Entries in inflation risk (6)


US Treasury to offer floating rate notes in January

This is a welcome and needed addition to Treasury offerings. Most investors don't have adaquate access to the capital markets to manage interest rate (e.g. swaps) and those that do may not want the incremental counterparty risk of banks or clearing exchanges ("value adding" intermediaries?).

This from the press release:

Floating Rate Notes (FRNs)

Treasury intends to announce the details of the initial Floating Rate Note (FRN) auction on Thursday, January 23, 2014, with the first auction occurring on Wednesday, January 29, 2014. Settlement of the security will occur on Friday, January 31, 2014.  

The FRN is the first new product that Treasury has brought to market in 17 years.  The FRN will have a maturity of two years and Treasury anticipates that the size of the first auction will be between $10 and $15 billion.   

Specific terms and conditions of each FRN issue, including the auction date, issue date, and public offering amount, will be announced prior to each auction.  For more details about the new Treasury FRN product, including a term sheet, FRN auction rules, and Frequently Asked Question, please see:


In addition, a tentative auction calendar that includes Treasury FRNs can be found at:



This will be a useful tool for investors looking to manage interest rate and inflation risk.


The taper of Q3: actual results may vary


Now you see me, now you don't. Now you see me, soon you won't!


The country seems to be facing a crisis of confidence that now surpasses that of Jimmy Carter’s “malaise”. There is a loss of confidence in leaders and institutions that now encompasses civil, cultural, educational, economic, and Constitutional dimensions. Americans are a practical people: they expect things and people to work, including their leadership.

Consider the non-stop headlines, some small, some large, all cumulatively indicia of a mechanic of dysfunction of large magnitude. It has financial implications.

Let’s start with the Fed, and we’ll quote our last posting which reflects our continuing view:

“We believe the Fed is in fact looking for an unwind strategy but can't find one.  A financial Burdian's Ass? Does any bale of hay contain an acceptable unwind? We've gotten a whiff of the revolt of the rational market investors squaring off on the 10 year rates at any sign of tapering which was not pretty.

Our take is that the Fed will do nothing intemperate, take an agonizingly slow incremental approach ... at least while all the knots hold. By this we mean near stasis. We suspect the probabilities are growing for a much longer & slower unwind than many contemplate. We are, however, unwilling to bet much of the ranch on it. The stasis scenario provides 'flexibility' for a strategy that is pinned to the hope of economic growth that may or may not materialize. One is tempted to suggest decades and for the intermediate period a near permanent increase in the money supply. Just a thought. Watch money velocity.” - THE FED, COLLATERAL AND REPO: MORE SYSTEMIC RISK?

The Fed, in pursuit of “transparency”, led the market to anticipate a “tapering” this week, or so some 67% of economists thought. After months of preparation & indications that “we will taper”, they did not. Hmmm.

“Federal Reserve officials created new uncertainty about how much farther they will push their easy-money policies—and new questions about how effective they are at communicating their thinking—with the decision to stand pat on the pace of their bond purchases for now.” Fed's Guidance Questioned As Market Misreads Signals

Paradoxically, the Fed is adding uncertainty as to the predictability of its short term actions but more certainty as to the ultimate outcome of its strategy. QE and the balance sheet of the Fed, which is now the largest undercapitalized hedge fund in the world, will have to be downsized, unwound at some point. The inflated asset prices it has created are not sustainable nor is the continual expansion of the money supply nor is the balance sheet of the Fed without market constraint. OK, but some problems arise. We don’t know the timing, magnitude, consistency, or forms of the ultimate unwind or market response. We do know that large complex things take time to process and adjust (or as the dinosaurs, die). We do not know the form of market response as it will be influenced by mode & timing of implementation.  Intuitively, we see two polar options: a potentially chaotic repricing of some magnitude or a gradual decline of our standard of living induced by inflation and/or lower productive economic output over time. Likely, it will be a more moderate combination of both. It is a huge Markov Chain. Look for rising risk premia.

One thing is certain: no jobs means no recovery, no growth. U6 is the green line. We basically have 15% of the country out of work. Equally disturbing is the youth unemployment: we are loosing a generation of workers which has huge long term cultural & economic implications. These wheels grind slowly but finely, and the fate of the black nuclear family comes to mind.  The Civilian Unemployment rate is simply misleading & does not count those who have left the labor pool over time for want of employment.

As to the inevitability of outcome consider this and ask if the trajectory is sustainable. Recall it omits unfunded liabilities:


Equities: But the juice works in the short term. Set aside for a moment that steady decline in real median family income and take a look at the ride in equities: Obama and Bernanke have delivered for the 1% like nobody's business.

US and non-US equities have put up great numbers. It seems extended low growth with expectations for the grind to continue in the US has been sufficient to buy Euroland and Asia some time to put their houses in semi-order. We remain skeptical of expectations for higher growth in the US. Evidently, so does Mr. Ben.


Large, mid and small caps all up: beta wins.  These are outsized gains clustered within a relatively small time frame. 

Growth or value pretty much didn't matter.


Fixed income: we know too well the implications for continued manipulation of zero to negative real interest rates. It is a coersed wealth transfer from savers & risk constrained investors to borrowers. You get no or negative real return on your fixed income investments, and the borrowers (including the US government) get the interest you do not. It’s pretty simple. In a macro perspective every fixed income investor (from Grandma to Bill Gross) become poorer. Real rates have increased substantially in proportional terms, and we suspect more to come... when is the question.

Meanwhile fixed income investors have learned a harsh lesson: maybe Grandma shouldn't hang out in long bonds. More learning to come?


We note again there are only three ways to get yield in fixed income: duration, credit risk, or liquidity risk. As the Fed starves the market of real interest rates, it drives investors out the risk curve along any of those parameters. So, if you buy the thesis that the current game is not sustainable, do you load up on duration, credit or liquidity risk when you know the markets are distorted by the Fed at the precise time when the Fed has demonstrated you cannot rely on its indications of policy? We think not, unless you have impeccable market timing which, by the way, neither you nor we have.

We maintain our bias to short duration investment grade product. A diversified portfolio with a duration of 2.7 pays a spread of .97% over the interpolated Treasury rate. Consider that the 3 year Treasury currently pays .87%.  The credit spread is more than the underlying Treasury, not a bad value.  We caution against chasing yield: it never ends well. You just can’t get 8% in a 2.75% market.  Remember that next time PT Barnum starts pitching you.

Our outlook: We anticipate low growth and increasing risk premia induced by the Fed, ill conceived regulations or geostrategic blundering. We look for sluggish employment and weak capital expenditures. Every dimension of fiscal, monetary, social, energy & tax policy is directionally wrong from an economic perspective. Paralysis may be the best hope as a least-worst outcome. We anticipate Ms. Yellen will be the nominee to head up the Fed and do not anticipate that she will raise rates in face of a congressional election year and certainly not in a presidential cycle, but as they say, the opera isn't over until the fat lady sings.

Stocks and bonds will respond favorably as will all risk assets. Everyone may well join the drunken pig pile, and all the animals of the forest will be happy, at least for a while. Systemic risk & moral hazard will grow and long tailed risk will increase. We see near term risk of inflation as offset to some extent by slack capacity in the economy. 

For equities the good news is that globally corporate balance sheets continue to be in great shape (excluding financials) and well positioned for marginally decent earnings in a slow growth environment. There is much less opportunity for cost cutting & greater efficiency. Earnings growth will start to converge with nominal GDP growth.

It is no trivial matter for the asset class as a whole that corporate compensation models are much better aligned toward wealth creation. There is no such scheme with fixed income assets, save the anti-model of governments that are driven by grafted re-distributionism, so to speak, and incentives to inflate. Equities historically have been a source of high sustainable real returns, and we don't anticipate that will change. We do anticipate greater uncertainty which may manifest itself in greater volatility from here to there and stretch the time frames required for those expected returns to eventuate as business models adjust.

We'll close with two last comments. We see two major risks to long term investors. One takes the form of undisciplined investment programs that devolve to decisions driven by emotion which in turn subverts the asset allocation and risk management. The fog of uncertainty holds implications, again, for the importance of asset allocation and diversification. The other risk is inflation. If you think you can go to cash and sit this out, consider the picture below (reproduced from  PRE Q3: IT'S NOT AN EMPTY CHAIR, IT'S AN EMPTY WALLET).  Here's a hint: if the graph starts to get darker blue, you've probably lost 70% of your real value.



pre q3: it's not an empty chair, it's an empty wallet

We’ve run silent for a while with good cause. Those with whom we speak know our distraction with and consternation about some corporate governance issues well away from WWB.  Our homily for last two quarters is, like QE3, ubiquitous: know before you go. More on that later.

The core issue for our silence has been that we've had nothing to say, at least nothing that made any particular sense. We were mesmerized by the magnitude of the geopolitical & macroeconomic frogs in global blenders and by the scale of cynicism marking the political hegemony.  What is it, "if you can't say anything nice, don't say anything"... well, our readers know we missed that bus a long time ago.
We have accelerated the quarterly review process for our clients because we wanted to be tucked in before the end of this quarter in light of the election and the potentially massive recasting of portfolios driven by tax windows and political outcomes. 

Talk to your tax advisors now

We suggest all check with their tax advisors to get a grip on their expected marginal tax rates next year; review any embedded long term capital gains and implications of future rates; and make sure you have adequate liquidity to tide over any potential geopolitical stress or untoward political outcomes domestically. 

QE3: Who made the Fed the 4th branch of government? 

The Fed has manipulated the rates for some time and now with the advent of QE3 the price of money will be determined by fiat of the Fed, whether driven by putatively leading economic thought, whimsy, or political objectives... exactly the same way FDR did in 1933. Amity Shlaes wrote a fascinating article in the WSJ on FDR and the notion of confidence, part of which is excerpted below:

Over the summer of 1933 ... Roosevelt launched a novel gold purchase program. The plan was to drive up the general price level by buying gold. Each morning, FDR set the gold price target, personally ... theoretically, Roosevelt's idea of reflating can be defended... but the exposure to investors that Morgenthau was getting through the gold purchase project of 1933 was already teaching him something. Investors didn't like the arbitrariness. It took away their confidence. One day Morgenthau asked FDR why the president had chosen to drive up the price of gold by 21 cents. The president cavalierly said he'd done that because 21 was seven times three, and three was a lucky number.

FDR, Obama and Confidence

That’s Bernanke today, and as we’ve said before “One might then reasonably inquire as to how and on what rational basis ... other than that to be found in a room, dimly lit by burning candles, with chalk pentangles and splatters of chicken blood on the floor ... how do they evaluate risk of this market which funds, essentially, the entire financial system of the known world.” 

The consequence of artificially low rates is a wealth transfer from the investor (you) to borrowers. Crudely put, you get low to no interest income while borrowers get low to no interest expense. Good for borrowers, bad for investors including retirees, your mom & dad, pensions, or anyone who wants to start saving…like young people with or without families. These are big, large scale numbers with generational implications for capital formation. The low yields are only one small part of the silent transfer of wealth & risk that is ongoing. 

Let’s talk about risk, shall we? 

In fixed income risk comes in two forms, duration & credit. Fed policy is attempting to force investors to load up on both. We all know what credit risk is: the weasel is shaky or doesn’t pay you back (Greece or General Motors come to mind, yes? Junk bonds? Your esteemed Uncle?). Duration is a measure of interest rate risk. So, for simple example, if you have duration of 14 as many long term Treasury funds do, and 14 year rates go up 1%, you just lost 14% of the value of your bonds. If the rates go up by 2%, then you lose 28% of your value (kind of a big numbers for purportedly low risk investments, don’t you think?). This is a big deal.

In fixed income there are only two sources of yield: duration or credit risk (let's ignore liquidity premia for the moment). Oh, by the way, these price changes and risk parameters move instantaneously with expectations, so the bond manager (or you the investor) needs to ask if he feels lucky today? Will the center hold? Long enough for me to pick up another coupon payment before expectations collapse? Well … do you?  Or maybe your grandmother shouldn’t own all those long term bond funds?  The Fed is force feeding markets. The investor who stays short forgoes yield, and retail investor who goes long does so by incurring duration risk. It will not end well. 

Inflation risk

Ah, the printing press. Another component of QE3 is the hidden cost of inflation, that part of price changes induced by excess money supply. When you look at the chart below, recall that Jimmy Carter took the title, as it were, with 14.8% inflation in March of 1980. It can & did happen. When you have monetary & fiscal policy created by the belief that $1.00 of government spending creates $1.50 of GDP and that belief continues to drive policy absent supportive data or in fact even in face of contra-indication… you may have a problem, particularly when you’re borrowing $.40 of each $1.00 you spend.

As you look at the graph below imagine it to be 3 sides of cardboard box with two walls and the top cut away. We drape a light blue cloth (a “surface” in math speak) along the upper left hand wall. Go the far upper corner where we start at $100 at time 0 with 0% inflation. You can see the real value stays at $100 where ever you are on the time line at 0% inflation. The front left axis of the floor of the box is the level of inflation running from 0 to 20%, and front right axis is time in years. Go to the rear wall, pick a line on the cloth (the first one is 1% inflation), and slide down the time line across the drape to the front.  Presto! You get something less than $80 in real value at 1% inflation over 25 years. 



Just so you know, the low points (closest to you, lower center, darker blue shade are the longest timeframes & higher inflation rates) represent about $1 of real value. You get the picture of a pretty severe loss of value over time even with fairly modest inflation: 3% inflation over 25 years kills half your purchasing power. That’s a big deal for individuals planning their retirement or for anyone including insurance companies or banks or corporations trying to fund assets or liabilities in the future. It’s a very difficult box to get out of.

the men would get paid in the morning. they would take pillow cases, put the cash in the pillow cases, walk over to the wall, and throw the bags of money over the wall to the women who would go out shopping, to spend the money before the merchants raised the prices in the afternoon...

source: as told to my friend LG by his grandfather on life in the Weimar Republic


Just witness the 25 basis point surge in break evens in the hours following the Fed’s QE3 announcement on Thursday last week, representing a “5-sigma event” for this market-measure of inflationary expectations.

source: Mohamed El Erian in Introducing the “reverse Volcker moment” Sept. 20, 2012

As you look at the graph ask yourself how do I price assets of any kind when I’m looking at a surface of real value that declines like a large water slide at an amusement park? This is how government lowers our standard of living. It is how government levies taxes without the consent or vote of the people. No elected official “votes” for “Quantitative Easing”. Who made these clowns the Fed an unelected 4th branch of government?  … but we digress into outright political control of the broad market economy.

There are very few places to hide, and those are imperfect places. This is not a pleasant time to be either an investor or in the investment management business. The general form of problem is that the Fed has manipulated the “risk free” rate to zero and announced it will print money without limit of time or amount. This causes two tectonic problems. It distorts asset price information and induces inflation risk. 



Real yields for US Treasuries with maturities less than 20 years are negative. This is the bond bubble. What value could there be in a 20 year bond with a real yield of 0%? We suspect very little positive value and potentially significant negative value. How shall we know? Ask Ben.

The problem of the “bond bubble” does not stop with bonds. The US$ is the global reserve currency, and the US Treasury market sets the benchmark for global asset pricing. As the Fed pushes investors out the “risk curve” the distortion of the Treasury market ripples across the globe and across prices of all asset classes. 

Recall that in response to instability of Euroland we saw investor flight out of the Euro and into the US$ and Treasuries which became too expensive, no yield, then catching its breath, the herd swarms into emerging markets debt & high yield debt which became too expensive, then into US equities generally, and particularly dividend paying stocks, which perhaps have become too expensive, or onto real estate which was previously too expensive and the proximate cause of the initial collapse? Or commodities that reside in bins? Or gold which has no earnings, no P/E ratio? The uroboros eats its own tail.

Add to this the uncertainty of the entire tax code, regulatory framework, the outcome of the US election, clueless Europe, Islamic instability on fire globally, with what appears more & more each day as a failed state on our southern border, not to mention the one in Washington.

Investment strategy

Our view has been that inflation is the primary risk to investors and that view defines portfolio & risk strategy. Of course, the solution is sustainable high real returns but there just isn’t a perfect solution, and there are no risk free solutions. An optimal strategy likely takes a form of ‘least worst’. Our general preference in relative order would include equities, real estate, commodities, short Treasury bills, inflation indexed bonds, and short duration spread product, all defined within prudent diversification and risk parameters.
Asset allocation

We do not anticipate significant changes in terms of existing broad asset allocations for most clients. That work has already been done & is embedded in the existing portfolios. We will be inclined to increase our exposures to real assets beyond the positions embedded in existing index product by adding slices of gold or silver, the size of which will vary by client risk tolerance.
On a good day the asset allocation decision already incorporates one’s ability to tolerate risk. We see nothing on a macro basis that would induce us to start adjusting those dials significantly for our clients. Risk tolerance will be the driver.
Fixed income

As a general comment we’ve had a legacy core bias to short duration investment grade credit augmented by moderate positions of inflation indexed product, emerging markets debt, and domestic high yield. We’re still inclined to avoid duration and favor short Treasury Bills, inflation indexed bonds, short investment grade spread product. We’re not buyers of high yield or emerging markets debt at these levels.  We’re content to hold for now.
We’re scared to death of municipal credits but suspect there may be value in certain long duration AAA/Aaa floating rate municipals. Ah, wouldn’t we all like to float or drift as the case may be?
Solutions to the inflation challenge can be problematic in that many investors simply lack the scale to tolerate the risks associated with the most robust effective classes or lack access to solutions which reside in the capital markets (e.g. interest rate swaps). What can we say, scale counts: “It’s good to be the king.”
Why not increase equity exposures?  

By all means if you've got the risk budget and faith in Ben. It has been a significant 3 months for virtually anything: US equities, non-US equities, emerging markets, and gold.  QE3 in connection with a slow grinding economy can do wonders. So do steroids, but there are bad side effects. 


While we believe that equities represent the best shot at sustaining higher real returns over time, we also recall the notion of Mr. Bernanke forcing investors out the risk curve. He has made some very large scale bets on a questionable basis. If it ends badly, the equity markets globally may be damaged or radically repriced along with all the guinea pigs herded out the risk curve.

We suspect the Treasury “bubble” has become ubiquitous, spreading to virtually all asset classes globally including equities. Historically, the US equity markets have been characterized by the stability created by a permanent equity market & investor class. Neither Asia, Europe, nor the emerging markets can make that claim credibly. In a heart beat…poof… they can go. Such things happen in panics.  US equities traditionally have stayed, we were open for business after 9-11. 

But things change. We started by saying that we view inflation as the primary risk. But are we not in a growth constrained and credit stressed environment too? The tertiary risk is an untimely, chaotic repricing of the distortions induced into the markets by imprudent fiscal policies & coercive & synchronized monetary policies globally. The risk is that Bernanke, the US Treasury, Congress, and the President, perhaps in conjunction with exogenous forces, unwittingly damage the fabric of the US capital markets and the investor class. We no longer assign a de minimis risk to that outcome. It's already started.

Look at what they did to our bond ratings. 



Inflation, deflation & asset classes

A recent article in WSJ referenced a helpful analysis for those interested in the risks of inflation or deflation by asset class. The primary source was the Credit Suisse Global Investment Returns Yearbook 2012

For the short story, go to p.14 of the Yearbook.


Maybe the Fed doesn't have Yahoo or Google finance?

Here we see the price behavior over the last 3 months of certain proxies of asset classes of interest:

  • energy (via the proxies XOM and OIL),
  • precious metals (GLD and SLV);
  • commodities (GSG),
  • 30 yr US Treasury yield (^TYN); and 
  • US $/EURO rate (EURUSD).

Those of us who are color blind may have difficulty discerning the finer points, but in some sense the colors don't matter. The blink test is sufficient. Annualize the gains, and you get some non-trivial numbers.  


The only things going down are the US $ and the credibility of the Fed. Oh, we forgot, short US interest rates too ... with thanks to Johannes Gensfleisch zur Laden zum Gutenberg who invented the essence but not the jargon of 'quantitative easing'.

We have, once again, Nassim Taleb tearing a very public and much deserved strip off Bernanke (its worth the full viewing), and Bill Gross in Run Turkey Run uses the failing credibilty of the Fed to induce fear:

Check writing in the trillions is not a bondholder’s friend; it is in fact inflationary, and, if truth be told, somewhat of a Ponzi scheme.

which Gross then turns into a marketing ploy:

We hope to be your global investment authority for a new era of “SAFE spread” with lower interest rate duration and price risk, and still reasonably high potential returns. For us, and hopefully you, Turkey Day may have to be postponed indefinitely.

Oh, my.  We don't necessarily disagree with his analysis, but find the style a little heavy handed... but that was before the Asian finance ministers cut loose with the 12 guage OO buck shot.

The spread between nominal bonds and TIPS (inflation indexed bonds) is a quick proxy for inflation expectations, and we note the same trend as the picture above:

 10 year constant maturity treasuries less 10 year TIPS:


Of course, over the weekend, right in the middle of this drafting, all hell broke loose in a Fresh Attack on Fed Move . 

The good news, though perhaps not for the Fed, is that important new independent sources of inflation data are making their way into the public arena.  Wal-Mart's data would appear to be more current than the Fed's and reflective of actual sales to the consumer:

A new pricing survey of products sold at the world’s largest retailer  [WMT  53.99    -0.14  (-0.26%)   ]  showed a 0.6 percent price increase in just the last two months, according to MKM Partners. At that rate, prices would be close to four percent higher a year from now, double the Fed’s mandate. Source: http://www.cnbc.com/id/40135092 

Meanwhile the Financial Times reports Google to map inflation using web data  We have every expectation that whatever eventuates from this initiative will be better, faster, cheaper, more precise, and, dare we say, potentially less biased, than the Fed's. Call it a measure of  just in time inflation...

We confessed our bias to short duration some time ago and suggest everyone watch the 10 year Treasury. We suspect there will be some credit turbulence in Europe.  Let's just hope it stays there. Pending sensible resolution of some of the major fiscal, trade & regulatory issues, there is still a fair amount of risk that could quickly compound or boomerang. We don't believe the nominal rise in equities is a panacea, although we'll take it, and we think there is still a fair bit of political & policy risk implicit in  these price levels.

If the Fed and Congress have gotten a whiff of the smelling salts, it will have been a good start. One suspects the Fed has already damaged its credibility, and if they keep pushing the Gutenberg agenda as a proxy for the failure of tax and fiscal policy, the public may very well ask the bald question: "Why do we need more monkeys throwing darts?"


Inflation or deflation: 5 yr TIPs go negative

From today's Financial Times Even Bondholders Have Deflation Doubts (excerpted below):

But something weird happened this week in Treasury inflation-protected securities, or Tips, US inflation-linked government bonds. For only the second time in history, the five-year Tips offered a negative real yield; that is, buyers get back less than inflation.

Why would anyone want to buy an inflation-protected bond that is guaranteed not to protect fully against inflation? Perhaps if inflation were expected to be very high, prompting a rush for even partial protection. But that is hardly the case today. Rather, it is because Tips investors expect inflation to be higher than nominal bond yields: only by one hundredth of a percentage point, but enough to make it worth buying Tips with a definite real loss rather than straightforward bonds.

The substance of this phenomena is worth thinking about. Seems to us this analysis is just about right, although risk preference may come in to the calculation as well.  Deflation, of course,  brings a whole new meaning: "I would gladly pay you less on Tuesday for a hamburger today." 

What to do? We think not much and certainly nothing rash. The key is the longer term strategy. Those, including ourselves, who have genetic disposition to chronic fear of inflation, would do well to consider the substance of the market view that any pick up in aggregate demand may not eventuate in the near to intermediate term...or even later. The bond vigilantes counter argue that the only actionable solution is to monetize the debt by inflation (check the CBO report below).  Certainly, in the context of fixed income portfolios, the quest for real value will chafe against the avoidance of risk (do no harm), and the uncertainty in the markets once again suggests that the basics of diversification and risk management are essential.