Futures and Expectations

Irving Fisher of Yale was one of the great economists of the 1920s, his unfortunate remark on Oct. 17, 1929, that "stocks have reached what looks like a permanently high plateau" notwithstanding. He must have been a terrific professor and a likeable sort, too, otherwise why would Yale alumni have chipped in to get him a place to live after he got clobbered in the subsequent crash and Great Depression?

One aspect of his legacy has come to be known as Fisher's Law, which states that nominal interest rates are the real interest rate plus the expected rate of inflation. Those who forget the "expected" part of the equation are guilty of abusing Fisher's Law, and this happens with distressing regularity. Simply subtracting a measure of inflation -- and it doesn't matter all that much which measure you choose -- from a selected nominal interest rate does not produce the real rate of interest. This can be seen in the comparison between annualized consumer price index changes and the nominal yields on Treasury bonds of 10 years' maturity or longer (10 years only since July 2000) since 1925.

Simple Subtraction Is Not Enough

Source: Bloomberg

The Chicago Mercantile Exchange has announced plans to launch a futures contract on the nonseasonally adjusted all-urban consumer price index (CPI-U). This is the CME's first foray into a macroeconomic market, and it is designed to serve, among other markets, the growing derivatives market on economic indicators. A Yale professor of later vintage, Robert Shiller, championed this development in his 1993 book Macro Markets. Shiller's timing was much better than Fisher's was, however: His book Irrational Exuberance was published in April 2000.

CPI futures, first traded prematurely and unsuccessfully by the Coffee, Sugar and Cocoa Exchange in 1987, appear quite attractive on the surface. Those who have a passing acquaintance with Fisher's Law can connect the dots and think they are creating their own do-it-yourself Treasury inflation-protected securities (TIPS) by buying both Treasury bonds and CPI futures. But "good enough for government work" is only going to take you so far in financial markets. A deeper understanding of the various moving parts involved is necessary to trade successfully.

Inflation-Linked Instruments

The reported inflation measures are a backward-looking snapshot; any longer-term interest rate embeds a series of forward rates and what is called a liquidity premium, or protection against the effects of inflation. The liquidity premium is responsible for the generally positive slope of the yield curve, and it counteracts the effects of convexity, the second derivative of a bond's price with respect to its yield, divided by the bond's price.

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At time of publication, Simons was long Pimco's Commodity Real Return Strategy fund, although holdings can change at any time.

Howard L. Simons is a special academic adviser at Nasdaq Liffe Markets, a trading consultant and the author of The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. The views expressed in this article are those of Howard Simons and not necessarily those of NQLX. As a matter of policy, NQLX disclaims the private publication of materials by its employees. While Simons cannot provide investment advice or recommendations, he invites you to send your feedback to Howard Simons.

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