TIPS Valuation Commentary

A quick glance at U.S. TIPS (inflation-linked bonds) shows that if we abstract past the thorny question of where inflation will be in the next few years, the market has largely reversed the relatively low inflation expectations that developed in the mid-2010s. If one believes that the inflation overshoot seen in recent years will be reversed within a reasonable time span, valuations are near a “fair value” based on historical data. (Of course, past performance is not indicative of future results, yadda, yadda, yadda.) If one is convinced that the secular tide on inflation has turned, TIPS might still be cheap on a longer-term basis.

The top panel of the above figure shows the 5-year and 10-year inflation breakeven inflation rates. (The Treasury breakeven inflation rate for a given maturity is the nominal Treasury yield for that maturity minus the “real” (quoted) yield on the same maturity TIPS. I discuss breakevens at length in my book Breakeven Inflation Analysis. I have an online primer here.) Although not identical, the two breakevens move together.

Breakeven Inflation Forecast Accuracy

I received a comment from a reader of my blog (“Lawrence”) that pointed out an article by Jonathan D. Church of the Bureau of Labor Statistics that discussed breakeven inflation implied forecast accuracy (link). The idea is that we want to compare inflation breakeven rates to what inflation is realised over the life of the bond (what the breakeven inflation rate is the expected value of).

I discussed this topic in greater length in Section 3.5 of my book Breakeven Inflation Analysis. The conclusion was not entirely satisfactory: we do not have enough data to do a proper historical analysis of breakeven inflation accuracy. The exception might be the United Kingdom, which started issuing inflation-linked bonds in the early 1980s. However, the bizarre structure of (old) U.K. linkers meant that it would take a lot of work to examine the returns for historical bonds. The Bank of England does publish historical real/nominal/inflation yield curves, but I would be a lot happier if I could compare “physical” bond yields to the fitted curve.

The Great Inflation Scare Of 2021 (Or Not...)

We had a blowout CPI print in the United States last week, which I probably should have discussed. Unfortunately for my writing productivity, I had some consulting work going as well as visiting family, so I did not have time to dig.

Since then, large numbers of electrons were spilled online discussing the inflation outlook. As I doubt that I will add any details that are novel at this point, I have decided to bow out of that discussion. Instead, I will just offer a few generic observations.

The first thing to note is that forward breakeven inflation rates (as calculated by the Federal Reserve) have risen since the pandemic lows — but are still not above the levels seen in the early 2010s. (As a technical note, one might be able to fine tune breakeven inflation calculations with access to security-level data. But the Fed H.15 data is perfectly adequate for a big picture chart like the one above.)

We need to use forward inflation since everybody accepts that there will be a run of punchy inflation data over the coming months. How long the “punchiness” lasts is the topic of heated debate. As a non-forecaster, I am staying out of that debate. That said, the TIPS market indicates that the punchiness subsides within 5 years. Say what you want, that is not exactly a secular shift in inflation pricing.

Could technicals influence the forward? Sure. The problem is that the most important technical is the demand for inflation protection by the private sector, which is really only counter-balanced by TIPS supply. If people were really worried about inflation, they would be bidding up protection versus fair value — the breakeven ought to be biased higher versus “true” expectations. If that were the case, then the “true” expectations are not elevated relative to “target” (which is vaguely defined at this point).

So unless we are convinced the market is wrong — and it could be (you pays your money, you takes your chances) — the inflation story is just about the timing of “transitory.” Even without digging into data, it seems clear to me that we need to get the flurry of holiday spending out of the way before we can see what the underlying supply chain status looks like.

The other angle is wage inflation. I think we have seen some unsustainable business models based on the availability of desperate workers, and/or hoodwinking people who were unable to account for depreciation into being “contractors” have finally hit the end of their sustainability. Such business are going to face higher wage costs. It remains to be seen whether this is a one-off shift, or sustains itself.

In any event, I hope to return to my inflation manuscript later this week. My feeling is that it will make sense to hold off finishing the book until after we see the backside of this inflation wave (or not), so if I get the bulk of the text sketched out, I will then let the text rest for some months.

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(c) Brian Romanchuk 2021

Transitory-Ness In The TIPS Market

With all the debate about the persistence of inflation, one natural thing to ask is: what is the market pricing? Unfortunately for those who are selling a “return to the 1970s” narrative, “Mr. Market” is firmly in the camp of “Team Transitory.” Of course, one imagines that the immediate response is that the “markets are wrong.” Since many of the people in the “inflation is coming!” crowd are also in the “markets are always right” camp, there is a good chance they might modify the argument to “markets are wrong according to some affine term structure model.”

(Note: The server issues that stopped me from posting this yesterday are obviously sorted.)

Recovery In U.S. Inflation Breakevens Not Surprising

The rise in in breakeven inflation in the United States is not particularly surprising, as it is just a return to projecting previous conditions forward. This could be mistaken, but at this point, the burden of proof is upon those who are pushing a story that inflation will be markedly higher or lower. We can easily see a replay of the dynamics of the past cycle, with President-Elect Biden pursuing similar policies to the administration where he was Vice President, and the Republican Party attempting scorched-earth debt scare tactics to force fiscal tightening.

For readers who are not familiar with the concept of breakeven inflation, it is the nominal yield on a conventional Treasury bond less the quoted yield (indexed, or "real yield") on a matched maturity inflation-linked Treasury (TIPS). I discuss the mechanics of breakeven inflation in my handbook, Breakeven Inflation Analysis. The key observation is that the breakeven inflation rate is (roughly) equal to the required rate of inflation for the TIPS and conventional bond to have the same rate of return when held to maturity -- that is, the TIPS is priced at a break even level versus the nominal benchmark.

Breakeven Inflation Unsurprisingly Low

Breakeven inflation rates in the United States have recovered from their crisis swoon, but remained at depressed levels. This is in contrast to the rather feverish inflation predictions that are coming from the usual sources, like gold enthusiasts.

This article is brief, just commenting on what I see as the implications of current pricing. I am largely reiterating my views that appeared in Breakeven Inflation Analysis. I am seeing commentators discuss the implications of low "real" yields, which I think is the wrong premise. As I discussed in Section 4.2 of my book, the breakeven inflation rate is what matters. The quoted yield on inflation-linked bonds (in my view, "real yield" is a term to be avoided, due to the ambiguity in the definition created by economists) is just the residual of the two metrics that matter: the benchmark nominal yield, and the breakeven inflation rate. All the quoted yields are telling us is that the markets are predicting inflation to be somewhat lower than desired, and that New Keynesian central bankers at the Fed will be New Keynesians.

No Supply Shock In Breakeven Pricing

Although it is early, U.S. inflation-linked bond market is acting in a stereotypical way: underperforming nominal bonds in a rally. This is conforming to the rule of thumb that breakeven inflation is directional: quoted yields on TIPS (real yields, or indexed yields) move less than nominal yields. This is perhaps not too surprising, but one might have expected that behaviour would be different in a supply shock.

Inflation Is NOT The Most Significant Factor Determining Bond Prices

One of the pieces of pseudo-science that floats around in popular discussion of bonds is the belief that bond investors are deadly afraid of inflation. In particular, bonds "lose money" every time the Consumer Price Index rises -- which is most months, in most developed countries. As far as I can tell, this is the legacy of some Economics 101 textbook story that has been passed on from "expert" to "expert" over the decades.

The correct answer is that nominal yields largely reflect the expected path of the short-term nominal policy rate, and is thus a reflection of the central bank's "reaction function." (At this point, some people will jump in and start going on about the term premium. However, unless we using an obviously dysfunctional term premium model, the term premium is only a small deviation from the fair value determined by rate expectations.)

On The Limited Issuers Of Inflation-Linked Bonds

This article is an excerpt from my latest book on inflation-linked bonds -- Breakeven Inflation Analysis. It describes one of the peculiarities of the inflation-linked bond market, which is the dominance of central government issuers.

One of the key economic problems facing inflation-linked markets is that central governments tend to be the major source of net supply of these bonds. This is very much unlike the case for conventional bonds, where non-central government supply is significant. If there is a shortage of private sector duration, it is in the 30-year part of the curve, as the credit analysis of such debt is tricky for most issuers. (Utilities and similar would be the most natural fit, but as the telecom industry showed, even apparently stable business models can be greatly disrupted by new technology, or by CEOs with grandiose schemes.)

Inflation-Linked Bonds And Portfolio Allocations

One of the difficulties with inflation-linked bonds is finding space in a portfolio for them. Very simply, most risk assets appear to offer a good long-term inflation hedge, and equity returns are typically expected to be higher. This article is an excerpt from my latest book, Breakeven Inflation Analysis. It is the second half of Section 4.8; the first half (on hedging efficiency) was previously published as an except here. Breakeven Inflation Analysis is available in paperback and electronic book editions at online retailers (link to the books2read.com book page which provides links to supported retailers).

Inflation-Linked Bonds In Portfolios: Hedging Efficiency

This article is an excerpt from my latest book, Breakeven Inflation Analysis (link to book description), being the first half of Section 4.8. It is a discussion of the efficiency of inflation-linked bonds as an inflation hedge. The second half of Section 4.8 discusses how these bonds fit within a portfolio construction, which will be published in another article.

Brief TIPS Market Comment

The U.S. inflation-linked bond (TIPS) market is in an interesting position right now. Inflation protection seems cheap, but the question always remains: is it cheap for a reason? Unfortunately, I am not able to answer that question, I am going to just briefly outline the debate.

Breakeven Inflation Analysis

The retail rollout of Breakeven Inflation Analysis has started. The ebook version is now available at some Amazon regional stores, and will appear at other retailers within a few days.

Universal book link: books2read.com/BreakevenInflationAnalysis

The publication of the paperback edition will take a few weeks.

Book Description

The great inflation of the 1970s in the developed countries provoked strong economic (and political) reactions. In finance, investors searched for ways to protect themselves from inflation. The United Kingdom launched the first modern inflation-linked bonds in 1981. In addition to being of interest to investors looking for protection against inflation, these bonds also provide a market-based measure of inflation expectations. Since investors have “skin in the game,” the resulting forecasts might be better than a purely survey-based inflation forecast. More reliable inflation forecasts should be useful for policymakers that aim to control inflation.

This report discusses the breakeven inflation rate that is implied by pricing in the fixed income markets. For those with a casual interest in the subject, it is probably good enough to view those inflation breakeven rates as a market-implied forecast for inflation. However, if one wants to delve into the analysis, it is necessary to come to grips with the complications in the subject. Is the forecast biased? Are there technical factors in the bond market that affect pricing? The objective of this report is to offer an intermediate-level introduction to these issues. The target audience is either those with an interest in finance and who are unfamiliar with inflation-linked bonds or economists who want to understand better the factors that affect inflation breakeven rates.

Publishing Update

My next book - Breakeven Inflation Analysis - is in its final stages before publication. Unless something goes wrong, the Amazon ebook (Kindle) version should appear within a few days; the non-Amazon ebooks (Apple, Kobo, ...) may face unknown delays.

I have been fighting with various formatting issues for the non-Kindle ebooks. One solution was to have nice generic formatting (courtesy of the document conversion of my distributor), but at the cost of breaking endnote links. Since all of my reference material is in endnotes (footnotes in paperback), this was not particularly attractive. I have instead gone a different route, but it embeds custom encrypted fonts in the EPUB file. The presence of the encrypted fonts may cause difficulties with acceptance with some retailers. I will probably only find out the magnitude of the problem once I actually submit to distribution.

Breakeven Inflation Book Entering Layout Phase

UPDATE: I've had to deal with other projects, but returning now to the breakeven book. I have run into formatting issues for the EPUB edition (Apple, Kobo, etc.) that I dealt with in the past by using kludgy workarounds. I am going to try basing the EPUB edition on the paperback files, and hopefully deal with the problem in a more systematic fashion. It may take a few days to validate that the EPUB edition is acceptable, at which point the ebook versions (EPUB and Kindle) will be released. The good news is that it means that I am also working on the paperback layout at the same time. However, I will want to see a physical proof of the paperback edition before releasing it.

I just want to announce a short publishing pause while I look over the edited text of my breakeven inflation book. Since the workflow for publishing has changed for me, and I have not yet read the documentation on the changes, I cannot promise any particular release date.

Primer: Seasonally Adjusting An Inflation Forecast

One exercise that often needs to be done either by fixed income analysts is to generate a forecast inflation series. For an economist, such forecasts are often part of the job description. For a fixed income analyst, even if they are not attempting to forecast inflation themselves, they will need to generate the forecast series to calculate cash flows. For example, we need to calculate an implied inflation forecast to build up a fitted inflation breakeven curve. One thing to keep in mind is that we need a forecast series that is not seasonally adjusted to be useful for inflation-linked bond analytics, but it is often easier to generate a seasonally adjusted series.

Primer: Inflation Swaps

An inflation swap is a derivative contract that corresponds to breakeven inflation. The advantage of an inflation swap for analysis is that it does give a pure read on an economic breakeven inflation rate, as the contract literally implies an economic inflation breakeven. The problem with the inflation swap market – at least when I was working in fixed income – was the limited liquidity for the contracts. In addition, it does not represent a cash investment, and so is not accessible to some investors, while for others, it does not fit into how they view portfolio construction.

This article is an unedited excerpt of my upcoming book on inflation breakeven analysis. There are numerous references to other sections of the book, which I have left in place. The book is largely completed, but I am holding off publication until August or September.

Understanding Why The Supply Of Inflation-Linked Bonds Is Limited

One of the key economic problems facing inflation-linked markets is that central governments tend to be the major source of net supply of these bonds. This is very much unlike the case for conventional bonds, where non-central government supply is significant. If there is a shortage of private sector duration, it is in the 30-year part of the curve, as the credit analysis of such debt is tricky for most issuers. (Utilities and similar would be the most natural fit, but as the telecom industry showed, even apparently stable business models can be greatly disrupted by new technology, or by CEO’s with grandiose schemes.)

This article is an unedited excerpt from my upcoming book "Inflation Breakeven Analysis." The book is essentially completed; I am just giving it a last read before passing it on to an editor.  

U.S. Inflation Breakeven Did What Breakevens Do

The change in personnel at the Federal Reserve has help sustain a miniature bond bear market that started in the third quarter of 2017. Although I do not offer investment advice, I think it is clear that nominal bond yields are better placed relative to Fed officials' desire to raise the policy rate. The key question is what level they will begin to pause. If mainstream theory were correct, there would be some way of estimating the natural rate of interest reliably, and we could then have a better idea of when the policy rate is at an appropriate level, and we could thus expect a pause. Unfortunately, the natural rate of interest appears to be a will-o'-the-wisp.

Can We Estimate The Inflation Risk Premium?

(NOTE: This article is an unedited first draft of a section of my upcoming book on inflation breakeven analysis.)

This section article continues the discussion in the previous section [in the book], focussing on our ability to calculate the inflation risk premium. The tendency among central bank and academic researchers is to focus on the answers provided by affine term structure models. I am highly skeptical about that approach, and prefer the simpler approach of analysing historical returns data. The problem with historical data analysis is the limited volume of inflation-linked returns data.