The Markets Say It's Anything But Inflation Right Now
AP Photo/Charles Krupa, File
The Markets Say It's Anything But Inflation Right Now
AP Photo/Charles Krupa, File
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The winter was the worst it had been in forty years, and this was during a time when winters were especially brutal. In camp near Morristown, New Jersey, the half-starved, half-thawed men of Connecticut’s 8th regiment would finally surpass their breaking point. Having fought – oftentimes bitterly – for the American Revolutionary cause sustaining immeasurable heartache to go along with innumerable physical wounds, the men of those companies could no longer accept the seemingly unending universal privations forced upon them.

 On May 25, 1780, one unnamed soldier had had enough, unleashing a verbal altercation upon his commanding colonel. The enlisted man then invited the rest of the 8th to join him on the parade grounds as a demonstration of solidarity against unfit, unfair conditions.

 Many perhaps most did, and then this mob of unruly men moved toward the similarly volatile encampments for the 3rd and 6th Connecticut regiments to enlist each of those to the side of growing mutiny. In the melee and chaos, officers from the latter units desperate to prevent their own troops from taking arms and joining it, another colonel was left with a bayonet wound to fend off alongside the ire of his own soldiers.

Despite a shared and resolute desire to see the United States become independent by its fight with Great Britain, the personal conflict for all these individuals had devolved into the far more immediate and indiscriminate. The one seditious wave which had swept the Connecticut Line in 1780, so, too, would the pitiful men of the Pennsylvania Line and even the home-state New Jersey Line join them.

There were several shared, interlocking reasons for such serious levels of discontent and how widespread it had reached. Primary among them, of course, money. Soldiers were paid in derivative paper which had rendered each proud fighting man little more than an unpaid volunteer with starving wives and children at home to spend whatever devalued scrip each could send.

When in 1781 the French finally offered useful money, specie, one private, Joseph Plumb Martin, who had participated in the Connecticut Line Mutiny as a member of the agitating 8th regiment, said it, “was the first that could be called money, which we had received as wages since the year ’76, or that we ever did receive till the close of the war, or indeed, ever after, as wages.”

As a loose aggregation of former British colonies, Martin’s plight was left up to his native Connecticut home government as well as the reluctant national Congress. The individual states oftentimes had to get creative in order to finance both the men at war in addition to the materials they used to fight it – occasionally each other.

Among the most creative, the Congress of Massachusetts had in 1777 first passed An Act To Prevent Monopoly and Oppression. This colony had, as had the other dozen, experimented periodically with paper currency whenever one of the wars with France and Europe might reach North American shores – going all the way back to King William’s War at the end of the 17th century.

The American Revolutionary conflict proved no different, this time with inflationary currency the most spiteful for those fighting it. Prices soared, actual money and specie grew very hard to find (it’s not like the British were going to ship hard money to their rebellious colonies to replenish what was spent abroad and hoarded at home).

The ’77 Act in Massachusetts sounds like it was written two hundred years later during Nixon’s portion of the Great Inflation: government-set price controls. And like those of August 1971, these already proved a dismal failure centuries earlier as the monetary disease made it uneconomical for any sane merchant, farmer, or regular person to sell anything at the demanded cost.

All basic items of necessity quickly disappeared from Massachusetts and the price controls were abandoned until, outside of wartime, Tricky Dick. Other efforts to do something about the hardship fortunately were not.

As 21st century Economist Robert Shiller (yes, that Robert Shiller) wrote in a December 2003 paper, his title spoils the surprise of Massachusetts’ novel brainchild: The Invention of Inflation-Indexed Bonds In Early America.

These weren’t quite the 18th century equivalent of TIPS but they weren’t far off, either. Catching Shiller’s notice was how this had been the first documented (Shiller notes that others had noted historical hints this may not have been the first actual instance of the practice, just the first anyone can find hard evidence for) use of inflation indexing.

Building upon the Massachusetts Act of ’77, authorities decided rather than repeat the arrogant stupidity of price controls, they’d more directly address the cause of so much severe economic anxiety. Shiller wrote:

“Unable to fix prices, the government of Massachusetts did the next best thing, to provide enough income to their soldiers so that they could buy the basket of goods defined by [a subset of] the list of goods in the 1777 act as if they still had their specified prices. Perhaps due to the difficulties of collecting price data, the indexed bonds were based on only 4 of the 50 commodities described in the 1777 act.”

Soldier’s pay was tied to the prices of those specific commodities; however much it cost five bushels of corn, sixty-eight pounds and four-sevenths part of a pound of beef, ten pounds of sheep’s wool, and sixteen pounds of sole leather. What the state government offered had been inflation-indexed bonds which protected their soldiers (and families) first from past currency devaluation and then any future adverse price changes.

Each 1780 bond itself noted right from its top how prices in just these four basic commodities between the Act of ’77 and the note’s issuance in January 1780 had increased by an astounding, “THIRTY-TWO TIMES AND AN HALF what the same Quantities of the same Articles would cost at the Prices affixed to them in the Law of this STATE made in the Year of our Lord One Thousand Seven Hundred and Seventy-seven.” [all caps in original]

You’d be reimbursed by principal and interest for changes in this basket of commodity prices, additional maturities added for length of service. It was not yet enough to save the American Army from the 1780 mutinies nor several more that followed, but it had been an interesting innovation by necessity proving several key issues long before the formal study of money, prices, indeed economics would come around.

What Shiller primarily lamented was how this inflation-indexing of securities once begun just disappeared until the 20th century. He doesn’t say it, but implied just in recalling the history here shows the real business of sound money throughout the 19th century – which was far from perfect, leaving the economic system vulnerable instead to the opposite problem, deflationary illiquidity.

It wouldn’t be until 1997, curiously, when inflation-indexed Treasury bonds formally made their American reappearance. The late nineties were hardly a time like the 1970’s let alone the three thousand percent inflation of the late 1770’s. There’s something deeply embedded in monetary distrust, this lingering idea governments will just print too much money one day regardless of any current proof or evidence for the suspicion.

Even though inflation was far from anyone’s list of problems during the dot-com (OK, consumer price inflation was far from anyone’s mind, but even Alan Greenspan’s irrational exuberance speech told you the issue wasn’t money printing but money itself), a 10-year TIPS instrument made its debut on January 29, 1997, anyway.

These securities give the holder inflation protection in two forms, each decided by the published CPI rate. Every year, the owner is credited with additional principal to make up for the amount general consumer prices have increased; if the CPI rises 5% during a yearly period, if you started it with $1,000 face value the government gives you an extra 5%, or $50, principal.

And then it pays you interest the following year on that updated principal value. You get both principal and coupon protection from inflationary currency in a way not too dissimilar to the Massachusetts trial.

There are any number of arguments relating to how accurately the CPI measures consumer price inflation, and there is definitely a mystique of pseudo-precision surrounding the government’s (BLS) consumer price bucket concoction, and whether there is such a direct relationship between modern money printing and how much or if might find its into this kind of data.

Yet, the index’s lengthy history correlates closely enough with bouts of genuine inflation that we can reasonably and predictably expect someaffiliation between perceptions about future inflation and the prices of these TIPS instruments. There’s enough of a profit motive in how these things pay out to make this a rational assertion.

Should the market get a sense of any money printing excesses, why wouldn’t we see it in the TIPS market?

You’ve probably already guessed where I’m going with this. Earlier this week, the BLS said the US CPI had increased a touch more than 7% in December 2021 from its level estimated for December 2020. The highest “inflation” rate in almost forty years; dating back just after that whole Great Inflation business of the seventies.

And, relatively speaking, TIPS are in pretty high demand. The way they’ve been priced – though not just recently – is so that each’s posted “real” yield is decidedly less than zero. Negative real yields because the market expects only some small positive level of CPI increases over the years each TIPS instrument (there are denominations of 5-years, 10-years, and 30-years) might be in any investor’s possession.

It is incongruous to last year’s elevating CPI rates.

The most straightforward interpretation, the only rational one, is that the market for inflation protection isn’t actually all the robust for protection against real inflation. There’s some expectation for some positive CPI increases, though nowhere near these recent levels.

Whatever they’ve been in 2021, the TIPS market doesn’t believe they’re going to stick around for long enough that these “real” yields would fall any further (as higher demand for TIPS given the perception for sustained CPI rates we are not currently seeing).

On the contrary, very recently, especially since the start of this year.

So, if the market isn’t actually expecting more inflation, or even “inflation” (the quotes are required given what has been behind the CPI’s in 2021, and it wasn’t money printing), what is going on in TIPS?

Let’s put some numbers on these: since December 31, the 5-year TIPS real yield has increased by 31 bps (from -161 bps to -130 bps), the same as at the 10-year maturity, and nearly as much out in the 30s (an increase of 27 bps).

But these changes go back further, back into November. On November 15, the 5-year TIPS real yield was an ungodly awful -191 bps, meaning it has gained 61 bps since even though CPI’s go higher and higher. The 10s TIPS, interestingly, have only increased by 40 bps, while the 30s added just 31 bps.

These instruments are supposed to be primarily priced with regard to inflation protection, yet there are other factors – clearly – in setting each’s market value. The relationship to nominal Treasuries is one, and as we see here that may not strictly be about growth potential.

Cutting to the chase, saving you from even more involved academic literature review and historical correlations since 1997 (actually 2004, with the re-introduction of the 5s TIPS), spoiler alert, the short run TIPS represent a very stable correlation with short run nominal UST yields during periods of either rising or perceived future rises in short-term interest rates.

Yes, rate hikes.

For example, between September 2017 (when the Fed announced QT in addition to more “hawkish” rate hikes) and early November 2018, the 5-year TIPS real yield increased from just about zero (1 bip) all the way to 115 bps. The 10-year TIPS went from 25 bps to the same 115 bps – yet again less.

Had growth or inflation perceptions increased during that time period? Absolutely not. Instead, what had changed was the Fed and its temporary influence over the short end of the yield curve. It wasn’t inflation fears so much as artificial interference.

The same exact problem had arisen in the previous rate hike “cycle”, too, going back to the decade before. From November 2004 until the end of June 2006, the 5-year TIPS increased 174 bps; the 10s again less, that time gaining only 98 bps.

Was real growth potential that much better during the middle 2000’s, the very mania of the housing bubble? No. What had changed was Alan Greenspan’s and then Ben Bernanke’s series of seventeen 25-bps rate hikes. These had altered the nominal frame of reference for the short end of the whole Treasury curve which anchors the choices made by TIPS buyers and holders.

They weren’t selling them (raising their real yields) in 2005 like 2018 because inflation was expected to drop, or even because they believed nominal opportunities in the real economy were set to be uniquely robust for the foreseeable future. Both times, TIPS were sold relative to the levels set in the nominal ends of the short-yield curve given the Fed offering non-economic money alternatives (a higher federal funds target for Greenspan/Bernanke, and a higher federal funds target range for Powell bracketed by IOER and RRP rates).

By mid-2006 like November and December 2018, the fiction of those rate hikes quickly reversed as yields for both TIPS and nominal UST’s dropped enormously thereafter; the pricing of real yields, especially, and particularly at the 5-year maturity having been little more than made up of those future Fed mistakes.

Confusing? Sure. What’s not is first how seven percent CPI’s are nowhere to be found in current TIPS prices. On the contrary, rising TIPS real yields have been accompanied by stable inflation expectations (breakevens) in that same timeframe going back to mid-November last year. The surge in these corresponds closely to rising expectations for imminent rate hikes.

Rather than any money printing as we’d come to expect from numerous historical examples, the current TIPS market is left to price mostly oil but now added to it the Fed’s hawkish stance. At the same time, also like 2018 or 2005, the nominal Treasury curve is and has flattened dramatically basically ruling out any other interpretation; or how inflation protection right now is, by market process of elimination, almost everything else but. 

Jeffrey Snider is the Head of Global Research at Alhambra Partners. 

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