Federal Reserve

Inflation Regimes And Equity Correlations

/ mtlucasmacro
Inflation of balloon from a system of aeronautics (1850) by John Wise (1808-1879)

About a year ago we wrote about Inflation Regimes and Return Distributions. The piece referenced an excellent chart we first saw from Goldman Sachs showing the Equity/Bond correlation vs realized US CPI. The negative correlation in the period since the late 1990s occurred in a world of low and stable inflation. The prior period in the chart, from 1970 to 1998 showed a period of higher than target inflation and a steadily positive correlation of stocks and bonds. Many portfolio strategies have been built with this negative correlation as the bedrock. It worked as the dual mandate acted like a single mandate on unemployment- the inflation side of the mandate could be safely ignored. Economy weakens, equity markets weaken, Fed cuts rates, bonds rally. Became self-fulfilling for a long period of time.

When inflation came back with a vengeance driven by pandemic supply chains getting overwhelmed with fiscal and monetary stimulus, then exacerbated by geopolitics and war, stocks and bonds fell together, partly as the starting point for yields was so low and durations so high. It depends exactly where you draw your lines, but long duration bonds – a diversifying asset relied upon to cushion equity markets – hit a drawdown approaching 50%. Traditional portfolios, built on that bedrock regime, only had one side of the distribution in one asset class to help diversify stocks – positive bond returns.

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As We See It: Yen Intervention Update

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Around this time last year we wrote here on currency intervention in the Japanese Yen. The TL;DR version.

There is a pretty simple reason we don’t see intervention much anymore – it does not work…Intervention is like trying to hold 100 ping pong balls underwater at the same time – sooner or later one will pop up. As long as the BOJ keeps interest rates artificially low and continues yield curve control, the currency will eventually, intervention or not, get blasted. When the Fed is guiding market yields close to 5% and even the Europeans are raising 75bps a meeting, the policy gaps are untenable. Something has to give.

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Inflation Regimes And Return Distributions

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Below is a great chart from Goldman Sachs. It shows the low or negative correlation between stocks and bonds we have seen over the past few decades has been in part attributable to the low inflationary regime over the period. This makes perfect sense given the way monetary policy has operated over the last twenty-five years, counter cyclical policy is very effective in periods of low and stable inflation. When equity markets start to become concerned about recessions ahead, earnings expectations reduce and valuation multiples contract. Stock prices fall. Bond markets typically would then anticipate the increased chance of the standard monetary policy response; cutting interest rates to spur economic growth. Bond prices rise. That explains the light blue dots below. The dual mandate was really a single mandate on unemployment, as the inflation side of the mandate was not biting.

On the other hand, periods of higher inflation have historically resulted in positive correlation between stocks and bonds, represented by the dark blue dots above. During periods of higher inflation, you tend to see rising interest rates, knocking bond prices down and putting pressure on equity multiples. It is much harder for monetary policy to operate in higher inflation environments to combat slowdowns, as the option of cutting interest rates is less easy. The two sides of the dual mandate are in conflict.

Sounds a bit like 2022. High inflation led to a more rapid rise in interest rates than expected, doing a lot of damage to long term bonds that were trading at very low levels – the US10 year ended 2021 at 1.50%. Equity valuation multiples were repriced lower as rates went higher. Stocks and bonds both went down. Portfolios built using bonds to diversify stocks, sometimes with leverage, saw some of the worst returns in decades.

While the long side of the return distribution has dominated since 1998, a return to higher inflation expectations, as seen from 1970 to 1998, requires the investor to consider the other side of the distribution when considering diversifying strategies.

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As We See It: Yen Intervention

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The big story in the past week was the massive currency intervention by the Bank of Japan (BOJ). Hard to know exactly how much went through, but reports were in the range of $70bn on Friday alone. FX interventions by major central banks are less frequent than they were years ago. This was the first BOJ buy side intervention since 1998. There is a pretty simple reason we don’t see intervention much anymore – it does not work. Let’s have a quick look at what’s going on.

Against the trend of most other central banks, BOJ policy has been to maintain low interest rates and keep long term yields under 25bps (a policy called yield curve control, YCC), despite rising inflation and a global backdrop of major economy yields rising substantially. They have been the principal buyer of Japanese Bonds, leading to a crash in liquidity. In recent weeks we have seen multi day streaks when the benchmark ten-year bond (the JGB as it’s known) has not traded. Forcing long-term interest rates to below market levels (the 10y swap market has rates around 70bps) has created massive pressure on the currency, and the BOJ has tried to stem the tide.

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As We See It: The UK Bond Debacle

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Same tune, different words. Every. Single. Time.

Some big pool of money (BPM) would like something for nothing. Large financial institutions (LFI) are happy to help. Heck, they even compete to help the most. As long as X never happens – and of course it never does – we can give you exactly what you want. In the 1980s, pension funds wanted to be long stocks but not the downside tail. Buying puts was too expensive. No problem says LFI! We will give you something called portfolio insurance. Instead of paying implied volatility, you can own an option-like structure at realized volatility. As long as the market does not gap down a lot – which of course it never does – there is plenty of liquidity to execute the hedge. October 1987 put an end to that little fantasy. Then there were those good old sub-prime loans. Some BPM would like some higher yielding debt. No problem says LFI! Each mortgage may be risky, but they are much better behaved when we look at a big basket of them and we’ll spread them out all over the country. As long as house prices never go down, which of course they don’t, and certainly not all over the country, these bonds are golden. We’ve even paid someone to give them a AAA rating! That ended…not well.

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As We See It: CPI

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The reaction to last week’s CPI print was pretty dramatic. We see a couple of related factors:

  • Given the fall in gas prices, the S&P had bumped off the bottom in anticipation of a soft print. Positioning went from negative to perhaps modestly positive. CPI caught the market on the wrong foot.
  • Gas prices as reported in the CPI did fall as expected, but just about everything else went up (see graph below). Everyone knows gas fell because of releases from the Strategic Petroleum reserve. That policy is the definition of “transitory” (they will need to buy it back, no less). With everything else going up, inflation fears pulled a Lazarus.

Watch rents. Lagging but steady inflation indicator, closely tied to wages.

Source: Bloomberg

The Inflation Supertanker

/ mtlucasmacro

I recently had a conversation with a colleague about the idea that portfolios over the last 40 years have been conditioned for falling interest rates. If that supertanker makes a turn, a lot of money will be on a collision course. He said in 1984 there was an equal and opposite issue … buying bonds for the prior 20 years had been a fool’s errand. The cycle climaxed in June 1984 with a hot GDP, a low inflation print and a collapse in bonds. Even though inflation was low, no one wanted to own them.

I was intrigued and pressed the conversation with our resident bond historian and partner, Paul DeRosa. His response below:

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Pricing Escape Velocity – The Rubber Hits Abbey Road

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The chart below is fascinating to us, particularly in light of the fairly modest in magnitude, but quite speedy rise in UK yields. The chart shows the difference between futures prices for sterling 3 month LIBOR expiring in September 2022 and 3 years later, in September 2025. They price at 100 minus the interest rate, so a price of 99.5 equates to a 0.5% prevailing rate at expiry. Roughly speaking, individually the contracts can be interpreted as the markets best pricing for interest rates at those points in time, the spread between them gives a look at how the path is priced to get there.

A year ago, rates were priced to be at about zero in September 2022, and not much higher – maybe 1 hike – by September 2025. At a starting point of functionally zero rates – that’s a pretty poor prognosis for 5 years time. Earlier this year, the spread between contracts increased as the nearer maturity contract dropped a little in price – implying higher yields – while the longer maturity contract fell more in price. The spread widened to a high of 78bps in early summer. That’s the market roughly saying things are a bit better economically – over the next few years we will see about a hike per year.

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Stresses In The Bond and Funding Markets: Post Mortem

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We wrote a few times during the depths of March and April on stresses we were seeing in bond, credit and funding markets. It was clear things were not functioning correctly. It was equally clear that both monetary and fiscal policymakers were trying as hard as they could to counteract. Now that some time has passed much more detailed examinations are coming out that are well worth reading to get a better idea of how the plumbing works, and sometimes gets blocked.

The first is from the NY Fed Liberty Street Economics blog and details the Feds Large-Scale Repo program.

The second is in the Financial Times (paywall) and details the moves we witnessed in the US Treasury markets:

The third is from Josh Younger of J.P. Morgan writing for the Council on Foreign Relations:

All succinct and detailed pieces that will explain a lot of what went on.