No Disaster

By: Michael Ashton | Fri, Feb 4, 2011
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U.S. Treasuries sold off another 4-9bps on Friday, bringing the 10y yield up to a 9-month high of 3.64%. And remember, that's with the Fed showing a $600bln bid! In just the last five days, 5-year yields are 35bps higher and 10-year yields are 32bps higher. About 35% of that selloff has come from a rise in inflation expectations, and 65% from a rise in real yields.

Looking over a slightly longer time horizon, though, the picture is more muddled. From a month ago:

  Nom Yld 1m Δ Real Yld 1m Δ BEI 1m Δ
T2 0.756% +13.5 bps -1.068% (35.7) bps 1.824% +49.2 bps
T3 1.231% +21.4 bps -0.646% (14.5) bps 1.877% +35.9 bps
T5 2.265% +25.7 bps -0.104% +0.5 bps 1.993% +20.9 bps
T7 3.008% +29.1 bps 0.673% +11.7 bps 2.335% +17.4 bps
T10 3.642% +31.1 bps 1.283% +33.2 bps 2.361% +2.4 bps
T30 4.736% +32.4 bps 2.161% +28.8 bps 2.562% +3.4 bps

 

Look at that change in the slope of the real yield curve! While everyone in the market is focused intently on the 'green shoots' of new growth, investors are increasingly willing to accept deeply negative real yields at the short end of the curve in exchange for inflation protection. Meanwhile, further out the curve investors are marking up long-run growth expectations (which are philosophically related to real yields) while not marking up expected inflation by as much. Fascinating. Keep that picture in mind, as I will have more to say about real yields later in this comment.

Don't say I didn't warn you about the Employment number. What a mess. The headline figure of 36,000 new jobs was feeble, but it was affected by weather. How much was it affected by weather? Well, I saw one dealer estimated the dampening effect at 150k-200k; another dealer said 40k. Which one do you think sees a robust recovery? Right, the first one. And isn't it curious...he was seeing the economy as robust before the report too.

The Unemployment Rate fell 0.4% again, to 9.0%. But the reason why isn't as simple as it seems. Yes, the Civilian Labor Force (CLF hereafter) plunged another 504k. However, this represents an annual adjustment to the estimated population, which estimate the BLS concocts with the help of the Census Department. So it isn't as simple as saying there was a 622k fall in unemployment and a 504k decline in the CLF producing a much lower Unemployment number (because 622k means more to the numerator than 504k means to the denominator, understand?). That would be absolutely horrible news, with half a million people dropping out of the labor force. In fact, what happened was that the BLS estimated a 117k decline in unemployment (rise in employment) on an unchanged labor force, and then applied the 504k adjustment to both (decreasing both unemployment and the labor force). It results in essentially the same fraction but this is much less bad. It is still not very good. Okay, so that is the news from the Household Survey.

The benchmark revision to the aggregate level of employment in the Establishment Survey, which is where the Payrolls change (+36k) comes from, also moved total employment lower by 483k (on a seasonally adjusted basis). Essentially, the numbers are saying "we were a little high on the count of total jobs, but it turns out that was because we thought the whole country was bigger than it was, so even though there's fewer jobs there are also fewer jobless." Got that?

This isn't malicious, just very confusing. The labor force participation rate, however you count the numbers, is still at a 26-year low and not signaling any great expansion of the economy.

The long and the short of it, in my view, is that there is nothing here to cause us to change the null hypothesis that the employment situation is improving, but only very slowly.

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In Egypt - I think it behooves investors to keep one eye on Egypt since it is currently the hottest spot within the hot spot that is the Middle East - President Mubarak did not in fact leave voluntarily on the "Day of Departure." For investors, this removes the one path that was likely to generate the least violence and least uncertainty. There are two remaining paths, since the President does not want to leave voluntarily: (1) he may end up staying, which likely will require increasing violence to quell the unrest; or (2) he may end up leaving involuntarily. Of those, the latter will cause the most short-term uncertainty and likely the most long-term certainty (unless you expect Mubarak to live forever) and the former will cause the least short-term uncertainty and the most long-term uncertainty. Which one do you think investors are clamoring for? Right again.

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The best headline of the day, from Bloomberg: "Madoff Trustee Seeks $295mm in Fictitious Profits." Hey, don't we all? And, um, isn't that what got Madoff into trouble, seeking fictitious profits rather than real profits?

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Back to real yields. I had several people send me a link to the story "Treasury TIPS: A Looming Disaster for Small Investors." Several others had previously sent me the Financial Times piece on which the article is based. So is there a disaster developing?

Well, the Wallace article is both right and wrong, as was Siegel's. The answer depends on how you own TIPS, and for what time period.

As with any bond that matures rather than defaulting, if you hold TIPS to maturity you know exactly what you are going to get: all of your money back, with interest, and with both principal and interest adjusted for inflation (this is actually even better than with a nominal bond, in which you get all your interest and all your principal back, but you don't know what those dollars will be worth).

Like any bond, if you sell the bond before maturity you do not know what you will end up getting. And, since TIPS funds generally do not have a maturity, this is also true of TIPS funds.

So it's only a disaster if you buy TIPS now and sell them when real interest rates have risen. And even then, if inflation and inflation expectations have increased you likely will have done better in TIPS than in non-inflation-linked bonds. So the disaster is relative. If you think inflation is going appreciably higher, the first thing you should do is to avoid normal bonds, where interest rates will rise (and mark-to-market principal fall) without any inflation compensation. In that case, you're long real rates and short inflation; with TIPS you're only long real rates.

Having said that, real interest rates on TIPS are fairly low (and quite low at the short end) and I sold mine out some time ago. But it is prudent to have some kind of inflation protection, and although OSM isn't as attractive as when I first wrote about it in May of last year it still is priced to yield around CPI+6% (closing today at $20.35). I also still own USCI, which I wrote about on October 21st.

I would also like to point out that long-term TIPS are yielding over 2%. Will they cause a disaster if the yield rises? Certainly, because they have a long duration. But by the same token, long-term real yields (unlike long-term nominal yields) are somewhat bounded by the relationship of long-term real yields to long-term economic growth. At the peak of the last expansion, 30y TIPS yielded around 2.5%. At the depths of 2010, they yielded around 1.5%. They're now around 2.15%. Could they go to 4% if nominal rates soared? Assuredly, although remember that if nominal rates are rising because of inflation expectations that will not affect TIPS. But can they go to 6%? Not without some earth-shattering developments. So, even though they have a very long duration, they also have more anchoring. Put another way, long-term real yields have much less volatility, relative to short-term real yields, than long-term nominal yields have relative to short-term nominal yields.

So, while I am delighted that people are finally pointing out that TIPS are not immune to bad mark-to-markets in inflation episodes, as long as you're holding to maturity or buying them with long-term real rates somewhat above 2%, it's probably not going to be a disaster. And in the event where you do have significant losses, they will probably be sharply less than your losses in nominal securities in that circumstance (especially your real losses in nominal securities!).

And I will make one final point. If real yields on TIPS are low, that means real yields are low everywhere. Real yields are a component of Treasury yields, but embedded in the nominal yield. Real yields are a component of equity pricing, but embedded in the P/E multiple. And so on. You can't avoid exposure to real yields by not holding TIPS! If real yields go from 2% long-term to 4% long-term all of these assets will suffer. A rise in real rates represents a rise in the cost of money, and that affects all assets.

Yes, it's much more fun to be an investor in an era of declining real yields and declining inflation expectations. I hope you had fun over the last thirty years. But we are no longer in that world.

 


 

Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
E-Piphany

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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