Norway Or The Highway

By: Michael Ashton | Wed, Oct 6, 2010
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Who says that inflation instruments are boring? Today TIPS and inflation swaps went on a wild ride, with yields more than 20bps lower early in the day before a selloff in nominal markets finally served to pull inflation-linked ones back down to earth (comparatively). This often happens in inflation markets; the big players (on the client side) have a larger share of the total volume than in the nominal Treasury markets, so when a few investors start to move at the same time the moves can be dramatic. Right now, with real yields negative over a significant part of the curve, many investors are short (or short their benchmarks), believing the inflation-linked bond (ILB) world doesn't offer value.

This is arguably correct, but as I showed yesterday the risk-lessening advantage of explicitly indexed bonds is substantial enough that it is hard to find an alternative that adds enough reward to compensate for the least, that's true these days when most asset classes are threateningly priced. Personally, I am considering selling some of my longer-dated TIPS, acquired at yields near 4% in early 2009, and buying short TIPS with significantly negative real yields but less exposure to a spike higher in real rates. I haven't decided yet whether to do so, because transactions costs for retail investors in TIPS are sufficient to discourage moves that are not made with full conviction.

(As an aside, I am not worried much about the negative real yields; sure, July-13 TIPS are at -0.67% but with 3y Treasuries at +0.57%, I am still better off if inflation is as low as 1.25% per year for three years. Since oil and grains prices have both been on the rise lately and my model for core inflation just for 2011 is around 1.6%, this seems a decent bet...and I get the "tail" if inflation gets out of hand in 2012).

The 5y TIPS yield ended "only" 11bps lower, but short inflation swaps rose around 25bps. I say "around" because dealer and broker marks in this kind of move are best viewed with some kind of skepticism. But on the chart I showed yesterday, with the 1y inflation swaps spot, 1y and 2y forward, the latest points are around 1.14%, 1.46%, and 1.96%, which means that since Friday the spot 1y is up 25bps, the 1y, 1y forward is up 17bps, and the 1y, 2y forward is up 24bps.

And, while the inflation market didn't react yesterday to the increasing drumbeat of QE2 in the U.S., I wonder if it is a coincidence that the reaction came after the Norwegian central bank essentially cut the interest paid on excess reserves. Thanks BN for pointing this out - the article on Reuters is here. Although the terminology is a little different than what the Fed uses, and their policy rates are not yet constrained by the zero bound, the statement made clear that they understand the importance of the interest paid on excess reserves. "This will enhance," they said, "the redistribution of liquidity in the interbank market."[emphasis mine] That is exactly the argument I have been making about IOER: if you want the QE2 (and QE1!) liquidity to be distributed into the economy more broadly, to increase M2 and the more-important aggregates, then you need to stop paying the banks to keep the money out of circulation. It is that simple. At least in Norway, they seem to think that it is important that the liquidity moves into the broader economy! This is encouraging, because central bankers do after all attend the same conferences and they do talk.

The economic news today, represented by a somewhat weak ADP figure (-39k versus expectations for +20k, albeit with a 20k upward revision to last month), highlights the fact that will probably be reinforced on Friday: it is, in fact, important that the liquidity moves into the broader economy!

However, I think it's also important that we keep in mind what quantitative easing can and cannot accomplish.

Recall that MV≡PQ is the monetarist identity. In words, it says that the amount of money in the economy, times the frequency per year that each dollar is spent, equals the price level times the real output. Or, in even simpler terms, the total amount of money spent each year equals the amount of stuff people bought times the price they paid for the stuff. You can see why this is considered to be an identity. It simply must be true. And it follows that %ΔM+%ΔV=%ΔP+%ΔQ ... the growth rate of money, plus the growth rate of velocity, equals the sum of the growth rate of prices (that is, inflation) and the real growth rate of the economy.

This is why I don't worry about deflation. If we assume that velocity is reasonably stable, then an increase in the rate of money growth must result in an increase in prices or an increase in economic growth, or both. If you print enough money, then unless the velocity of money perversely contracts at exactly the same rate you're expanding the money supply, you will get an increase in nominal output.

But this is both the strength and the limitation of quantitative easing. When the money supply is goosed, the central bank cannot control whether it results in increasing prices or increasing output. And there are good reasons to think it will be primarily the former. When the amount of money in the economy increases, it is easy to see how that results in inflation. Pure supply and demand logic dictates that as the amount of money increases relative to the amount of stuff to buy, the exchange rate of money to stuff increases. That is, prices rise. Why would output rise? Well, with more money in the system, and therefore in each consumer's pocket, consumers may feel wealthier and therefore spend more, triggering growth.

But this additional wealth is, of course, illusory. If I personally own 1/200 millionth of the money in circulation, and the value of all accounts is doubled, all my dollar bills exchanged for two-dollar bills, all my $5 become $10, my $10 become $20, and so on, then I still have 1/200 millionth of the money in circulation. I have twice as much money, but each dollar buys me half as much of the economy's output as it did before. If I spend a higher proportion of my income now because I feel wealthier - if I continue to save $1,000 every month rather than doubling that amount - then I am being tricked into consuming. We call this "money illusion," and there has been vigorous debate about the existence and potency of this illusion for a very long time. But note that if there is no money illusion, and the money is distributed equally, then my behaviors shouldn't change in real terms - I'll just double the amount I spend on everything, and since the same amount of stuff is available but twice as much money is being spent on it, the price of stuff will simply double. No deflation, but then again no real growth.

Well, I don't know how powerful the money illusion is. At low levels of money growth it may be important, but I suspect that as the level of printing increases the illusion weakens.

So here we go: QE2, if it is combined with an elimination of interest-on-excess-reserves, will probably cause at least some inflation. It is a good instrument with which to avert deflation, but it is a blunt instrument with which to cause growth. Since core inflation (ex-housing) has been around 2-3% over the last year and food and energy are both rising as well, it isn't clear to me that QE2 is needed to avert deflation. Moreover, it isn't clear to me that it will do much to spur growth, although Evans yesterday and several other speakers recently seem to be leaning on the argument that the Fed needs to "do more" to bring down unemployment.

The question for an investor, though, isn't whether QE2 should happen, but whether it will happen, and it is sounding more and more like it will. The political reality is that Congress and the Administration are out of bullets and that "someone" needs to do "something." The only someone and something left is the Fed and QE2, so that's what will get done.

Tomorrow, in the last pre-Employment data gasp, Initial Claims (Consensus: 455k vs 453k last) will be released at 8:30ET. Dallas Fed President Fisher speaks at 1:20ET in Minneapolis. Fisher is well-known to believe that gold is an important inflation indicator, so if he comes down on the side of QE2 then you can pretty much mark it down as done. Speaking at 1:30ET, in Nebraska, is Kansas City Fed President Hoenig, but the meeting is closed and it isn't clear how much information we will get about that speech.

Watch inflation indicators: TIPS, commodities, and the dollar. These markets are starting to get rather exciting.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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