Love Is In The Air

By: Michael Ashton | Mon, Feb 14, 2011
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Ah, there is nothing quite like the manufactured holiday of Valentine's Day.

It is a time to reflect on the impact in our lives of all those whom we love: family, friends, commentary subscribers, Twitter followers, et cetera. It is a time to salute Pepe Le Pew as being a tireless suitor rather than an annoying stalker. It is a time to be moved by Elizabeth Barrett Browning's Sonnet 43 and not to disparage it as a cloying attempt at one-upping her secret love (and future husband) Robert. And it is a time for letting people we love know that we really do love them.

For example, it is clear that I do not often remember to say "I love you" enough to Alan Greenspan. Without the Maestro, how would I ever have been inspired to write Maestro, My Ass? (Note that you can still get a discounted copy here.) And my affection for Ben Bernanke burns even hotter, for he is really trying to help those of us who specialize in inflation markets. God bless his little heart. I adore Obama's cute little Socialist tendencies; socialism creates such wonderful opportunities for entrepreneurs to offer efficiency as a product. Every dollar of expenditure in the Federal Budget (the President's proposal was released today with a record deficit projected for the recovery year of 2011 before dropping to "only" 1.1 trillion in 2012) represents an opportunity to do something better than the government. Would FedEx have ever gotten started if the Post Office wasn't run so well? I hope Fred Smith sends a valentine every year to the Postmaster General.

I don't really much care for Congress. There's just not room in my heart for those little dickens. You can't love everyone.

More seriously: the budget proposal released today is amazing and, if you are think of buying 30-year nominal Treasury bonds you really ought to give it a read. While the bond market managed to eke out a small gain with 10y Treasury notes closing at 3.61%, it is hard to imagine those low rates will be available to the Treasury a year from now. The budget contemplates a $1.1 trillion deficit next year and never less than $600bln over the forecast horizon. By comparison, before 2009 there had never been a full-year deficit of more than $455bln (see Chart below if Valentine's Day puts you in a charitable mood that makes you feel uncomfortable).

Calendar-year federal deficit
Calendar-year federal deficit (source: Bloomberg)

For another comparison, interest on the national debt is expected to be $474bln in 2012. That's up 14.5% for fiscal year-on-year and that, my friends, is with record low interest rates! But don't let your blood boil: it's Valentine's Day after all. And another observation: until 2008, the amount of currency in circulation had never exceeded $830bln (it is now not quite $1trln). So if you gathered every U.S. penny, nickel, dime, quarter, half dollar, dollar coin, and every bill in every wallet and piggy bank in the world, you still would be more than $100bln shy of covering next year's deficit. Not debt, folks: just the single-year shortfall.

What is amazing to me (and I don't want this to become a political comment, but large deficits have a market effect and an economic effect and so it's worth discussing) is how many parts of the budget are increasing at the very time when we're running pan-trillion-dollar deficits. Look at the wonderful color-coded chart that the NY Times has up here. This is true even among discretionary items, but let's be frank here: if the alternative is that the nation is unable to fund this budget and unable to borrow it, these are all discretionary items.

It is a depressing reminder of the state we are in to look at what is considered a reasonable budget proposal. But again, for an inflation consultant these should be lovely times. For many people, and although I am an optimist I increasingly count myself among them, can't figure out how we get out of this mess without completely changing the structure of the budget and the scope of the entitlements and then inflating ourselves out of the existing debt. Make no mistake, just doing the latter won't work because the entitlements are inflation-linked and the average maturity of the debt is right around five years - meaning that in five years, your interest payments will rise to reflect the new inflation reality. We must put the budget into surplus and then inflate.

Except that I don't think there is anything approximating a plan to do this in a rational way. We are guiding the ship of state through the murkiest, most-dangerous shoals in the world and no one is steering. (And is that perhaps one of the reasons the equity market is rallying? Because the only hope is to spin the roulette wheel and get lucky?)

But this should be a happy occasion. This is no time to bicker and argue over who killed who. (Apologies for the Monty Python and the Holy Grail reference). Let's focus on the good news, for there is at least some.

The good news is that for whatever reason, the financial markets are not yet punishing us for what is surely an increasingly obvious denouement to the predicament. The Federal Reserve is right, at least presently, that the cleanest read of inflation expectations indicates that no one has caught on yet. The chart below shows 5y inflation swaps and then the 5y inflation swap starting 5 years from now (the 5y, 5y forward inflation swap).

Forward inflation measures are calm and contained
Forward inflation measures are calm and contained.

While the 5y is near multi-year highs around 2.25%, the 5y5y is only just above 3% and seemingly in no danger of breaking out to new highs. While 3% is well above the Fed's stated target, there is always a little risk premium in the forward since all of the long-tail risks are to higher inflation (there is no chance of -10% inflation, but +10% isn't even all that difficult). Even back in the halcyon days of 2006 and 2007, the 5y5y ranged between 2.70% and 3.05%. So there certainly seems to be scant alarm in the inflation derivative markets. The chart below shows a scatterplot of the last year's worth of data with the latest point in red. Arguably, 5y5y is even lower than it should be, given expectations for inflation over the next 5 years and the "usual" relationship between these two measures.

5y CPI swaps (x-axis) vs 5y5y CPI swaps (y-axis)
5y CPI swaps (x-axis) vs 5y5y CPI swaps (y-axis) suggests that if anything,
forward expectations may be low!

Now, let me be clear. There ought to be some alarm. Given a choice between buying the 5y5y at 3% and selling it there - not as a trade but as a bet to hold for 5 years, mind you - the choice is simple to me. I can tolerate a loss of 1% per year if I am wrong and inflation expectations in 5 years are at 2%. I can tolerate a loss of 2% per year if expectations are for a mere 1% inflation over 2016-2021. But I don't want to be in the situation, five years hence, of possibly having to buy inflation protection at 10%.

Some of this is due to the fact that the Fed is trying to hold down long-term nominal rates, and while this chart shows inflation swaps rather than inflation breakevens the two measures are kissing cousins. But the Fed is also buying TIPS, and that will tend to drive up the same spread, so while 10y nominal yields are clearly lower than they otherwise would be if there were no $600bln gorilla in the room, it is not quite as clear that forward inflation metrics are as perverted as nominal yields themselves.

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In contrast to last week's desert of economic data, this week's more-interesting slate gets moving tomorrow.  The Empire Manufacturing Index for February (Consensus: 15.00 from 11.92) will be released at the same time (8:30ET) as Retail Sales (Consensus: +0.5%, +0.6% ex-auto). I expect bonds to resume the recent trend to higher yields, but at 3.57% on the 10y yield I'd reconsider the immediacy of that stance. Stocks will someday fall, and fall appreciably, but I see no reason to expect that yet. Love is in the air.

 


 

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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