Saturday, September 15, 2012

Give me a break (even)

Top: TIPS  & UST curves; Bottom: break-evens
Some market participants have described the mechanism through which quantitative monetary policy (read: LSAPs) works or is intended to work to be centered around inflation expectations. The line of thinking is that the Fed is trying to stoke inflation expectations to incentivise purchase of goods today by increasing the rate at which people expect the price level to increase while holding down rates, increasing the gap between yields and expectations of inflation, commonly referred to as the "real rate" and observed in the market for Treasury Inflation Protected Securities (TIPS).

From the TIPS and US Treasury Notes and Bonds curves we can derive what we call "break-evens," or the level of future inflation at which payoffs of both TIPS and regular Treasuries are the same. There's some idiosyncrasies here because there is optionality in TIPS as and a right skew to inflation, and so it is possible (and in my opinion true) that this option is reflected in yields and TIPS holders are willing to pay an additional premium (which is constantly changing) for the embedded option which is ultimately reflected in break-evens, which are often interpreted as "inflation expectations."

5-year, 10-year, and 5-year forward 5-year break-evens (rhs)
YoY All Urban Consumers CPI (lhs)
It is hard to ignore the sudden rise in break-evens coinciding with anticipation for Fed LSAPs (QE), and I am choosing to interpret this reaction as representative of market participant "animal spirits." The sudden rise in break-evens (71bp for 5y!!) means that a level of inflation above the Fed's symmetrical target is now "priced-in" for US Treasuries. Which leaves us with the question, "Will incremental asset purchases by the Fed increase the compounded annual rate of inflation by 0.70% over the next five years?" My opinion is that they will not and break-evens are showing us that there is either panic over what additional LSAPs mean for near-term inflation or there the option embedded in TIPS is being aggressively bought and the rise in break-evens reflects the rising premium of this hypothetical call option.

With both core and headline YoY CPI comparisons below the 2% symmetrical target, core YoY CPI displaying a negative 1st derivative and YoY comparisons getting easier (CPI rate of change peaked last year around August) it looks to me like break-evens are excessively ebullient given the evidence of quantitative policy effects on the general price level over the last 3+ years in the US. It is my belief that quantitative monetary policy alone during a period of deleveraging can not generate the necessary credit growth to drive meaningful price inflation other than through whatever transitory effect a weaker currency has on commodity inputs (which represent a small % of final price).  As I mentioned in The Twist, redux,
While borrowers continue to deleverage, any impact from lower rates will be limited and as mortgage debt outstanding continues to fall, the marginal stimulative power of monetary policy, unfortunately, diminishes.

Additionally,there is evidence to doubt whether lower MBS spreads will be passed on to customers or whether the banks will keep the windfall. Despite current coupons trading at record tight spreads, the "primary-secondary" spread remains, not only stubbornly high, but near all-time record highs! (see lower left). ... This is why, unless we see further expansion of H.A.R.P. (Home Affordable Refinance Program) which increases the pool of homeowners eligible for refinance, I think the ultimate effect of an "MBS Twist" on aggregate demand will be limited and the ultimate economic beneficiaries will be banks and security holders who see their securities increase in price. 
YoY % change in average hourly and weekly earnings
of private sector employees. (source)
That is why, unless the Fed's continuing LSAPs are paired with fiscal stimulus (hopefully in the form of an extension of the HARP program) I have a hard time believing current break-evens will be achieved. Additionally, I have chosen to interpret the Fed FOMC's decision to embark in another round of LSAPs as confirmation the economy remains fragile and the growth outlook has not improved and, with gasoline prices flirting with $5/gal, and real wages still falling, it is hard to see how marginal purchases of mortgage securities (that have marginally diminishing impact) will manage to stoke aggregate demand to a level that drives meaningful inflation in the short term. Keeping mortgage rates low provides an increase in discretionary income for homeowners able to refinance at a lower rate but, if real wages don't grow and gasoline price increases are taking a significant portion of those savings, the beneficiaries are basically just treading water. And, if I had to guess, I would guess that a non-trivial portion of savings from any mortgage refinancing will go towards paying down revolving credit.

That's why, against every piece of folksy advice* I've gotten from veteran traders, I am very much bullish on the 10-year Treasury Note. I bought exposure to this tenor because I think, in no uncertain terms, that inflation expectations have a harsh reality check coming, the embedded call in TIPS is grossly overpriced and--due to their healthy roll, favorable 2s10s steepness and high exposure to inflation expectations--the ten year note is the ideal way to play this thesis. As such, I will continue to buy weakness in the note and concentrate my duration exposure around this particular tenor. The market has become entirely too intoxicated with the promises of QE and has forgotten that monetary base expansion is not inflationary without both credit and wage growth.

The you go, that is my thesis for buying dimes. In the words of my friend Kevin Ferry, "book it, time-stamp it, laminate it, decoupage it, roll it up and smoke it!"

* "Don't fight the Fed," "Don't fight the tape," "Don't get married to a position," "There's old traders and bold trades but no old bold traders"

4 comments:

  1. Listen. Great article, you should post more.

    ReplyDelete
  2. Question: if you think Breakevens are too wide. Wouldn't you want to play the spread instead of buying 10 year outright?

    ReplyDelete
    Replies
    1. good point. I chose to buy the 10s outright because I don't think a breakdown in inflation expectations would be met with rising real yields (real yields most often driven by RGDP growth) and think isolating the spread here would affect the payout disproportionally in the case I am precisely wrong (some sort of stagflation). I'd rather hold a smaller long position in nominals that carries than lever up the spread and risk eating my hat if headline CPI shows an ugly right tail for a pair of months. I might consider that in the future, but when putting on trades that are counter-momentum, I like to have my next moves planned out in case the trade goes against me, as they often do.

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