Lies, Damn Lies & Statistics
From John Mauldins Outside the Box at Investor's Insight, a missive by Peter Bernstein regarding Paul McCulley of PIMCO's recent piece called "Phyrric Victory". Snipets from his missive in italics follow my rantings.
Bernstein sees the expectations on inflation being much different than in the past and believes that as a result, adverse surprises may be in our future.
The changing terrain of being "down the slope" and "in the flats" rather than "on the mountain" or "up the slope" changes one's PERCEPTION of the investment landscape.
Berstein points this out in his observation of the new paradigm, where inflation is viewed at a LEVEL, rather than as a RATE OF CHANGE.
He also points out that the change in PERCEPTION necessary for this paradigm shift is convincing investors that inflation has been washed out of the system.
The observation that "a bear market in bonds looks like a very low probability outcome" is based upon this WIDELY HELD PERCEPTION of inflation being benign, tame, and almost non existent.
In addtion to the "changing terrain" and PERCEPTION that "inflation has been washed out", he adds "estimates of inflation expectations have followed suit".
Mark Twain said it best, "There are three types of lies - lies, damn lies, and statistics". In our opinion these consequences of the "new paradigm" are nothing more than a reflection of hedonic and statistical inference propagated by the CPI and other widely held metrics of inflation.
We think that perhaps the WIDELY HELD PERCEPTION is really a misperception on the part of many. This misperception is in response to misdirection on the part of the metrics.
The misdirection is caused by improper incantations or invocation of the metrics on the part of those who are conjuring the calculations. But unlike in the fable, "The Emperor's New Suit", it does not take a child's utterance to recognize the naked truth.
In the end, perception is not reality, money is; and Bernstein suggests that "this is the perfect environment for adverse surprises to have a tremendous effect", and we could not agree more.
If long bond yields start to rise, investors will understand that higher rates will bring about conditions leading to lower rates, so they will not sell. If yields start to fall, investors will understand that lower rates will bring about conditions leading to higher rates, so they will not buy. Hence, bond yields will never change.
McCulley points out that Greenspan is caught in the time inconsistency problem. Greenspan has been using a measured increase in Fed funds to push up the yield on long-term bonds in order to raise mortgage rates, his ultimate target.
But he is doomed to frustration. Forward-looking investors will simply buy long bonds on the dips, confident that Greenspan will cut the Fed funds rate as soon as the housing boom crumbles. Easy pickings for investors. No sustained bear market in long bonds. No bust to the housing bubble.
Long rates have dropped a thousand basis points below the 1981 peak and are now less than 450 basis points from zero. Being down from that Mountain has a deeper meaning. The atmosphere on the terrain this close to zero is not like the atmosphere on a slope with a long way to go before it reaches zero.
The same observation applies to the current rate of inflation compared to 1990, when it was in the area of 6%. Inflation since 1992 has averaged 2.6% with a standard deviation of only six basis points!
Estimates of inflation expectations have followed suit. This set of conditions bears no resemblance to the situation when the slope was still clearly downward. Indeed, the entire history from 1954 to 1992 may be irrelevant for forecasting what lies ahead.
From the beginning of this history in 1954 until the mid-1990s, the whole focus was on the rate of change - inflation is a rate of change, after all.
But once investors became convinced that inflation had been washed out of the system and that any inflationary episode was likely to be brief and mild, the world's perspective becomes a view of a level rather than rates of change.
Under those conditions, mopping up is easy to foresee, and a bear market in bonds looks like a very low probability outcome.
The point is an important one. What McCulley sees as a trap Greenspan has set for himself is a natural outcome of the sequence of events.
But beware! Even Greenspan cannot guarantee "those conditions" will persist into the indefinite future. On the contrary. This is the perfect environment for adverse surprises to have a tremendous effect. From this point forward, bets on mopping up should be hedged.
Bernstein sees the expectations on inflation being much different than in the past and believes that as a result, adverse surprises may be in our future.
The changing terrain of being "down the slope" and "in the flats" rather than "on the mountain" or "up the slope" changes one's PERCEPTION of the investment landscape.
Berstein points this out in his observation of the new paradigm, where inflation is viewed at a LEVEL, rather than as a RATE OF CHANGE.
He also points out that the change in PERCEPTION necessary for this paradigm shift is convincing investors that inflation has been washed out of the system.
The observation that "a bear market in bonds looks like a very low probability outcome" is based upon this WIDELY HELD PERCEPTION of inflation being benign, tame, and almost non existent.
In addtion to the "changing terrain" and PERCEPTION that "inflation has been washed out", he adds "estimates of inflation expectations have followed suit".
Mark Twain said it best, "There are three types of lies - lies, damn lies, and statistics". In our opinion these consequences of the "new paradigm" are nothing more than a reflection of hedonic and statistical inference propagated by the CPI and other widely held metrics of inflation.
We think that perhaps the WIDELY HELD PERCEPTION is really a misperception on the part of many. This misperception is in response to misdirection on the part of the metrics.
The misdirection is caused by improper incantations or invocation of the metrics on the part of those who are conjuring the calculations. But unlike in the fable, "The Emperor's New Suit", it does not take a child's utterance to recognize the naked truth.
In the end, perception is not reality, money is; and Bernstein suggests that "this is the perfect environment for adverse surprises to have a tremendous effect", and we could not agree more.
If long bond yields start to rise, investors will understand that higher rates will bring about conditions leading to lower rates, so they will not sell. If yields start to fall, investors will understand that lower rates will bring about conditions leading to higher rates, so they will not buy. Hence, bond yields will never change.
McCulley points out that Greenspan is caught in the time inconsistency problem. Greenspan has been using a measured increase in Fed funds to push up the yield on long-term bonds in order to raise mortgage rates, his ultimate target.
But he is doomed to frustration. Forward-looking investors will simply buy long bonds on the dips, confident that Greenspan will cut the Fed funds rate as soon as the housing boom crumbles. Easy pickings for investors. No sustained bear market in long bonds. No bust to the housing bubble.
Long rates have dropped a thousand basis points below the 1981 peak and are now less than 450 basis points from zero. Being down from that Mountain has a deeper meaning. The atmosphere on the terrain this close to zero is not like the atmosphere on a slope with a long way to go before it reaches zero.
The same observation applies to the current rate of inflation compared to 1990, when it was in the area of 6%. Inflation since 1992 has averaged 2.6% with a standard deviation of only six basis points!
Estimates of inflation expectations have followed suit. This set of conditions bears no resemblance to the situation when the slope was still clearly downward. Indeed, the entire history from 1954 to 1992 may be irrelevant for forecasting what lies ahead.
From the beginning of this history in 1954 until the mid-1990s, the whole focus was on the rate of change - inflation is a rate of change, after all.
But once investors became convinced that inflation had been washed out of the system and that any inflationary episode was likely to be brief and mild, the world's perspective becomes a view of a level rather than rates of change.
Under those conditions, mopping up is easy to foresee, and a bear market in bonds looks like a very low probability outcome.
The point is an important one. What McCulley sees as a trap Greenspan has set for himself is a natural outcome of the sequence of events.
But beware! Even Greenspan cannot guarantee "those conditions" will persist into the indefinite future. On the contrary. This is the perfect environment for adverse surprises to have a tremendous effect. From this point forward, bets on mopping up should be hedged.
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