr TIPS yield of 4% is back-up-the-truck stuff if you see it. At those real yields, with no risk, other asset classes simply can’t compete. At 1% breakevens there was no reason to own nominal bonds rather than TIPS; at 4% real yield there would be no reason to own stocks rather than TIPS.
But that sort of yield is of course very rare and we won’t see it unless nominal yields get up to double-digit land. At the current level, with TIPS at fair or slightly-cheap relative value and approaching fair absolute value, it is worth accumulating TIPS as a long-term hold.
It has been an astonishingly long time since I could make that statement. And TIPS may well get cheaper from here. I hope they do! But in the meantime, you can do a lot worse than guarantee yourself that your wealth will increase 18% more over the next decade than the price level rises.[2]
[1] I have written previously though about the value of long inflation tails, and how that value is NOT reflected in TIPS so that even when our model says TIPS are fair, they’re still very cheap if that tail option is reasonably valued. But that isn’t included here.
[2] (1+1.67%)^10 – 1 = 18%.
Low Real Yields – You Can’t Avoid Them
Recently, 10-year real yields went to new all-time lows. Right now, they’re at -0.96%. What that means is that, if you buy TIPS, you’re locking in a loss of about 1% of your purchasing power, per year, over the next decade. If inflation goes up 2%, TIPS will return about 1%. If inflation goes up 8%, TIPS will return 7%. And so on.
With that reality, I’ve recently seen lamentations that TIPS are too expensive – who in the world would buy these real yields?!?
The answer, of course, is everybody. Indeed, if you can figure out a way to buy an asset without locking in the fundamental reality that the real risk-free rate is -1%, please let me know.
Because when you buy a nominal Treasury bond, you are buying them at a nominal interest rate that reflects a -1% real interest rate along with an expectation of a certain level of inflation. The whole point of the Fisher equation is that a nominal yield consists of (a) the real cost of money, and (b) compensation for the expected deterioration in the value of that money over time – expected inflation.[1] So look, if you buy nominal yields, you’re also getting that -1% real yield…it’s just lumped in with something else.
Well golly, then we should go to a corporate bond! Yields there are higher, so that must mean real yields are higher, right? Nope: the corporate yield is the real yield, plus inflation compensation, plus default risk compensation. Your yield is higher because you’re taking more (different) risks, but the underlying compensation you’re receiving for the cost of money is still -1%.
Commodities! Nope. Expected commodity index returns consist of expected collateral return, plus (depending how you count it) spot return and roll return. But that collateral return is just a fixed-income component…see above.
Equities, of course, have better expected returns over time not because they are somehow inherently better, but because buyers of equities earn a premium for taking on the extra risk of common equities – cleverly called the equity risk premium – over a risk-free investment.
In fact, the expected returns for all long positions in investments consist of the same basic things: a real return for the use of your money, and a premium for any risk you are taking over and above a riskless investment (the riskless investment being, we know, an inflation-linked bond and not a nominal bond). This is the whole point of the Capital Asset Pricing Model; this understanding is what gives us the Security Market Line, although it’s usually drawn incorrectly with T-bills as the risk-free asset. Here is the current market line we calculate, using our own models and with just a best-fit line in there showing the relationship between risk and return. Not that long ago, that entire line was shifted higher more or less in parallel as real interest rates were higher along with the expected returns to every asset class:
So why am I mentioning this? Because I have been hearing a lot recently about how people are buying stocks because TINA (There Is No Alternative) when yields are this low. But if the capital asset pricing model means anything, that is poor reasoning: your return to equity investment incorporates the expected real return to a riskless asset. There is an alternative to equities and equity risk; what there’s no alternative to is the level of real rates. The expected real return from here for equities is exceptionally poor – but, to be fair, so are the expected real returns from all other asset classes, and for some of the same reasons.
This is a consequence, of course, of the massive amount of cash in the system. Naturally, the more cash there is, then the worse the real returns to cash because a borrower doesn’t need to compensate you as much for the use of your money when there’s a near-unlimited amount of money out there. And the worse the real returns to cash, the worse the real returns to everything else.
You can’t avoid it – it’s everywhere. I don’t know if it’s the new normal, but it is the normal for now.
[1] Unhelpfully, the Fisher equation also notes that there is an additional term in the nominal yield, which represents compensation being taken on by the nominal bondholder for bearing the volatility in the real outcome. But it isn’t clear why the lender, and not the borrower, ought to be compensated for that volatility…the borrower of course also faces volatility in real outcomes. In any event, it can’t be independently measured so we usually just lump that in with the premium for expected inflation.
