Archive
Is Inflation Flowering?
To know that you’re standing before a cherry tree, you needn’t have cherries; cherry blossoms suffice. The seasons are long, so if you want to be able to harvest the fruit you need to look early for the signs.
So it is with inflation, and some would say it is with markets in general. We look for the early hints (a less-poetic scribe might call them ‘green shoots’) that signal when the season has turned. With inflation, indeed, the season has turned long ago, when core inflation bottomed in Europe, the U.S., and Japan in 2010 (and in the UK even earlier). But as we have seen, markets have not yet internalized this turning, or in some cases (as with nominal yields) have begun the recognition and then reversed it.
Consider now the humble 7.5% gain this month in the DJ-UBS commodity index (and comparably large moves in many other indices). It isn’t the size of the move, or its consistency, that is interesting to me; rather, it is that the movement has come partnered with a break of commodities’ relationship to the dollar.
Since commodities for the most part are priced in dollars, it is natural that they tend to move in the opposite direction from the greenback. When the dollar strengthens, then commodities are more expensive to non-dollar consumers, and they demand less. Yes, of course there are other factors, but when there are no stronger underlying currents then commodity indices tend to move inversely to the dollar. The chart below (Source: Bloomberg) illustrates the strong coupling of the dollar index (here inverted) and the DJ-UBS Commodity Index in yellow, both normalized to August 1st, 2011.
But note that this recent movement in commodities has come not in conjunction with a weakening in the dollar, but in spite of a strengthening (albeit a modest one) of the unit. This, I think, may be the first blossoms of spring in commodity-land.
Some may object that the rise in commodity prices is primarily driven by grains, but this is not the source of this divergence. The chart below (Source: Bloomberg) shows the dollar index again (and again inverted) against the DJ-UBS ex-Agriculture Commodity Index.
I am not a disinterested observer of the Commodity Spring, as readers well know; our models have for some time now indicated that commodities were the only outright-cheap major asset class and our main strategy has been heavily overweight them for quite a while. So perhaps I will be accused of seeing blossoms where none have yet bloomed. But as commodity indices approach their highs of the year, they are still only 14-15% off their lows, and far below their highs of a few years back. They remain the cheap asset class.
.
Moving to inflation more-broadly, it seems the market is growing comfortable with the notion that core inflation may have topped since it hasn’t risen appreciably in a few months. It is certainly useful for those expecting QE3 – as am I – if that perception gains currency (no irony intended) since de-fanging the hawks on the Federal Reserve Board would seem to be a sine qua non for loosening policy appreciably. But I believe that comfort is ill-placed.
I had been expecting, based on the lagged effect of the large inventory of unsold homes last year, for the housing portion of core inflation to ebb from its recent pace. It has merely flattened out, and while inventories are coming down those declines shouldn’t begin to push shelter CPI up for another quarter or two. But long-lag relationships are inherently difficult since the lags can shift over time. So let’s look at a shorter-lag relationship.
The housing component of CPI is driven by rents, both for consumers who rent their residence (“Primary Rents”) and for the consumption value of owner-occupied housing (“Owners’ Equivalent Rent” or OER). The chart below shows the relationship between OER and the CBRE index of rents on multifamily property, lagged 2 quarters (the red dot marks the last OER point). The goodness of fit of this relationship, shown for the period 2001-present in the Chart below (Source: Bloomberg and BLS), is quite reasonable[1] but interestingly, the recent rises in rents suggests that OER is significantly understated.
The number for the rental series ending in Q1 suggests that OER, which was last at 2.03% year-on-year in June, should be more like 3.4%. Since OER has a 23.5% weight in CPI and a 30.7% weight in core CPI, if OER were to converge it would be worth 0.4% on core inflation. And rental increases do not yet show much sign of ebbing. In short, the flattening out of core inflation over the last few months may represent the extent of what we can get out of housing at this point.
.
The last piece of evidence is really more corroboration of a speculation I’ve previously mentioned here. The sudden revival in apparel pricing this year has caught many analysts by surprise, and most have been expecting for the series to relapse soon (the price of cotton is often blamed, as if cotton hasn’t had any previous spikes in the last twenty years). My speculation was that the flattening and declining of apparel prices beginning in the early 1990s could plausibly be related to the opening of the U.S. textile industry to global competition, but if that is true then there must eventually come a time when the globalization has run its course and there are no more gains to be had from the declining domestic labor content in apparel. Thereafter, the rise in prices going forward should reflect rising wages in the source economies, without the dilution of changing composition.
Now Morgan Stanley has published a piece, by Joachim Fels et. al., called “Margin Call” (July 25, 2012). The authors illustrate that the U.S. margins of Chinese exporters have shrunk by 20-30% between 2004 and 2010, and argue among other things that “Price increases for Chinese imports and the spillover effects these are likely to generate may contribute to meaningful upward pressure on inflation.” This is not inconsistent with my speculation above, but adds a separate potential cause for the rise in apparel prices and other China-sourced prices (significant among them, incidentally, resin prices).
.
All in all, these pieces of evidence contribute to my belief that as consumers we ought to take time to smell the flowers, because the harvest of cherries is likely to follow in train. And in this case, that would be the pits.
[1] The R2 should be taken with a grain of salt, however, since these are overlapping observations.
What If There Was No Cash?
Bonds, stocks, inflation-linked bonds, commodities, real estate, MLPs, hedge funds, and cash. That is essentially the asset class universe we face as investors. Now, before reading further, think about what you would do with your investments if it were no longer possible to invest in cash, or if some aspect of “cash” made it inadvisable to hold. What would you do with your wealth that is currently sitting in money market funds?
You would clearly invest in riskier assets, since (with the exception of inflation-linked bonds held to your investing horizon) there isn’t a less-risky asset than cash in most cases. You may choose to buy a short-duration bond fund, or you might trickle some extra funds into stocks you feel are undervalued or into commodity indices that I feel are undervalued.
The reason this is a relevant thought-experiment is that the New York Fed, in a little-covered report issued last week, has recommended that investors in money market funds be prohibited from withdrawing 100% of their funds without significant advance notice. The staff of the New York Fed recommended that 5% of an investor’s balance in a money market fund be stuck for thirty days, in order to “protect smaller investors” from the sort of runs on money funds that caused investors in the Primary Reserve Fund to lose the awesome sum of 1% of their money when Lehman obligations went bust in the worst credit crisis in a century. Furthermore, they “suggest a rule that would subordinate a portion of a redeeming shareholders MBR [what the Fed calls the “minimum balance at risk”], so that the redeemer’s MBR absorbs losses before those of non-redeemers.” In other words, if you hear that your money fund is 100% invested in Lehman 2.0 as it teeters on the edge of bankruptcy, you get to choose between taking 95% of your money out now and potentially losing the rest before anyone else loses money, or leaving it all in the fund – in which case you’ll get the second loss, but all of your money is at risk.
Clearly, the New York Fed’s suggestion is a solution in search of a problem given the historical rarity of losses and of the insignificance of those losses, but it is chilling for a couple of reasons. Reason number one is that it pretty much eliminates the main reason for holding a money market fund, which is ready access to cash. People aren’t holding assets earning 0.01%, with 2.2% inflation eating away the real value every year, because they like the return. If you tell investors that they need to have 5% of their principal at risk, and that they may have to choose a gamble between a high-likelihood loss that would be capped at 5% and a lower-likelihood loss that is capped at 100%, the rational investors will simply leave. They may invest in short bond funds, commodity funds, or equity funds where there is much more risk, but at least their money is available with no advance notice. While this development is in a sense bullish for all other assets since it pushes potentially trillions of dollars out the risk spectrum, it isn’t clear to me that our biggest societal problem is that investors aren’t taking enough risk.
Reason number two that I hate this idea is that one destination for money market fund cash will be bank deposits. However, savings deposits are time deposits, and technically can be subject to similar sequestration. Some of the money will go into checking accounts, where it will doubtless burn a hole in many investors’ pockets. The biggest question about the inflation challenge that has been rising over the last year or two is, “how fast will velocity rise, when it rises?” If the Fed effectively forces money into checking accounts, among other things, the velocity of money will surely rise and the pace of the rebound in velocity will become that much more difficult to predict than it already is.
Speaking of velocity, Friday’s GDP figures allow us to make preliminary estimates about what M2 velocity was in Q2. The velocity of the transactional money supply last quarter fell slightly, to 1.5766 (Bloomberg calculation that closely matches my own). The pace of decline is slowing. The quarterly decline was -0.5%.
It doesn’t make a lot of sense to focus too much on quarterly wiggles, but since the big risk here is that velocity abruptly begins to rise (contributing to, rather than blunting, the rise in transactional money in terms of generating inflation) it is worth keeping in the front of our minds. Of course, velocity is a plug number so this doesn’t tell us anything we didn’t already know: we deduce it from the M, the P, and the Q. The trick is in knowing when V is turning and has turned, and as I have said before (see here, for example) there are some reasons for concern on that score.
Going back to the NY Fed study that I discussed above, here is another thought to ponder. Remember that the biggest single objection that the Fed has made against dropping the interest on excess reserves (IOER) charge is that it might damage the money market fund industry by making it impossible to preserve “the buck” if there are no instruments with yields that exceed the cost of operating the fund. And yet, this proposal puts those very same money funds precisely in the crosshairs. Personally, I think it would be just fine to have good-as-cash funds that didn’t guarantee a $1 price and indeed had a negative yield over time, so I don’t think dropping short yields would kill good-as-cash funds even if they weren’t technically money market funds because they traded on price. But changing the contract so that investors can’t get their money back immediately – that’s much worse, in my view; moreover, I don’t know why the reasoning couldn’t be extended to bond funds which are, after all, just as vulnerable to runs. That slippery slope makes me nervous.
.
Price action on Thursday and Friday in bonds and stocks was surely frustrating to observers of the macroeconomy. Weak economic data on Thursday and uninspiring data on Friday didn’t prevent 10-year nominal bond yields from rising 15bps (to 1.55%), real 10-year note yields yields from rising 7bps (to -0.61%), and equity prices rising 3.6% (basis the S&P). ECB President Draghi’s apparent determination to support the Euro with every tool at his disposal is mainly to credit for the mid-week about-face. The question that the markets have to consider, and Mr. Draghi as well, is the question of what that toolkit actually contains. There is some evidence that the Bundesbank doesn’t believe Mr. Draghi has quite the authority he thinks he does, and this weekend Draghi and the Bundesbank President are meeting to discuss their differences.
I think that equity markets are overvalued and are over-anticipating QE3 (although I agree that it is coming soon). There isn’t much going for stocks other than QE3, although if the Fed starts taking potshots at low-risk investing alternatives it will help them. I can come up with arguments for extending this rally further, but they all depend on a bunch of faith and a little luck. I am trimming what small equity investments I have, and raising cash allocations. Since the VIX is also quite low considering the kaleidoscope of large risks, I may also buy puts on the S&P.
Happy $10 Trillion Day!
It seems that few people look at M2 money supply these days, so the fact that the odometer on the key money supply gauge rolled to $10 trillion today seems likely to remain unlamented. The trip from $9 trillion to $10 trillion took a mere 66 weeks, half the time that the trip from $8 trillion to $9 trillion took. The robust growth of money supply, even though money velocity continued to decline over most of the period (we will find out whether it declined in Q2 when tomorrow’s GDP figures are released), is clearly implicated in the rise of core inflation over the same period (see Chart, source Bloomberg).
The pace of M2 growth recently has softened to only 8.4% over the last year, and is likely to fall further over the next few weeks as the end-of-July spike from last year falls out of the data. Yet even a decline to 7% implies a faster rate of core inflation, unless velocity continues to decline as well. As commercial bank lending growth is now growing comfortably faster than 5% per year (most recently at 6% over the prior 52 weeks), this seems a bad bet, and I continue to expect core inflation in the U.S. and in other developed countries to move higher rather than lower.
The Fed, as it readies QE3, will not be acting alone. This is made evident by ECB President Mario Draghi’s statement this morning that “Within our mandate, the ECB is ready to do whatever it takes to preserve the Euro. And believe me, it will be enough.”
And yet, as of yesterday, Greek bonds are no longer good collateral at the ECB. The reports from the Troika out of Greece seem to make plain that no more rescue money will be headed to that country. I will note that a “planned” exit of Greece from the Euro, or at least a planned default, would surely include the refusal of Greek bonds as ECB collateral, because otherwise upon the event the ECB would be suddenly vastly undercollateralized or uncollateralized on its loans to Greek banks – not a good idea. I won’t go so far as to predict that Greece is about to be squeezed out of the Euro, but it is consistent with the following:
- Increased discussion of QE3 and the mooting of the question by presumed Fed mouthpiece Jon Hilsenrath of the Wall Street Journal.
- The ECB’s decision at its last meeting to cut the deposit rate to zero, and recent discussion of the possibility of a negative rate, even as Euro M2 last month rose to its highest year-on-year growth rate in several years (albeit still a feeble 3.4%), shows a renewed determination to get the pendulum of monetary policy swinging in a positive direction.
- The rejection of Greek bonds as good collateral at the ECB, as mentioned above.
- The story in Der Spiegel that declared the IMF wants to cut off Greek aid, which is after all a reasonable thing to do the moment it is clear that it has no chance of staving off Greece’s collapse and exit from the Euro.
- Increasingly us-against-them comments by Greek Prime Minister Samaras, who sill be responsible for rallying his country’s spirits and economy after the exit.
The timing of a Greek exit from the Euro is perhaps not ideal – that would have been last year, before so much money was wasted, when the European economy wasn’t yet in recession, and when the U.S. economy at least had some positive momentum – but it is not likely to get much better. From the Fed’s perspective, the timing of additional easing will get more difficult, especially if the domestic economy awkwardly begins to zig-zag back up. It is much more politically astute to do QE3 after a horrible Durable Goods number (like today’s, which pushed the 6-month average change in core Durables negative for the first time since 2009) than it would be to do it when it was obviously done to help Europe.
Moreover, headline inflation has recently dropped below core, but it will not stay below core for long as gasoline and food prices have recently begun to rise. So there is a limited window during which the doves can point to domestic economic weakness (this window may not be so small, but you never know) and the hawks can claim they see no inflation evil even with core inflation sitting at the Fed’s target. The Fed’s contribution would very likely be to drop the interest on excess reserves (IOER) charge to zero, which would also harmonize deposit rates with the ECB. This would be a significant policy move, spurring even more lending, while not looking as significant as a QE3 that involved further bond-buying.
In short, I think you should say your goodbyes to IOER and to Greece, because I expect neither of them is going to be around for very long.
There was another interesting development last week – a very significant story whose implications seem to have been largely overlooked. I will discuss this story, which has near-term bullish implications for both stocks and bonds, tomorrow.
It Turns Out That Margins Matter
A mild surprise on Monday afternoon from Alcoa, which beat a significantly-lowered consensus estimate, wasn’t enough to sustain stocks overnight. Another pulse higher came when the broader group of European finance ministers completed the Memorandum of Understanding (MoU) for the Spanish bailout, which included a provision for €30bln of the money by the end of the month. This rally too failed, and the reason Bloomberg cited was funny.
Bloomberg said “U.S. Stocks Fall on Earnings Pessimism…” According to the article, “profits for the entire S&P 500 are projected to have fallen 1.8 percent.”
That’s funny, because it suggests that this is somehow a surprise, today. Analyst forecasts have been coming down, to be sure, but they’ve been weak on Q2 for a long time. And profit margins have been at very high levels for a while now (see Chart, source Bloomberg), so downward pressure was overdue.
Combine weak growth with rising cost pressures and you will eventually get margin compression. The chart below (Source: Bloomberg) shows the spread of core CPI minus core PPI, in white, plotted against the trailing 12-month EPS of the S&P 500. Note how when the spread of output prices (CPI) compared to input prices (PPI) is widening, it augurs well for profits one-year or so forward, and vice-versa.
Really, the remarkable thing is that earnings have remained elevated for so long, even though producer prices have been increasing faster than consumer prices for a while now. My theory is that since that spread is narrow, and the labor market is very weak, there were ample opportunities for employers to squeeze just a bit more out of their workers. This shows up, of course, in improved margins. But – and just as important, if not more so – it is a game that cannot continue forever. Unless producer prices stop rising faster than consumer prices, earnings are going to come back down to earth. So investors find themselves with a bit of a conundrum. If CPI accelerates, this is good for earnings (as long as it outpaces PPI!) but bad for multiples historically. If CPI stays down, then unless producer prices slacken appreciably, the current earnings are unsustainable. I will say it again: stocks shouldn’t be up here.
Incidentally, I wouldn’t read too much into the apparent correlation of levels on the chart above. Over time, the yellow line will clearly move up and to the right, while the white line is designed to be mean-reverting. If I had the data, I’d make the yellow line the year-on-year change in earnings and see how the correlation holds up over time.
.
This is my last article for a couple of weeks. I am going to be traveling to Texas and Colorado, with family and to visit family, until late in July. Enjoy the silence!
The Importance of Being Clueless
We wrote off last week’s dull equity trading to the fact that the U.S. had a holiday in the middle of the trading week. Despite some interesting data, including weak Employment news on Friday that moves us closer to another Fed action (as I wrote on Friday), trading was lethargic. I’ve been chronicling the decline in equity volumes for a while now. It has become unusual to break 900mm shares unless there is an options or futures expiration, or a month-end. Cumulative year-to-date volumes are only 81% of last year’s volumes, and only 58% of the last 5 years’ volumes (see Chart, source Bloomberg).
Sure, some of this is due to the moving of share volumes off of traditional exchanges, but that doesn’t explain that much of the trend – if you measure other volumes, instead of NYSE volumes, you get a similar story. I hold that a lot of this is due to the crusade against high-frequency trading (some of which is actually market-making), some of it is due to new SEC and CFTC rules concerning reporting, and a significant part is due to Volcker Rule restrictions. Hopefully, some of it is also due to public disenchantment with the stock market as a path to easy wealth – that would be a healthy development.
But we’re not exactly going through a boring time in the markets. Just a couple of weeks ago we had a really exciting European summit, and on virtually every day since we have unwound the significance of what happened then. Today, ECB head Mario Draghi said that the ESM (which is supposed to recapitalize Spanish banks) will not be functional until 2013. Oh, and Italy and Germany still need to give their final approvals.
Spanish yields in the meantime continue to slip higher, with the 10y Spanish yield back above 7% today. U.S. bonds weren’t asleep: the 10y Treasury rallied 4bps to 1.51% (10y TIPS rallied to -0.60%). But stocks snoozed, even when President Obama announced his intention to seek an extension of the Bush tax cuts for all taxpayers earning less than $250,000 per year. That ought to have launched stocks higher, and in years past certainly would have. It’s a bad sign for the President when the market takes his big announcement as being nothing more than a cynical political ploy. Hey, even if it is a cynical political ploy, it ought to be supportive of equity values since it removes one reason to sell stocks this year to take gains under a lower tax regime!
Commodities certainly weren’t asleep: the DJ-UBS added another 2% today, with across-the-board strength in Crude (+1.8%) and Gasoline (+1.6%), Grains (+3.6%, now up 25% over the last month), Softs (+2.0%, up 12.6% over the last month), Precious Metals (+0.9%), and Industrial Metals (+1.0%). Where did that come from?
I admit to bias here. Readers know that for a long time I have been pounding the drum for commodities as the cheapest conventional asset class (and which provides inflation protection besides). Partly, this rally – for the DJ-UBS, it’s 7% over the last 7 trading days – is due to the asset class being semi-loathed and certainly under-owned. Yes, grains are shooting higher because of Midwestern drought, but what about Nymex Crude? Sugar? Coffee?
I think there may also be an inkling from the so-called ‘smart-money’ along the lines of what I wrote Friday. The weak data recently increases the odds of QE3, at least in the form of an elimination of interest paid on excess reserves. Europe has already taken that step, with some immediate effects:
- JP Morgan, Blackrock, and Goldman closed their European money market funds to new money after the ECB lowered the floor rate. This was the Fed’s stated fear, that ultra-low rates could cause the money market industry to close down. Then who would buy the Treasury’s TBills?!
- The first French T-Bill auction after the ECB rate cut resulted in negative yields (for the first time), joining Germany and the Netherlands in doing so. It turns out that all we will do by letting the money funds go out of business is to save a layer of fees! By the way, I still think that if money funds just reorganize into a form where there is no forced $1 share price, then problem solved. Maybe that takes legislation, but it certainly insurmountable.
- Commodities launched higher. While the launch occurred prior to the actual rate cut, it wasn’t like the cut was a complete shock.
The real question, as central banks eliminate these floors, is what happens next. What should happen if the Fed stopped paying interest on excess reserves, or made it a penalty rate?
The Federal Reserve has made much ado about how their large-scale asset purchases (LSAP) have “acted like” a further easing of interest rates. But I am not so sure of that. The money went into vaults, and short term interest rates didn’t decline. The effect on longer-term interest rates is unclear – while it’s plausible to think a ‘portfolio balance channel’ drove long-term rates lower, it’s hard to read the magnitude of such an effect with the huge amount of noise from changing issuance patterns, various flight-to-quality events, and so on. If the Fed wants to see how much LSAP affected short-term interest rates, then let the market find the clearing price! If the Fed declared that there would now be a -2% penalty rate to keep money at the Fed, I have no doubt that the clearing rate for overnight rates in the U.S. would be clearly negative. And there’s nothing at all wrong with that, philosophically. Repo rates already trade negative from time to time, as do T-Bills. The market can cope. Really.
But if the Fed did that – said “take your money back,” essentially – where would it go? It would definitely in that case push the short end of the yield curve even lower, perhaps even out to 2-years, and by extension the entire curve would be affected since longer-term rates are after all just impounded expectations of short rates.[1] More importantly, some banks would choose to make more loans rather than endure negative carry on reserves. With commercial bank credit now growing at a post-2008 high rate of 6.0% over the last year, this seems less important, but if the Fed believes they can do something about growth, this is the thing they can do and I think a prime candidate for what they will do. Some of this cash also will flow into assets that historically earn zero real returns: commodities, for example.
Now, in Europe it is harder to figure out what will happen. If banks can give money back to the ECB rather than experiencing increasing negative carry, they may. I don’t remember if the LTRO allows that. European banks seem to be increasingly stuffed to the gills with sovereign paper, and are probably less able than U.S. banks to extend loans given the sorry state of their balance sheets. Gold at least stores well, but there’s a lot of volatility there, and it means dollar exposure as well.
I don’t know the answer, but the freeing of short rates to go negative is potentially a game-changer. I think it’s far more important than more asset purchases, especially because investors are likely to be somewhat clueless about how important it is and what it should do to the inflation outlook. That cluelessness is important, because the last thing in the world that central bankers want to do is “unanchor” inflation expectations. (Personally, I don’t think inflation expectations matter, but the important thing is that the central bankers think so).
[1] Well, okay, they’re not “just” impounded expectations of short rates, but in many ways they behave like that, so if we allow negative short rates then we impound lower expectations in longer nominal rates and they should decline.
The Choppers Are Warming Up
Today’s market selloff owes much to the people who put together the ADP figures (that is, Macroeconomic Advisers). Yesterday’s cheerful ADP report raised expectations for today’s Employment report. Unfortunately, those expectations were dashed. The U.S. economy generated 80,000 new jobs in June, which wasn’t far statistically speaking from the Bloomberg consensus of 100,000 but was far from what investors were hoping for. The economy has now expanded payrolls at the blistering pace of 75k per month over the last three months. Wow!
The Unemployment Rate nudged slightly higher to 8.217%, although unchanged on a rounded basis.
It wasn’t a horrible report, just horrible compared to what investors were expecting. The stock market judged the labor market progress harshly, with the S&P losing -0.94% although it was down more than that for most of the day. It didn’t help that European markets were getting smacked again, with Spanish 10-year yields +53bps and Italian 10-year yields +25bps. It was revealed today that another of the key summit concessions, the fact that the ESM would lend directly to banks rather than to the Spanish government which would then lend on to banks, won’t actually happen in practice. First of all, the Troika report which was to precede the signing of the memorandum of understanding wasn’t ready on time (because you know, they probably have more-pressing problems than the €100bln hole in Spanish banks). Second of all, the ESM isn’t ready yet, so any money going to banks will have to pass through the sovereign and that messes up the whole works. Moreover, a senior EU official reportedly said today that the mechanism of having the ESM lend to the banks was only to “cut out the effect of that loan on the debt-to-GDP ratio of the sovereign…It remains the risk of the sovereign.” So, again, financial legerdemain over substance.
Moreover, if the Spanish banks can’t or won’t buy Spanish bonds, and the ECB won’t buy any more Spanish bonds, who is going to buy the Spanish bonds? Apparently, this is something of a question or 10-year yields wouldn’t be back near the crisis highs (see Chart, source Bloomberg).
Commodities finally reacted to the weak turn in the growth story, and the further rise in the dollar, by declining today. The energy sector, let by Nat Gas, fell 3.1% (Natty was -5.4%). The DJ-UBS index was -2.3% (although our preferred commodity index vehicle, USCI was only -1.2%). U.S. bonds rallied, with 10-year real yields -2bps and 10-year nominal yields -5bps. Ten-year inflation expectations as reflected in US CPI swaps fell to 2.39%, the lowest since January although well above the lows of last year.
In the jobs report, Average Hourly Earnings provided an upside surprise, with the year-on-year rate of earnings increase rising to 2.0%. As I’ve said in the past, though, wages follow inflation so this isn’t particularly important to the inflation outlook. Potentially more-significant is the fact that M2 money supply growth on a year-on-year basis fell yesterday (largely from base effects) to +8.0%. While that’s still quite high (if we had real growth of 2.5% and velocity was stable, it would imply inflation of 5.5%), it is the lowest it has been in almost one year. Further base effects could bring M2 down to the 6-7% range over the next couple of months, which is still too high for comfort but which will help Chairman Bernanke build the internal coalition for additional easing as some of the traditional monetarists conclude they can stop worrying about the money supply. In the next few weeks, M2 will surpass the $10 trillion mark, but this is likely to go unremarked and unlamented. Today’s Payrolls report, along with the ebbing M2 growth and continued malaise in Europe, raises significantly the likelihood of near-term Federal Reserve quantitative easing.
Green Acres Is The Place To Be
The repudiation didn’t take very long to begin. Despite good economic data and generous central bank action, stock markets sank in Europe and the U.S. and the U.S. bond market rallied with both real and nominal 10-year yields falling 3bps.
The ADP jobs report produced a 176k gain, compared with expectations for +100k, provoking some economists to raise their expectations for tomorrow’s Payrolls gain. ADP is an imperfect measure, but it gets the sign right more often than not. Initial Claims were also slightly stronger than expectations, but more significant were the actions of central bankers globally. The Bank of England announced an expansion of their Quantitative Easing program of another £50bln. Accounting for the size of UK GDP compared to US GDP, as well as the UK/US exchange rate, that works out to the equivalent of roughly a $500bln increase if the Fed wanted to do the same thing, so it isn’t a small measure. The People’s Bank of China and the ECB acted (apparently coincidentally) in near-unison, with both cutting rates. Significantly, the ECB cut its deposit rate to zero, so all banks that took LTRO and left the money on deposit at the ECB are seeing their negative carry on that deal worsen. Denmark also cut its deposit rate sharply – in that case to a sub-zero rate. More on the zero and sub-zero deposit rates, later.
And yet, global equities dropped, in some cases sharply.
This may be somewhat related to the slow-motion repudiation of the “progress” made at the summit last week. German Chancellor Merkel said the deal cut at the Euro summit last week doesn’t mean that German has taken on any additional liabilities. This echoes what I said on Monday:
What in Merkel’s history or makeup would make you expect that she would cave in to foreign leaders, especially just one day after she had been so hostile to Eurobonds? Isn’t it much more likely that she doesn’t see the new deal as being a big deal, since it doesn’t involve much new money?
The old riddle goes Question: “How can you tell if a politician is lying?” Answer: “Her lips are moving.” Never, never accept the joint statement of a summit meeting as representing anything useful, and certainly not truth. In the wake of the good economic data and the robust central bank actions, Spanish 10-year yields rose 36bps and Italian yields rose 21bps.
The dollar reached one-month highs today, but here is the interesting part: commodities reached two-month highs. Believe it or not, since the end of March the DJ-UBS commodity index has now outperformed stocks, thanks mainly to the rally over the last week.
That rally, to be sure, owes a lot to the energy and grains complexes. Energy is up partly because the “tail risk” of a renewed global depression seems to have receded somewhat in some investors’ minds and partly because of renewed tensions in the Middle East (with Iran drafting a bill that would adjure its military forces to try and stop tankers from passing the Straits of Hormuz en route to countries that are sanctioning the nation, and the US reportedly stepping up its military presence there). And grains are up primarily to poor weather conditions in the Midwest, which has led to downgrades on the expected crop yields.
Those are the excuses, but remember one advantage that commodities have over stocks is that commodities tend to “crash” upwards (they are statistically positively skewed and positively kurtotic) while stocks more often do the opposite. Sharp moves higher, especially after a long period of being beaten down, are not unusual in commodities.
That said, real grains prices are not at all-time highs. Not even close, although nominal corn prices are near all-time highs and real corn prices are about to reach the highest level since the early 1980s (see Charts, with real wheat prices first. Ignore the absolute level of the y-axis, which is an artifact of the formula “commodity price/CPI price level * 100”).
In fact, the huge rally in corn prices since 2005 has done nothing more than to cause the long-run rise in corn prices to just about exactly equal the long-run rise in prices generally. From December 1969 until now, headline CPI has risen around 509%, while front Corn futures have now risen about 536%. While Corn, since it’s not a storable commodity, doesn’t have the automatic tendency to a zero real return that, say, gold or copper does, in the long run it should still rise in the general direction as the overall price level. The languishing of grain prices for most of the 1980s and the 1990s helped speed the demise of the small farmer although it was beneficial for the development of emerging economies and our own. But, as with other trends that have tended to dampen inflation – apparel prices come to mind – this one seems that it may have run its course. How surprising would it be to find grain prices actually rising with overall inflation again?
.
The actions by Denmark and the ECB to cut their deposit rates to or below zero, and the opposite prescription mentioned today by San Francisco Fed President John Williams, recall to my mind the prescription I’ve mentioned many times in these pages. The key link between QE and inflation isn’t base money, but transactional money (I generally use M2). These two have always been closely related, until the Federal Reserve began to pay interest on excess reserves (aka IOER).
IOER is basically the barn door holding the monetary horses in. Traditionally, it has been okay to look at the monetary base with respect to the MV≡PQ equation – not because it was right to do so, but because the relationship between the money base (which the Fed controls directly) and transactional money was very regular. That is why some inflation-phobes got really terrified when the Fed was doing QE, while those of us who focused on the significant part of the relationship perceived that inflation would come, but much more slowly. While base money exploded, M2 did not explode, simply because the Fed was paying banks not to lend it.
Money sitting in vaults, unlent, to a large extent doesn’t act like “money” at all (it is a store of value, but not a medium of exchange!), which means it doesn’t pressure prices since it has never entered the flow of commerce. There may be “too much money” and “too few goods,” but there was no “pushing,” or at least not as much as the rise in base money would have suggested. Because, again, because the Fed was paying IOER and therefore incentivizing banks to be more hesitant to lend.
If excess reserves yielded zero, or especially if there was a penalty rate, all of that money would have been lent and M2 would have exploded. This is the policy that the ECB and (less-significantly) Denmark are following. As noted above, banks have negative expected returns on the LTRO funds sitting at the ECB. Some of those funds will stay there simply because there is an insurance value to liquidity. But at the margin, if a bank can make a loan even if it has an expected loss, as long as the loss is smaller than the guaranteed loss of keeping money at the ECB then it will have a tendency to do so.
The problem with IOER is that we don’t know how sensitive the money multiplier between base money and M2 is to IOER….since we’ve never had IOER before.[1] So – we don’t know whether those reserves will slowly leak into the system, or if a 10bp change in the IOER would have a huge effect, or none at all, or what. The ECB also doesn’t know this, but they obviously sense that it’s now or never, and before they do another QE they ought to free up the first one. It seems like a fairly innocuous move, and will produce fewer fireworks than another LTRO (it may be that disappointment about the lack of an LTRO was part of the reason for weak market reaction today), but in fact it may well be more significant.
All in all, it may be better to be a farmer than to be a policymaker!
[1] When I wrote this sentence it sort of reminded me of the line in Dr. Seuss’s “Bartholomew and the Oobleck,” when the magicians tell the king, “We just can’t tell you any more/we’ve never made oobleck before.” And the similarities don’t end there. “IOER is gooey, it’s sticky, it’s like glue.” “If it sticks up robins, then it will stick up people too!” And so on. I wonder if Seuss was a policymaker wannabe.
Slow-Motion Repudiation Yet To Come
After a huge rally like we had on Friday, it’s often prudent to wait for at least one trading day to see whether the move will be instantly repudiated, or whether the repudiation will take place over time.
Here’s how I see the results of the Euro summit. A bunch of heads of state agreed to a package that increases by a little bit the total amount of capital committed (not the €120bln of the headlines, as the headlines included some programs already planned), makes some concessions to help Spain, and makes some important improvements in the way money is to be dispensed and the seniority of the claims of the EU authorities in such a case. Nothing has been approved by any legislatures, and nothing is to go into effect very soon.
It’s a useful step, but merely a step; the perception of success was enhanced by the convenient fact that the conditions of quarter-end raise the costs of incredulity. Better to go along, for at least the last day, and keep from ruining a quarter of good trading! That’s why a modest step forward was worth 20 S&P points, as well as 40-50bp rallies in the 10-year bonds of Italy and Spain, which in turn produced a palpable sense that this time, the Eurocrats sounded the right note.
It was better, to be sure. Subordinating the bailout money to the claims of holders of sovereign debt was critical, since otherwise yields would have gone to the moon in very short order. Make no mistake, if push comes to shove the authorities will still do a cram-down, but at least they seem to understand why they don’t want to make it obvious now.
I always find amusing how important “narrative” is to the markets. Investors cling to a popular narrative point even when it makes little sense. I heard on Friday that Merkel “conceded when surrounded by foreign leaders.” Really? What in Merkel’s history or makeup would make you expect that she would cave in to foreign leaders, especially just one day after she had been so hostile to Eurobonds? Isn’t it much more likely that she doesn’t see the new deal as being a big deal, since it doesn’t involve much new money?
But the market jumps were so powerful psychically that moves were mostly sustained today even though the predictable chinks appeared in the story. Crude oil jumped 9.4% on Friday, as well as copper, coffee, gold, and other commodities as the dollar dropped sharply. They sustained most of those gains today as the DJ-UBS closed +0.2%, even though the buck rallied some. It makes sense, if commodities have been beaten down so badly on the disaster scenario, that any whiff that the scenario might not come to pass should send them skyrocketing. Not that I think that commodities really need global growth to accelerate in order to do just fine, but the asset class is out-of-favor, widely scorned, and under-owned for the first time in several years so it shouldn’t take much to provoke a rally.
Equities, up sharply on Friday, added another +0.25% today (on the S&P), again extending the prior gains as the narrative continues to beat. Bonds, on the other hand, reversed their Friday selloff to rally today, almost wiping out Friday’s loss. It seemed the bond guys were the only ones to notice that the Manufacturing ISM printed its lowest level (and first sub-50) since 2009 (see Chart, source Bloomberg).
The last couple of months have seen a rather sharp fall. There are more important data this week than ISM – Employment on Friday, for example – but this is somewhat disturbing, especially after the Milwaukee and Chicago purchasing managers’ reports late last week both exceeded expectations slightly. The 2-month change in the ISM is actually the worst 2-month fall since December 2008, worse even than the post-Japanese-earthquake setback. So it’s not just the level, and not just the direction, but the rate of acceleration that’s disturbing. Again, though, it’s just one piece of a data collage.
As for those predictable chinks, how about this one: Finland declared that it, along probably with the Netherlands, will prevent the ESM from buying sovereign bonds in secondary markets. Well, whoops! The decision to use the new entities to stabilize markets was kinda sorta one important development to come out of the summit. And, while technically the summit wasn’t about Greece, it can hardly be productive that, hard on the heels of a new Greek government being installed (and one elected on a platform of renegotiating the austerity measures so as to remain in the EZ), the ECB told Greece not to hope for any concessions or aid such as Spain has received.
I suspect that we are going to see, shortly, yet another re-think about the prospects for Europe. But while it’s easy for me to see that I am still not excited by the prospects for equities, it is harder for me to see where bonds are likely to go, near-term. The knee-jerk reaction, conditioned over decades, to every piece of bad economic data is to buy Treasuries. But at 1.59% for the 10-year note, we are clearly not just pricing in weak economic data. With core inflation at 2.3%, and 10-year inflation expectations at 2.40%, we are clearly not pricing in deflation or disinflation. I can’t think of any reason to buy bonds here, and even if I was running an LDI program that needed to be 100% in fixed-rate bonds to be immunized, I’d buy inflation-linked bonds as a surrogate that has pretty much only upside (relative to nominal Treasuries!) from here. But that reasoning was the same at a 2% 10-year note, so the glass remains dark to me. I will say that our “Fisher decomposition” model (which sounds a little bit like a mortician’s dissertation, come to think of it) is indifferent on being short the bond market through being long inflation or being short the bond market through being short TIPS – it is simply short nominal rates, but importantly at a leverage ratio below 1.0. I suppose that matches my view: bearish on bonds, bullish on inflation breakevens (e.g. through RINF or INFL, neither of which I currently own), but very cautiously in all cases.
