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Wednesday, December 13, 2017

Comments On Short-Dated Breakeven Inflation

In an earlier article, I commented on the usefulness of breakeven inflation as an inflation forecast. This article continues that line of thought, but with respect to short maturity index-linked bonds. In my view, there is significant market segmentation in the index-linked market when compared to conventional bonds. My belief is that short-dated breakevens are relatively unbiased, but have to be interpreted as a play on oil prices.

Note: This article is fairly loose. In it, I explain why I thought the front end of the TIPS curve was fairly valued when I looked at it in 2006-2008 (pre-Crisis 2008!). Someone with the access to the relevant data could bring the argument up-to-date. It is a safe bet that an academic would sneer at the suggested methodology. Instead, most academics would apply the standard statistical techniques to the problem -- and get the standard wrong answer.

Digression: Market Segmentation

Before we discuss the efficiency of short-dated breakeven inflation, we need to understand why I am breaking out the analysis of this part of the curve in the first place. Although "short-dated" is a relatively vague term, in this case, we can be more precise: under 1-year maturity? What is special about the 1-year point of the curve? That's where bonds drop out of standard bond indices.

The first background point to realise is that a significant portion of the bond market is now held by institutional investors who are managing against a bond index. For an non-levered indexed investor, your portfolio is thought of as:
  • the bond index itself;
  • levered spread trades that represent your deviations from the index.
The fact that your departure from the index portfolio are effectively leveraged trades means that you can read exactly the same dealer research as levered investors and apply the same trade ideas. If you do not want to borrow securities, you are limited in how far you can sell securities short (minimum holding of $0), but that's about it.

Holding a bond of maturity under a year means that you are effectively entering a spread trade against longer maturity bonds. Since the duration of bonds under 1-year decay much faster in percentage terms than long-dated bonds, your hedging ratios move rapidly. (For example, a 6-month bond loses 50% of its time-to-maturity over 3 months, while a 2-year bond loses 12.5%. Time-to-maturity is a decent proxy for duration.) This makes managing the position a pain, so you normally want to sell those bonds out of your bond index portfolio.

In the conventional bond world, this is not a problem. Money market funds can generally buy bonds of up to one year maturity, and money market investors are generally desperate to find any way to outperform. As a result, selling from bond funds is easily absorbed.

The same does not hold for index-linked bonds. There are no inflation-linked money market funds. It is extremely difficult to imagine scenarios in which anyone needs to buy inflation protection on a one-year horizon (outside of fantasies spun by some economists). Meanwhile, since nobody issues index-linked bonds of under one year maturity, there is no primary market activity to help create a yield curve.

By default, leveraged investors have to step up and buy the bonds. And say what you want about leverage investors, they are not going to make analytical mistakes like buying an index-linked bond because it has an attractive quoted (real) yield. Since they are borrowing in nominal terms to fund the position, they need to know exactly what the forecast nominal return will be.

Limited Sample Size

One of the problems with analysis of this style is that the sample size is very small. There are no issuance programmes of index-linked Treasury bills; we only have a few bonds crashing through the 1-year maturity barrier.
  • In Canada, the shortest maturity linker matures in 2021, and so at the time of writing, no Government of Canada Real Return Bond was below 1 year maturity. (There may have been provincial issues.)
  • The old U.K. index-linked gilt design was horror show, and coupon payment was fixed six months in advance. If you have the price data and associated pricers, this market gives the longest back history. That said, it appears that such bonds would have been completely illiquid, and so the reliability of pricing data would be open to question.
  • Since 2008, euro area linker pricing is very sensitive to things like default risk. There is a decent sample size, but you would need to be very careful with the data.
  • There were a few U.S. TIPS that matured to provide a sample.
  • (I am unfamiliar with the linker markets elsewhere, such as Australia and New Zealand.)
Since the maturing bonds are at one extreme of the linker yield curve, you would need to look at their individual pricing data, and not rely on a fitted curve. Your statistical tests of market efficiency would be purely an analysis of how well the yield curve fitting algorithm extrapolates the curve. Based on my experience, I would have zero confidence in any algorithms ability to extrapolate a linker curve. (For conventional bonds, you can start pulling in other instruments to pin down short maturities.)

Is Pricing Efficient?

It is extremely common to discuss the "efficiency of pricing" in markets (or market efficiency). As I discussed earlier, we really should be thinking about the efficiency of investors, and not anthropomorphise markets.  In my limited experience (which could be easily out-of-date), the short end of index-linked market featured efficient investors.

If you looked at any strategy analysis, it revolved around comparing the breakeven CPI index fixings, and compared them to the author's forecasts. During the 2006- to mid-2008 period, those forecasts were pretty close to realised fixings. (I do not remember whether the forecasts from the strategists were close to the the survey consensus; but they probably close.)

Under the assumption that is how the market participants were pricing the bonds in practice, that methodology is theoretically efficient. This is great contrast to the multitude of valuation methods used to come up with a fair value for the conventional 10-year Treasury yield among strategists and commentators. (The 10-year JGB yield is an even greater source of analytical confusion.) The price action I observed matched the evolution of the presumed weighted average forecast.

That was obviously a subjective opinion. However, the reader could look at current pricing, and come to their own opinion in a straightforward fashion; they do not need some academic with a highly questionable affine term structure model to tell them whether the economic breakeven is off market when compared to forecasts. If one wanted a more general answer, there are two standard methods, both of which are unsatisfactory.
  1. One could compare the breakeven inflation rate versus published consensus forecasts. The problem with this is that these consensus forecasts largely represent herding behaviour of street economists, and most investors would not base investment decisions solely upon them. Furthermore, breakeven inflation rates are available in real time, while forecasts reflect slow-moving committee decisions.
  2. We could compare the economic breakeven to realised inflation. The problem with that approach is that it testing whether market participants are clairvoyants, not whether they are leaving money on the table.
The second point can be expanded upon. The main driver of CPI inflation in the short term is oil price (technically, gasoline) movements. All useful CPI forecasts are effectively conditional upon oil price movements. This means that short-dated index-linked positions are extremely interesting to fixed income macro investors: this is one of the few ways within fixed income to take a position on anything other than interest rates (or credit spreads).

Historically, this was not the case. Bond investors would take currency risk as a way of macro trading. However, modern portfolio management techniques have put currency risk into the hands of the forex team ("the separation of church and state"). Once you take away credit risk (in the hands of the credit team). emerging market bonds (in the hands of an EM team), the only other way to generate excitement is insane leverage levels (either via derivatives or borrowing). This means that trading short-dated breakevens as an oil proxy generates trading activity.

The side effect of this oil dependence is that the uncertainty of the effect of oil prices on the oil forecast is probably an order of magnitude larger than any term premium that might exist in the instrument. If we try to see whether there is a bias in realised inflation versus the economic breakeven, all you are doing is testing whether these fixed income investors were correct in their oil forecasts.

You just need to look at a oil price chart from 2007-2008 to see that a lot of people had to be wrong about oil prices in both directions. There is no particular reason to believe that fixed income investors did a better job forecasting oil than investors in other markets did.

Once the Financial Crisis hit, pricing in the index-linked market bore no resemblance to serious inflation forecasts. The reasoning was simple: levered fixed income investors had been bullish on oil, and got trapped in long index-linked positions that everyone knew that they could not finance. There was a large "squeeze premium" in inflation-linked yields.

The standard tactic in academic finance is to label any departure from fair value as a "term premium." In my view, this is misleading, as most people associate "term premium" as a risk premium associated with holding long maturity debt. The standard definition really should be labelled as "how far off ,market my model's fair value estimate is." In other words, labelling the extreme mispricing of index-linked bonds in the aftermath of the Financial Crisis was not the result of some mysterious move in some "term premium" or "inflation risk premium," it was just the result of hard-to-model market squeeze. (Perhaps an agent-based model could quantify such squeezes.)

Concluding Remarks

My analytical bias is to view short-dated economic breakevens for inflation-linked bonds as being very close to the weighted average forecast level of inflation over the bond's lifetime,. where the forecast comes from market participants (and not the herding economist consensus). Any bias in market pricing versus the forecast -- a term premium of some sort -- is going to be swamped by the uncertainty in the oil price forecasts that are embedded in the CPI forecast.

However, this lack of bias may not transfer to longer-dated breakevens, which I hope to discuss in a followup article. (This article is a very rough draft of material that may go into a report on breakeven inflation. This draft seems to be too subjective, so I expect that it will be heavily rewritten.)

(c) Brian Romanchuk 2017


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