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Happy to see you again. The week is coming to an end and I promise that next week we will not be talking about inflation at all. I really mean it this time. But today we will.
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Why higher inflation is ignored
The consumer price index was a little higher than expected on Thursday, with core inflation at 3.8 percent, but government bond yields were not budged. In principle, it’s a little weird. Inflation is bad for bond prices, so it should drive up yields. But the indifference of links is not unexpected. Bond yields peaked in March. Since then the story has been “look at the 10 year bill he says inflation will be transient, everything is cool” or else “look at the 10 year treasury he says investors think inflation will be transient, but the boys are they have a surprise, buy canned food and guns ”.
I am closer to the first camp than to the second. Again, most of the things that drove the index up in May were things the pandemic crushed, including hotel rooms, or created bottlenecks, like cars. Capital Economics had a tidy array of hot categories:
All of this must be transitory. But we can’t really relax. Three comments on why not.
First, all of the warming categories absolutely cannot be dismissed as a natural consequence of reopening. One example was the cost of housing (“owner’s rent equivalent”) which increased at an annualized rate of over 4 percent. This is not a crazy number (“so far there is a standardization, not a push,” wrote Strategas in a reassuring note). But it makes me want to see what next month’s issue looks like.
Second, there is strong price insensitive demand for US sovereign bonds, which may prevent yields from reacting to inflationary fears. These are the most liquid assets, used for all kinds of purposes other than maximizing returns. They are an alternative to safe cash and a form of collateral for just about everyone, everywhere.
An example. My former colleague Tracy Alloway, now at Bloomberg, posted a nice article this week on the growing demand for US Treasuries in banks, which are required to hold a very liquid and secure pile of paper. The collapse in yields on other options has shifted demand from banks to Treasuries, and banks have bought hundreds of billions of them over the past year.
Also, remember that US Treasuries always earn much more than other sovereign bonds. Japanese bonds are barely paying anything. The Germans have a negative return. So if you have a safe sovereign bond allowance that needs to be filled, what are you going to fill it with?
And, oh yeah, besides this, the Federal Reserve buys $ 80 billion in treasury bills per month. That’s almost half of net issuance in the past 12 months, according to data from the Securities Industry and Financial Markets Association, or about 4% of outstanding treasury bills. As a trader who tweets as Five minute macro the summary :
“The Fed is all about the bond market at every maturity, but people always want to analyze what every move and move in the bond market says about the economy or investor expectations. Combination of old habits that die hard and the rather nihilistic alternative.
I mean, if the yield of the 10-year Treasury doesn’t tell us much, what do I do for a living? But whatever . . .
Finally, we have a perfectly simple explanation for what is happening, which is that the effect of inflationary fears on rates is masked by falling real rates. Here are the market-derived inflation expectations for the five years from five years, compared to the 10-year yield (Fed data):
Put simply, inflation expectations can rise while returns remain stable because the inflation-adjusted return that investors demand from money, the real interest rate, falls.
I wrote about the real rates yesterday. Thinking back since then, it occurs to me that a very low and falling real interest rate is hard to say about the nihilism of investors (“the return on everything stinks, I’ll settle for anything. with a tiny bit of yield and waiting for something to happen will get me fired, is it time to drink? ”) but that’s a problem for another hour.
Banks and cryptocurrencies
The Basel Committee on Banking Regulation believes that banks that hold cryptocurrencies should maintain capital equal to the total value of those digital assets. In Basel: “Capital [should be] sufficient to absorb a full write-off of crypto-asset exposures without exposing depositors and other senior bank creditors to a loss. ”
This makes perfect sense and makes crypto a terrible business for banks.
This makes sense because cryptocurrencies (except those permanently attached to more stable assets, which Basel excluded from high capital demands) are extremely volatile. Bitcoin lost almost half of its value in a matter of weeks in May for no apparent reason. A bank cannot leverage something that behaves this way.
This is obvious, and adds to the technological or criminal risks associated with crypto (“cryptographic key theft, compromise of login credentials and distributed denial of service attacks”).
But banks basically get all of their money from leverage. Their return on assets is around 1 to 2 percent, they get about ten times as much, and they get a return on equity just above their cost of capital. Seems like they make a lot of money in good times, but that’s an accounting illusion. Throughout the cycle, it’s a pretty tough business. Assets that can’t be tapped don’t fit the business plan, at least not at any scale that matters.
This is not a review of bitcoin or crypto assets in general. And that shouldn’t bother crypto believers too much. A key part of the crypto pitch is that it will allow users to tell the government-controlled banking and monetary system to be buzzing. If this system wants the crypto to trigger too, well, everyone should be happy. Bitcoin hasn’t moved much on the committee’s news.
The Financial Times, however, found a banker willing to substantively say the committee is wrong:
“We’ve all seen what happens when you drive the activity of a fairly well regulated system into the Wild West. . . Do regulators want adults to do business, or would they want teens to do business? “
That’s a hilarious bad argument (“If you don’t let the bankers smoke crack, who’s going to smoke all the crack? Kids!”). Yes, we want crypto to be run in some sort of stand-alone system where, if it explodes, we don’t need to stage a mortgage bond sell-off to fill the hole left by the explosion. The interesting question is how this autonomous system should be regulated, taxed, etc.
A good read
Martin Sandbu of the FT believes there is no labor shortage, no widespread wage pressure and no lingering inflation. He backs up his argument with a lot of data and solid logic. Read his column if you feel panicked.
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