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« The ABX Indices and the Banks/Brokers | Main | Some thoughts on the Fed's two day bender (aka "Mr. Bernanke's Wild Ride" »

December 12, 2007


Bond investor

ZB, you have an impressive intellect. We should both try to get higher-paying jobs...

A couple thoughts:
1. You're right on the mark with ex ante and ex post inflation. Just look at the TIPS market -- you often pay too much for ostensible inflation protection. You may *think* you're getting protection, but if you sell your TIPS after what you think is a "high" CPI print, you will often be disappointed because the market is trading on expected future inflation.

2. The fat-tailed distributions for taking equity risk versus the somewhat normal distributions for inflation risk suggest (to me, at least) that stock risks are understated, and journalists like the annoying Jack Hough of SmartMoney should get their heads examined. Using the average arithmetic return to justify a 100% stock portfolio is cold comfort to those who bought in March 2000. The 7-year return on stocks vs. bonds is about even, and bonds had a much less bumpy ride.

3a. You correctly (I think) eliminate default and liquidity risk from owning T-bills, and conclude that only inflation risk remains. Yet you also acknowledge that inflation is a long-term, creeping phenomenon that really only begins to bite over several years. By definition, T-bills are not a multi-year investment. Further, they are too easily affected by the Fed's monetary policy, which often lags the market. I think you're just arguing for an upward-sloping yield curve. Those worried about preserving purchasing power against inflation should be in longer-term bonds (either nominal or TIPS, depending upon their forecast), not short-term bonds.

3b. There is another "risk" that should be priced into T-bill rates: the real rate of interest. People will charge a borrower *something* for deferring consumption above the rate of inflation. Historically, that's been about 2%. Morgan Keegan economist Dr. Rataczjak has covered this in detail in his weekly commentaries (can't find the cite -- sorry).

4a. People that say "I can't just own bonds, I must speculate in stocks, credit, houses, energy, etc. to keep up with the real inflation I experience" may be mistaking a change in the mix of goods and services they buy vs. a general increase in prices that really would be worrisome inflation. My elderly money mgt clients complain about rising health care costs, but that's a demographic shift, not "inflation." Conversely, they see falling prices in apparel, telecom, or declining-demand goods like newspapers as "good budgeting" on their part, not "deflation." For more info, Google "Inflation: The Cost-Push Myth" by Dallas Batten of the St. Louis Fed back in 1981.

4b. Yale's Robert Schiller (of home price index fame) has been way out in front on the problem you described and that I discussed in 4a. The major problem with good- or service-specific price increases is that historically there's been no easy, reasonably-priced way to hedge. Now that the CME trade housing-price derivatives, you can hedge away your home's price decline. (Imperfectly, to be sure, but better than nothing.) It's too bad that going long the Health Care Spyder isn't a better hedge against rising health care costs...


I appreciate the kind words bond investor. As you have been my most faithful reader, I apologize for the long absence. The combination of being busy, mild writers block, and time spent working on a website that proved too difficult took too much time away from my blog. Thanks for checking back, I appreciate the loyalty.

1. The TIPS market is similar. I think the TIPS market suffers from a very fat tail liquidity risk. It is not that deep and each issue is relatively small. Since it is a type of "insurance", if things get deflationary, TIPS investors can lose tons of money as I would think many conservative investors, would flood the market after seeing this fall and swap into a vanilla Treasury Bond with a more stable risk distribution.

2. I couldn't agree more. I think we are going to come to a major liquidity crisis in the equity market in a few years as investors realize that they have been valuing equities improperly for the past 10 - 20 years beleiving that "stocks go up over time" and there will be someone who is willing to pay. If interest rates begin to creep up, Treasuries will be much more attractive than 1% dividend yields and people will realize that an investment should be valued on some sort of earning stream for THE INVESTOR not for the company who merely pockets the earnings through obscene compensation, or the government through higher tax rates than dividend tax rates.

3a. True but many people invest in T-Bills through some sort of money market fund which just rolls them over rather than going to auction. So I'm making assumptions based on the term structure of interest rates. Obviously, reality is much more complex. Those worried about inflation would go to longer term bonds or TIPS, but I think equities have offered a much more attractive risk profile and have been invested in instead.

3b. I think its an interesting measure but would think it is dependent upon many other phenomena such as wage inflation, wealth effects and many other consumer type data. Also, since the savings rate is negative, one would say that this is not really a choice being made any more and actually dependent on inflation and short term rates - which would introduce tons of model mispecification. Although interesting to look at, I believe it is very hard to add that into an analysis without introducing tons of bias, but will look into it.

4a. People don't really understand inflation in general. They don't see stock price returns as inflation, but gas prices as such. It is also underscored by the major difference between consumer and investor behavior. With price inflation, inflation is seen as a cost and usually attributed to some conspiracy, but price deflation is attributed to some skill - whether it be they are a good shopper or that a politician is a good politician. On the other hand, asset inflation is seen as a skill. People who pick a great stock or buy a house that increases in price did it because they were clever and are a sophisticated investor, whereas asset deflation is seen as a cost or better yet, a crisis. The recent bailouts and this whole subprime crisis show this quite nicely. The same is true with wage inflation as is with investment inflation. The best example of this is property taxes - the cost associated with your property. You think you are skillful when your house doubles, but think its a travesty and the government needs to change when your taxes double as well. It also relates back to the whole preference for gratificaiton now versus in the future. With investments we immediately accrue what paper gains we have and wish to defer our losses. We realize all cost increases or decreases dynamically, therefore would rather spend our money on what is certain - the now, then take the chance of realizing the losses that have been deferred into the future.

4c. I don't think a market could develop around this, and would really help anything - possibly make things worse. Most services and products are either intangible or depreciating in nature, therefore the futures market would never be as deep as the actual market. Nobody wants to speculate in the widgets market and have to buy futures on widgets and have to hold inventory. Futures markets develop because speculators are willing to trade commodity futures because commodities are assets and many people buying them are willing to accept payment in that commodity in the future. I just don't see how you can receive a "healthcare service" in the future and how anyone within the market could participate. The housing one works because of the amazing amount of derivatives based on home prices that banks hold.

Bond investor

ZB, thanks for the reasoned response and always-interesting content. Let's dig a little deeper...

1. So if TIPS have major tax, liquidity and structural shortcomings, why are they among the best performers among bonds this year? (Although nominal 20-30 yr cpn Tsy and STRIPs have outperformed Vanguard Infl-Prot Secs Fd) I think it's just coincidence that the *trailing* 12-month CPI and a flight to Treasuries occurred at the same time. I will have to check CPI vs. spread-widening trends historically. My gut tells me that the Fed and bond markets used to be less pre-emptive and expectational, so trailing CPI might peak at a different time as your typical flight to Treasuries. Also, most recessions are not credit-induced (like this possible one might be), but due to other shocks: Internet mania, Gulf War + tax hike, hyperinflation + oil embargo + structural change from mfg to service economy.

2. You're concerned that stocks (particularly low-dividend ones) may not be good investments in an age filled with skepticism about stock exit-strategies (like Baby Boomers retiring/dying) and the value of that final "liquidating dividend" in a Dividend Discount Model. I wholeheartedly agree! I also think the converse may be true -- if the real interest rate and the level of inflation both fall, then the equity risk premium may be exposed as being not large enough. (Actually, I think we're saying the same thing!)

3a & b. I'll try to dig up the Morgan Keegan piece on this, but I agree that it's just a hypothesis -- the effect is nonzero, but whether it's more significant than the forces you outlined, I dunno.

4a. You hit the nail on the head with loss aversion and mental accounting of "money I made" vs. "money *they* take away" (taxes, retailers, et.) It will be very interesting to see how loss aversion affects the housing market. NYTimes Business, of all places, has a good article on this today, about the LA suburb of Paramount, where house sales of any kind, at any price, has fallen -78% YOY! Refusing to take a loss on a house will only prolong the housing recession.

4b. I agree that without an active speculator community able to take the other side of a trade, the hedges Shiller would like available will remain illiquid or never be created. Where I live, there *is* a firm that specializes in "retail" sized gasoline forward contracts for non-agricultural buyers. So if you commute an insane amount to work in a big honkin' SUV, you can buy "insurance" on gas prices forward for months or years. You purchase at a price above the spot price, and buy in gallons, which can be "redeemed" at most gas stations in my metro area. The problem that I see is that the firm will be left with a lot of out-of-the-money options on old contracts. Yes, they paid more up front, and hopefully the firm earned money on the float, but if their "insured-price" gallons are out-of-the-money, such as if gas prices fall, then they can just pay in cash like regular Joes at the service station.


Bond Investor thanks for the response. what do you do for a living? Do you have a blog by the way?

1. With the end of the curve at less than 5%, CPI at 3%, the yield curve reverting and steepening, and the Fed cutting interest rates with oil and food at all time highs, wouldn't you rather be in TIPS than sitting on the end of the curve? I think it DID offer a better risk return for fixed income money, however its a bit of a crowded trade with a ton of retail/401k money flowing in. My dad asked me about them the other day, and immediately told him not to buy them. The average guy hearing about inflation on the news and in the paper, unaware and unable to hedge against it sees a Vanguard Inflation Protected Treasury Fund and piles in. Plus ETF's that invest in TIPS have also become very popular.

2. Yeah its the same thing just the other way around, but i think its almost inevitable. At some point boomers will need income, so one of two will have to give. With low interest rates they get crappy treasury yields and with no low dividend yields its the same thing. So either they begin to sell stocks and buy bonds (perpetuating the bagholder scenario), or stocks begin to issue dividends to retain capital. Either way the they get marked to market.

4b. Yeah but I think any type of insurance perpetuates inflation in the asset being insured and simply misallocates resources. Health insurance is a perfect example. It has enabled people to access health care they don't need bidding up costs of both insurance and healthcare - eventually to a price where most people can't afford either. The government, which has a very strong insurance lobby to no surprise, steps in because of political reasons and further adds to the problem. The only type of insurance that has fixed premium payments is that which insures something that is not a financial asset or good - such as life insurance. A less vanilla example is index puts to hedge market risk. As the ability to hedge against this supposedly risk that can't be hedged (up to a point in IV profitably) causes a bias on stock prices to move up as there is less stock selling and more put buying and investors get nervous, and increases the cost of the volality hedge beyond what the actual volatility will be. Eventually, when things get too out of control (like now) the government must step in and provide liquidity to prevent a crash, which is essentially what a put option provides (since it is a contractual agreement to sell stock at higher price). This further inflates the cost of the asset. Cars wouldn't be as expensive as they are if people didn't have to buy the insurance and gas prices would be lower. In an insurance contract risk is simply transferred, and if the eventual reinsurer is the Federal Government, it is automatically inflationary as it increases the liabilities and decreases the currency.

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