A Relatively Good Deal Doesn’t Mean It’s A Good Deal

I suspect that everyone has ‘default activities’ that they automatically turn to when nothing else is working. For example, when I can’t sleep and I’ve tried everything, I go downstairs and have a bowl of cereal. Some folks hit the gym when they’re frustrated. Others go shopping when they’re depressed.

And apparently, some people buy stocks when they’re not turned on by anything else.

There wasn’t any outrageously positive news today that sent the S&P +0.8% on the day. Initial Claims (371k) was slightly higher than expected (but I advocate ignoring that release in late December and most of January). The dollar dropped sharply against the Euro. I initially thought that this was because the President nominated as Treasury Secretary someone with no financial markets experience at all but a solid resumé of hard-nosed negotiations with Congress, but the Euro gained against all major currencies so it was perhaps due more to the fact that ECB President Draghi didn’t ease further at the policy meeting held today (though they were not expected to). Bloomberg blamed a better-than-expected rise in Chinese exports, but the miss was well within the usual variance for a volatile number so that seems unlikely to me.

I am not entirely kidding about the frustration that “there’s nothing else to invest in.” I was just working today on a chart for a keynote presentation I have been asked to give at the Inside Indexing conference in Boston in April (See the link here, although most of the information on the site is still the 2012 data). I have previously run this chart, showing Enduring Investments’ projected 10-year annualized real returns and risks (this is as of year-end 2012).


The slope of that line indicates that the current tradeoff of risk for return is 2.7:1. That is, for a 1% higher expected annualized real return, you will have to accept a 2.7% increase in the annualized standard deviation of annuitized real returns (the “right” measure of risk, as it measures the variance in the long-term real purchasing power of the investment). Now, here’s the chart as of April 23, 2003, using all the same methodology:

The slope of the line back then was 9.1:1. That is, in 2003 you needed to take more than three times as much risk to add 1% in expected real return to your portfolio.

But notice something else also that is very important. The change in the slope of the line didn’t come because expected equity or commodity index returns got better. Indeed, those two asset classes have roughly the same forward expected returns as they did back then, although slightly different risks the way we figure it. What happened is that the expected real returns to Treasuries, TIPS, and Corporate Bonds all fell precipitously.

Of course, this comes as no surprise to anyone, because we’ve all watched the Fed push interest rates down so far that we need extra decimal places. But I think comparing these charts you can understand a fundamental verity: people are not buying stocks because they expect awesome returns going forward (hopefully, anyway, because they’re not going to get them). They’re buying stocks because there’s less reward to buying less-risky asset classes. Which is, after all, what the Fed was trying to do (this is called the “portfolio balance channel” in monetary policymaker parlance: force people to take more risk than they want, because it’s a relatively good deal even if it’s not a good deal in an absolute sense).
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A few other notes about today’s news:

Inflation markets were abuzz today, with inflation-linked bonds outpacing their nominal counterparts in many countries, because the UK’s ONS announced that it has decided not to change the RPI that applies to Gilt linkers (inflation-linked bonds, like TIPS). The ONS (similar to our BLS) has been studying how to make certain important technical corrections to the way the RPI is calculated to make it more accurate; these changes would have had the effect of lowering the RPI significantly. As a consequence, these bonds have been trading at higher real yields, reflecting the fact that if the ONS chose to change the RPI formulation, the yield on the bond would have to be higher to compensate investors for that change if the same value was to be delivered. That is, instead of a yield of (for example) 1% added to expected inflation of 2.5%, the yield would rise to 1.5% to reflect the expectation that measured inflation would be at 2.0%. Many investors thought it was very likely that the ONS would choose one of several options for restating RPI that would have had such a deleterious effect on the bonds.

In the event, the ONS made the wise decision that it would be unfair to change the terms of the bonds retroactively by making a significant change to the RPI, so they will release a second index called the RPIJ, which will now be the benchmark index and featured in ONS releases. But they will also continue to calculate the RPI and the existing bonds will continue to track RPI.

This is a great relief to inflation-linked bondholders the world over, because it sets a very important precedent. The U.S. Treasury has long said that if the BLS made a material change to the way CPI was calculated, it would plan to continue paying on the basis of the old-formulation CPI (if it was still available) or a suitable alternative, but many investors from time to time have worried about whether they would do that in practice. It will be harder to do so with the ONS precedent.

Because investors had thought the ONS was leaning the other way, Gilt linkers rallied a bunch. For example, the UKTI 1.25%-11/2055 rallied 10 points on the day (the yield fell by about 20bps), which is an enormous move at the long end. The 5-year linker (Nov 2017) yield fell 35bps. This is likely to have a spillover effect in US TIPS, since the latter now look much better on a relative value basis than they did previously. Anyone who was long UK linkers yesterday is probably considering 30 year TIPS at a pickup of 42bps.

Finally, in Fed news Esther George, the President of the Kansas City Fed (replacing Thomas Hoenig) was on the tape today. “Fed’s George Says Low Rates Risk Stoking Inflation Surge,” said Bloomberg. No kidding? (See here for Market News’ coverage of the same speech). At the very least, said George, the asset purchases will “almost certainly increase the risk of complicating the FOMC’s exit strategy.” Neither of those statements ought to be the least bit surprising or controversial, but it’s unusual to hear a Fed official state these things so bluntly. But she may have crossed the line with this one, which might get her ostracized at the next FOMC meeting:

Like others, I am concerned about the high rate of unemployment, but I recognize that monetary policy, by contributing to financial imbalances and instability, can just as easily aggravate unemployment as heal it.

Keep speaking truth to power, Ms. George!