Article Updated: Some quantitative errors were made in the inflation analysis section. These are now rectified and are consistent with the broad theme of the post.
This article looks at inflation and its love-hate relation to the yield curve. Inflation, consensus logic dictates, is not a good thing, except in those cases when it is good. So is it just a case of who benefits, where can it occur and, more importantly, when will it occur?
For the fixed-income addicts out there, inflation can make or break your day: they pump up your yield or crash down your investment model, all in the time of a market news wire. For the average household, prices go up, sort of like taxes and advertising on tv, not a big deal until you notice that it never seems to end and your wages haven’t matched the rise. For governments, inflation is a double edged sword: it makes the past cheaper but the future more expensive.
So where are we today and what can we expect over the next few years?
This post will take the recent September 15th 2010 auctions of 3 year treasury notes together with inflation estimates from the TIPS inflation index ratio for a July 15th 2012 maturity (Series C-2012 912828AF7) to illustrate the oddities currently shaping our yield curve and our future economic development. The inflation estimate used below is the Federal Reserve’s historical statistical estimate and not the actual TIPS inflation market pricing. Though the latter measure, derived by calculating the spread between the TIPS and equivalent treasury note or bond yield curve, is probably more accurate, it is also affected by the liquidity premia available over these securities. This article is therefore simplifying the analysis by sticking to the Fed’s own historical inflation index ratio.
But before I get into too much detail, let me give a very quick background on how bonds are priced: a treasury note, as other fixed income instruments, is priced either as the present value of future cashflows or by its current yield to maturity, which represents the constant discount rate required in order to get a net present value of 0. In layman terms, we price the security either as the sum of all its future discounted cashflows, its present value (PV), or by the Internal Rate of Return of the instrument, its discount rate (YTM).
This means that when yields go up (ie funding costs for the issuer are higher) then the value of a security goes down (the price of buying/selling a security today); but when prices go up, the cost for an issuer is lower, and then the quoted yield is therefore lower.
To illustrate this, say the government wants to borrow a million dollars from the market: if yields are lower it can issue more securities at a value closer to Par (redemption value = $100) than when yields are higher. Essentially, it can issue them at a higher ‘price’, say $99.881642 (recent price of a 3 year note issued on september 15th), then pay a low interest on them, with two coupons per year at $0.375 each, and after three years pay one last coupon back and the value at par or $100.
As you might already notice, this is a particularly good time for governments to borrow money from the market. If I were a government, I could take $99.89 today, at a nominal cost of $0.375 x 6 over three years (total of $2.25) and then pay back at par ($100). This gives a total nominal cost of $2.25+(100-99.89)= $2.368. Not bad really…
But there’s an other side to the equation in an environment where inflation picks up. You see, inflation is a bit of a two-edged sword as I mentioned in the opening paragraph: as inflation goes up, the present value of currently issued securities tend to go down. Here, the future value of money in the market is being discounted back by an increased rate. In other words, dollars that are paid out tomorrow are worth less in ‘purchasing power’ terms compared to what they are worth today if inflation remained low.
So to illustrate this: say the government wanted to pay you back $100 in three years time but you knew that the costs of the goods over which you could use that money would be higher than $100, then it goes without saying that you would want to be ‘rewarded’ so as to not ‘lose’ purchasing power over that period: in other words, you would still want the ability to buy the same amount of goods with your ‘nominal’ $100.
So how much should the government be paying you back?
Well, you should be getting a security with a discount rate in excess, or at the very least, equal to the rate of inflation. So if in 3 years time you are paid back in full, you have ensured that you have not ‘lost’ some of your purchasing power along the way. Okay, so that’s for the basics of the market, but then there’s the current market environment.
Taking the recent September 15th auction for three year notes, we get a yield to maturity (YTM) of 0.790 %. This YTM is effectively the funding cost of the note, an investor should ‘technically’ only invest into such a security if and only if that rate is equal or above to the expected inflation discount.
An assumption over the inflation rate:
Okay, so how do we measure inflation in order to track this performance hurdle? Well, there are popular statistical measures such as the consumer price index or producer price indices out there. Both of these give us an expected price rate index over which to measure consumer and producer’s cost of operations.
This article will use the US Treasury inflation measure currently being used to fix in the TIPS market. So, we would want to ensure that this 0.79% is above our expected annual inflation target over the next three years, or else we would be getting a fairly raw deal, right?
And so the penny drops…
The thing is, and I realise this isn’t the best answer out there, though the calculation should be fairly simple, it simply is just not that simple. The market isn’t just buying treasury securities in order to beat inflation. Though that should still be a core prerogative for all rational investors, there remains a number of other factors that drive the market in making asset allocation decisions. I will get to these in a second but let’s just quickly return to the government’s point-of-view in the equation.
As the inflation rate rises due to the economy picking up steam and with economic activity becoming more buoyant, the value of its liabilities, ie of its debt, start to decrease. In other words, the securities on the market start to get discounted back more heavily and their market price should technically drop.
The government can then do one of two things: it can continue paying the coupons and then redeeming at Par at maturity over the security or, it can take advantage of the current market conditions, and repurchase the securities prior to Par and and write-back the gain on the investment.
Let’s illustrate this by a quick example: assume the following that two years from now, on september 15th 2012, the inflation rate went up to 1.21238% per annum (this is the historical assumption rate taken from the TIPS market). This gives us, for the recently issued three year note, two more cashflows: one coupon of $0.375 due on the 28th of February 2013 and one final coupon and par redemption on the 15 September 2013 of $103.75. Therefore the present value on september 15th 2012, using the TIPS inflation index ratio as a proxy discount rate:
So, on September 15th 2012, the nominal cost of a three year note becomes: Coupons of year (2nd half 2010) and (2011) and (1st half 2012) = $1.5 + $100.144761 = $ 101.644761
In other words, compared to the issue price of 99.881642, the nominal cost has dropped from the initial $2.368 over to $1.82834139. Another way to put this is the nominal cost of funding has gone down by 29%.
I realise this is a bit of number play used to re-emphasise the effect of inflation. Clearly, inflation is not the only driver in the US treasury market, but it is worth noting that under the assumptions presented above of an inflation based price and an inflation rate of 1.21238% in 2012 (a cautious estimate), the government can book a significant profit over its operations. The term profit is used lightly here as it is framed within a nominal setting of performance over monies owed and not a value creation styled definition of the term.
So why are markets offering money for free?
Pushing the example above to its extreme, where treasuries are priced based on discount rate set by a presumptive 1.21238% inflation rate on September 15th 2013, then the yield to maturity for the 3 year treasury note should have been set at 0.8826% upon its issue date.
The market knows that current inflation estimates are around 1.2%, the treasury itself indexes this ratio for the upcoming period to 1.2%, but everyone is letting the government borrow at a real negative yield. This is essentially free money. But as any good economist knows, there’s no such thing as a free lunch, and as any good financier will tell you, there’s no such thing as free money.
The question then becomes, what is pushing the market to price US treasuries at such a ridiculously low discount? Well, there are a number of other factors weighing on the market at the moment. It isn’t entirely coincidental that I’ve chosen this particular 3-year note as an illustration for this article.
The auction occurred on September the 15th, and this date will forever more be marked in history books as a turning point in economic history: on September 15th 2008 – Lehmann Brothers went down (see article on FCIC hearings). This event dramatically changed our world and dramatically shifted the core objectives of our markets in ways that we have yet still to completely define. Indeed, this small date will reverberate well into the future as the current yield curves already demonstrates.
FX and Risk Pricing
The position of US treasuries in global markets is unique in its aspect as the ‘risk-free asset’ of choice. Combine this factor with the increasing uncertainties lingering in global markets, sovereign risk in Europe, rapid de-leveraging in the private sector, and a flight from risk, and you enter into a perfect storm where record-low treasury yields become normal – as opposed to curiously abnormal. There is therefore a further push towards safety at a global level which, when taken into account with the recent FX revaluations, put the treasury note as an even more appealing market investment.
To understand the foreign exchange outlook, again, one needs to view the US treasury note within the backdrop of global uncertainty and its ‘risk-free’ status. The US dollar has, despite being the market most central to the economic downturn, also become the safest currency due to the denomination of the de-facto risk-free security: the US treasury bill/note/bond.
As the graph above shows, the US dollar drastically revalued upwards over the course of 2008 to 2010 further pushing up the value of US treasury securities for foreign security holders. The EUR/USD cross is fairly self explanatory as both markets followed a policy of record low, almost zero, rates and the FX rate therefore became a proxy for the market’s risk assessment over both regions. The Australian Dollar despite appearing to have regained its position, is still nonetheless heavily undervalued from a relative interest rate yield point of view: the Australian RBA had, at its lowest, offered a 300 basis point yield (3%) or roughly 6 times more than the Federal Reserve’s lowest setting of 50 basis points (0.5%).
This strong US dollar stance can be viewed on two fronts: the direct FX rate aspect but also from a liquidity point of view.
On the FX front, the strong revaluation of the US dollar compared to the Euro seen over the past two years has provided an added boost to demand: for an investor that had bought in to US treasuries in early 2008, the net effect would have been an added FX revaluation profit in excess of 20%.
Furthermore, that investor would have maintained a strong risk-adjusted value to his investment due to the reduced liquidity risks existing within the market for US treasuries. Another way of putting this is: where could the investor have put his money in today and still expect to regain it tomorrow? Clearly, between US treasury notes or Lehman Brothers bonds, one would prefer the safety of the T-Note. This risk adjustment dramatically assisted the push-up in prices (or the squeezing of yields).
Finally, there is a temporal effect also acting on the market: assuming that you were operating fairly strongly back in 2007/08, the potential for you to want to move out of your US dollar denominated assets would have been limited post ’08. In 2009, the growing fear of increased volatility in international markets would have pushed you to roll forward (re-invest) your investments in US treasuries and to maintain, again, the strong, revaluation potential of the underlying FX rate.
Last but not least, there’s the case of the elephant in the room, China and its foreign exchange reserves. The big problem here is that the US treasury market is in effect absorbing China’s local inflation within its own securities market due to the Yuan’s currency peg. By keeping the Yuan at a fixed artificial rate, China is able to transfer out of its market the inflationary pressures of its recent economic performance. This inflation pressure is then passed on to other currencies by higher artificial values, and in the case of the USD, with a strong level of support compared to other major currencies.
Now this might sound again a bit counter-intuitive. Indeed, shouldn’t the US actually want the extra demand fuelled by China’s excess reserves? Well, yes, it does actually want a strong buyer into its market, however, remember that the record low yields within this market would also reduce the potential for early buy backs and the potential for quick re-booking of the US debt at a profit (see worked example above).
Given that timing of this rebooking could be a strong key in managing the current US debt, it shouldn’t be too surprising if over the coming years the US pushes more aggressively to have the Chinese Yuan revalued progressively higher. The net effect could be as follows:
- 1. A Yuan revaluation should assist a gradual rebalancing out by China of the US treasury market to minimise FX currency losses
2. The reduction in demand over US treasuries should lead to an increase in treasury yields
3. Higher yields reduce the price of US treasuries allowing a progressive reduction of the debt ahead of redemption and reduced expense load on the US taxpayer
Clearly, the above three point argument is an overly simplified outlook of the relation between China’s FX reserves and the US treasury yield curve, however, the example highlights the differing pressures and mechanics currently at play over the present yield curve. More to the point, they help us in understanding why the market isn’t, actually, giving money away for free.
Inflation’s Sharp Edge
The underlying risk that sudden inflationary and foreign currency revaluation shocks may occur are front and center of any analyst, trader and portfolio manager, not to mention any government treasurer, risk horizon. The inflation risk drawn-out above illustrates a core tenet of duration risk: a core risk metric in any fixed-income instrument portfolio.
Furthermore, the actual yield on US treasuries is also set as a benchmark rate for a number of other reference rates, which are in turn critical components in practically every other financial derivative in the market. This so called ‘basis’ risk is a critical factor in anything from commodity futures to theta time-decay variables and equity valuation models.
Needless to say, that the potential impact of inflation rapidly runs across a market, but here’s the funny conundrum: when inflation is high, equities (from the private sector) usually do well as higher prices primes up profit figures which in turn increase valuations and share prices, and, as detailed above, inflation can also assist the government to help re-book its public debt at a profitable level. This is a long way of saying: a lot of people actually want some inflation in the market.
So as to the question of whether inflation is about to pop its head around the corner? I would keep a close eye on that yield curve particularly a sharp edging up of its front-end.
- Background Links
US treasuries Recent Auctions
US Federal Reserve FX Historical Data
US Treasury Yield Curve Data
US 3 year treasury auction results, September 15th 2010, CUSIP: 912828NY2
US Treasury – September Release: CPI and TIPS Index Calculations
RBA Cash Rates Historical
NY Federal Reserve: Historical Open Markets rates
Investopedia Definitions: Commodity Futures, Theta, an example of a ‘fair’ value equity valuation model