John Dizard: Time to buy Tips before price of protection goes up

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The Treasury department’s inflation-linked securities, or Tips, are probably the least efficient part of the Treasury market, which may now be creating a relative value opportunity for risk-averse investors, of whom there are more and more these days.

The potential opportunity has been created by a problem with the core inflation measure, which is the principal signal for investors seeking to estimate inflation risks. That is not good news. It is rather like tapping on a fuel gauge while flying over the Andes, and finding it has been accidentally stuck at the safe level.

Tips are indexed to the so-called “headline” consumer price index, which much of the public believes
is understated, and much of the economic profession believes is overstated. “Core” inflation, followed by market analysts and policymakers, excludes food and energy costs. Those more volatile components are supposed to bounce around too much to provide a useful indication of the underlying trend. Monetary policy doves cite relatively benign core inflation numbers as a justification for moderating the pace of rate increases by the Federal Reserve.

But it is now becoming apparent that the core numbers have been massaged and adjusted in a way that led to complacency about inflation pressures. Each adjustment made by the Bureau of Labor Statistics made sense when it was done, in the context of the economy of the time. You would think the market would have sniffed out the problem, without necessarily understanding why, and already adjusted bond prices. But that has not happened, or at least not yet.

That is why it makes better sense now to buy Tips rather than their “nominal” counterparts.

The US inflation panic this month, which created the fear that the Fed would increase rates for the indefinite future, was the result of the April rise in what is known as “owner’s equivalent rent”. The OER was invented in 1982 as a substitute for a homeownership cost measure that was thought to be too much of an asset price measurement, rather than a cost of living measurement. The Fed, more than other central banks, has been opposed to targeting asset prices.

OER is measured by taking samples of rent levels in a set of representative neighbourhoods, and then assuming that the homeowners in those neighbourhoods would pay those rents if they did not own houses. It seems reasonable but there are odd quirks that result from trying to create artificial comparables.

The fuel price adjustment is a quirk that has created some of the biggest distortions recently. Remember that core consumer price index is supposed to exclude fuel costs, the variations in which are assumed to be noise rather than trend. In the case of OER, that means the fuel costs embedded in rent are stripped out of the data so that rent is only measuring the cost of housing. Fuel costs are added in to the headline CPI number, so they don’t go away.

However, in a period of rapidly rising fuel costs that means OER is actually reported by the government to be falling, since rents do not rise as quickly as what the landlord, or statistically assumed landlord, is paying for that fuel. According to Barclays Capital, which has dominated dealer Tips research and market making in recent years, “the downward pressure on OER from fuel costs has been substantial over the past year . . . We estimate (the fuel cost adjustment) subtracted 0.86 percentage points (from OER) in April.” Since the OER accounts for about 30 per cent of the core CPI measurement, the effect is substantial. Again, this does not affect the CPI adjustment to the value of Tips but it does affect the pricing of Tips’ value in the future, by reducing estimates of trend inflation. As Mike Pond, a fixed- income and inflation linked strategist at Barclays Capital says: “Longer inflation breakevens are driven more by core CPI rather than headline.”

That is the market inefficiency that has developed in Tips. Simply put, inflation expectations are too low.
So on a net basis, you should sell nominal bonds and buy TIPS at the same maturity.

But there are those who are even more suspicious of housing cost estimates. Bridgewater Associates, an investment group that provides a gold mine of information for data junkies, reconstructed the old homeownership data series using current information. Its estimate includes an asset inflation component, by definition, but it would presumably argue that those asset prices are part of the cost of living. Bridgewater’s Greg Jensen and Jason Rotenberg wrote in the middle of May: “Recently, the cost of home-ownership would be (increasing) at almost 12 per cent. Using those numbers, Bridgewater believes that headline inflation is about 5.9 per cent, while core CPI is 5.4 per cent . . .”

That probably over estimates the impact of house price increases; most people’s month-to-month costs are not tied to speculative frenzies in high turnover markets such as Santa Monica or Palm Beach. But Bridgewater has a point that asset price inflation increases cost of living.

John Brynjolfsson, portfolio manager with Pimco’s real return group, says: “We have seen our real return (inflation-indexed) franchise go from zero to $60bn, mostly in the past five years.” The market’s implied assumptions about future inflation have been lagging increases in recorded CPI, but he thinks that will change. “We like Tips relative to the nominal bond. We think the market should price in a higher forward break-even rate. [The break-even rate is the inflation rate at which Tips yields equal yields in the uninflation-adjusted bonds.] We look for another 20 basis points or so. There is another shoe to drop, when people’s inflation risk-premium rises.”

You might think a housing bust would lead to a fall in OER. You would be wrong. As Mr Brynjolfsson says: “When there is an abundance of home buying and home construction going on, that eases pressure on the rental market. With housing turning, people who might otherwise have been buying are turning to the rental markets.”

Ben Bernanke, Federal Reserve chairman, has a lot to prove. It is likely investors will be willing to pay more for inflation protection. So for your dollar bond portfolio, buy Tips before the price of protection goes up and the yields go down.

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