E-piphany

It is true, the economic data is not singing harmoniously. Employment not only remains weak, but seems as if it may be weakening again; housing was temporarily pumped up by government action but it appears that nothing permanent was occurring as a consequence of “Cash for Cottages.” There are three ways to resolve divergences (1. the stronger returns to the weaker; 2. the weaker catches up to the stronger; 3. they meet in the middle), but rather surprisingly – since the preferred method in this case is (2) and (3) is the most common way – it appears that in the case of the housing data the huge surge last year in Existing Home Sales relative to New Home Sales (see chart, source Bloomberg) is being resolved in favor of weakness-for-all after Friday’s surprising continued plunge in Existing Home Sales.

Big divergence of Existing and New Home Sales is being resolved.

All, of course, is not bad news. The Chicago Purchasing Managers’ report made economists 0-for-2 on the day by coming out stronger than expected, a point which augurs well for Monday’s ISM national report (Consensus: 57.5 from 58.4, although the consensus would probably be higher if they had taken the survey after Chicago PM).

But non-synchronous data is nothing new. Rarely are all the data singing from the same hymnal, except for that reasonably brief period in the middle of the expansion or contraction when almost everything is pointing the same way (and by then, you may already have missed the meat of any market move…which is not to say that that the market anticipates correctly with a very good batting average, but it does anticipate and sometimes it is right!). The challenge for the analyst is to discern the consistent story that explains the data in the clearest and cleanest way possible.

The consistency of the story is in the eye of the beholder, to be sure. Dad’s explanation in the dialogue below (taken from this link) is consistent, if wrong:

Calvin: How come old photographs are always black and white? Didn’t they have color film back then?
Dad: Sure they did. In fact, those old photographs are in color. It’s just that the world was black and white then. The world didn’t turn color until sometime in the 1930s, and it was pretty grainy color for a while, too.
Calvin: But then why are old paintings in color?! If the world was black and white,
wouldn’t artists have painted it that way?
Dad: Not necessarily. A lot of great artists were insane.
Calvin: But… But how could they have painted in color anyway? Wouldn’t their paints have been shades of gray back then?
Dad: Of course, but they turned colors like everything else did in the ’30s.
Calvin: So why didn’t old black and white photos turn color too?
Dad: Because they were color pictures of black and white, remember?

So when we look at the data and see employment growth weak/negative and perhaps stalling, while manufacturing surveys are quite strong, one simple narrative (that we see a lot) goes like this: “Employment always lags the economy. We are in an expansion, but jobs haven’t caught up yet.” Some analysts will even go a bit further and by calling it a “jobless recovery,” assume away the weakness in employment altogether.

But the narrative that says the economy is enjoying  normal recovery and jobs are just lagging runs into problems when we start adding data points from other sectors such as an abrupt re-weakening of housing and a drop in consumer confidence. It cannot simply be that employment is lagging. Something more is happening (or, rather, something less than a normal recovery is happening).

I think that we need to be careful about getting too cheerful about things like Philly Fed, Empire Manufacturing, the Chicago PM, and the ISM. One reason that caution is due is that all of these reports share the characteristic that they are surveys of relative measures. That is, in each case respondents are asked how business is shaping up this month relative to last month. When things are near normal, then a comparison to last month is easy, and not a bad way of taking the economy’s temperature. When things are coming off a deep recession, I can certainly imagine that it is somewhat difficult to ascertain just how much better things are now than they were last month, and probably any improvement at all tends to be noticed. Also, since the surveys are diffusion measures, a broad but weak recovery will register high on the surveys. This isn’t a problem in normal times since a broad recovery tends to also be a strong one; coming out of a crisis, though, any company which hasn’t failed has a decent chance of doing better from one month to the next.

These are very different from surveys of absolute measures. In the Conference Board’s Consumer Confidence survey, one of the questions concerns whether jobs are “hard to get” or “plentiful,” and the economic environment is graded as “good” or “bad.” It is very easy for me to create an understandable narrative here: high surveys of relative measures, combined with low surveys of absolute measures (and weak enumerative data reports like Initial Claims and Housing) suggest that things are getting better, but they’re still pretty bad and, I suspect, vulnerable to further setback.

In addition to the aforementioned ISM, on Monday we also see Personal Income (Consensus: +0.4%) and Spending (Consensus: +0.4%), which report also includes the Core PCE index. The ISM is for February and Personal Income is for January, so ISM is probably more important near-term for the market.

It looks like it will actually be a 5-day workweek. President’s Day and then the blizzard have conspired to give us only about seven tradeable days over the last couple of weeks, and now that the Olympics are over CNBC can go back to talking about the day’s markets instead of their afternoon programming, which briefly led me to believe that CNBC stood for “Curling, Nothing But Curling.” (Not that I wait breathlessly for CNBC’s analysis. I strongly suspect that they will be bullish on stocks).

Last week ended with 10y yields are 3.61%, and the inflation market pricing forward calendar-year CPI as follows:

2010: 1.2%

2011: 1.7%

2012: 2.1%

2013: 2.5%

2014: 2.7%

2015-2020: 2.9%-3.0%

This seems darn optimistic to me. If this pattern of inflation actually obtains, along with reasonable growth, then stocks might not be as overpriced as I think they are. But that’s a narrow branch, and there are lots of ways to fall off it. Maintain a healthy margin of safety, as always!

The big storm we were supposed to get rages on, I suppose. So far, it is underwhelming – due predominantly to the fact that the temperature today was well above freezing, which tends to limit accumulation. The 18-24 inch total that my town was supposed to receive is less than a handful of inches at this point. Isn’t it just like meteorologists to neglect thinking about something like the temperature?

In related news, stock market investors continue to do their best to neglect thinking about the macroeconomy. Stocks took a dive early today, with the S&P down around 20 points early on, as the economic data surprised on the negative side for the third day running. At some point, a repeated occurrence starts to look like a trend, and while I am not too impressed by the big miss in Durable Goods (core durables -0.6% versus expectations for +1.0%, although with an upward revision to the prior month it doesn’t look as bad but the trajectory worse), the surprise in Initial Claims probably should no longer be a surprise. With economists guessing an improvement to 460k…continuing to refuse to believe the last month’s worth of data…Claims instead worsened to 496k. Since this was the survey week, expect some changes to economists’ forecasts for February Employment, due next Friday.

The rise in Initial Claims is getting quite hard to ignore. Not only is the series failing to continue to improve, it arguably may be worsening again (see Chart, source Bloomberg).

Not yet definitively heading higher, but definitively not heading lower!

This is actually more alarming than you might think, even if the true rate of ‘Claims is around 450k-475k. Why? Because that is just where Claims were prior to September 15, 2008, when Lehman declared bankruptcy. In other words – all of the “improvement” we have seen in the data over the last year has done nothing but retrace the unsustainably-bad data we saw immediately following the financial calamity. All of the king’s horses and all of the king’s men haven’t managed, despite all of the liquidity added and all of the government spending thrown away bravely committed to the fray, to improve what was the underlying condition of the economy prior to Lehman. Payrolls, too, show the same thing: in the six months ended July 2008, the nation lost 144k jobs per month; in the most-recent six months, 128k per month (with Dec and Jan yet to be revised).

Until now, the rejoinder to that observation could have been “but in August and September 2008, things were worsening; now, they are improving, so they are just ships passing in the night.” That argument seems a little more forced when the recently-improving trend – in employment, housing, confidence – has stopped improving.

To the list of things that have stopped improving, we must add the fortunes of corporate America. The stock market has seemed tired and aimless recently, although at the current level the S&P is still beneath where it was in the summer of 2008 (mid-1200s), so maybe it’s cheap (just kidding…it was just really rich back then!).

It may be that we have just hit one of those inevitable ebbs and flows in the data. But I am struck by the fact that we have hit a wall right here…right about where Humpty originally fell off it. I suppose I should have anticipated that; to the extent that government spending crowds out private spending (which it does by sucking all of that money up when it issues bonds), there should be no lasting effect from that government spending unless it alters economic incentives sufficiently (and salutatory changes in economic incentives tend to derive from tax changes, not from spending changes). I’m just surprised it seems to have worked that way so cleanly.

In the natural cycle of things, eventually, people get tired of hunkering down and start to look for things to change for the better. If the government merely stays out of the way, the natural tendency of people to believe that bad times eventually get better will lead to organic economic growth. So far, we can’t seem to trust the government to stay out of the way, however. We needed one or two of the Fed actions (although it wasn’t clear at the time just which ones until they finally created the Commercial Paper Funding Facility and bank liquidity improved almost overnight), but I wonder how much better off we would be right now if Congress had just stayed out of it.

On Friday, economic data includes the unexciting revisions to Michigan Sentiment and Q4 GDP. No major revisions to these data are expected. More interesting are the Existing Home Sales for January (Consensus: 5.50mm from 5.45mm), which economists still think will bounce in the same story as the New Home Sales reasoning went: a big plunge last month on the original expiry of the homebuyer tax credit should be retraced this month. Or so they say. As before, this is sort of a one-sided risk: a bounce is roughly expected; a continued deterioration is bad news.

The first good look at February data, in the form of Chicago PMI (Consensus: 60.0 from 61.5). The last print was higher than any reading in 2007, before the crisis…but remember that this is a rate-of-change measure. Business that is recovering from a deep recession should be improving at a high rate. It would be very disturbing, but consistent with the other recent data, to see Chicago PMI back into the mid-50s although that would represent a large decline indeed.

For the second day in a row, the economic data fairy left a lump of coal in the market’s stocking. January New Home Sales, expected to show a bounce-back from last month’s decline, instead fell significantly further. The 11% decline took the annual run-rate to just 309,000 units. That’s not just disappointing, it’s an all-time record low (see Chart, source Bloomberg, below).

Not just low, but the lowest ever.

The presence of massive government stimulus always makes it difficult to tell what is happening, organically, beneath the stimulus. Late last year, when home sales were bouncing, however feebly, it was not easy to discern how much of that was true organic growth – a turn in housing market fortunes perhaps sparked by the government tax credits – and how much was merely pulling demand forward. Sometimes, it’s impossible to ever tell: if the bottoming in New Home Sales happened to coincide with the onset of government stimulus, there would be no way to tell how many New Home Sales were “created or saved” by the stimulus compared to the natural growth that would have happened anyway simply because the economy was enjoying the upside of a natural oscillation.

It now appears, though, as if there was never a turn in the market after all. It appears, right now anyway, as if a large proportion of the bounce was in fact due to the pulling of demand forward from 2010 to 2009. Certainly, it is difficult to make the argument that we’re better off having spent the money to goose the housing market, since it didn’t stay goosed.

I am sure that some observers will blame the weather in January. Perhaps that is some of the underperformance, since the biggest decline in sales was in the Northeast. But I seem to recall that the weather in January is usually pretty poor and the seasonal adjustment provides for much of that.

Now, the good news here is that most home sales don’t happen in January, so a disappointing seasonally adjusted run rate in January is not as bad as a disappointing rate of sales in late springtime. But it’s still bad news.

Equity market participants, however, seemed not to care much. Stocks came into the day on fire and, after briefly retracing some of the gains on the New Home Sales data, launched higher to end the day +1% while bonds languished (a weak sale of 5y notes didn’t help. Sometimes $42bln really feels like $42bln!).

So stocks didn’t care about weak home sales or, more likely, they cared more about Chairman Bernanke’s reassurance that the Fed isn’t going to be raising any relevant market rate (whether the Fed Funds rate or the Interest On Balances) any time soon. Although he merely repeated the “extended period” language, stock investors breathed a sign of relief because, after all, lower rates are good for stocks.

When buyers of residual claims on the earnings of corporate entities (that is, stocks) begin to look to the level of interest rates as the reason that stocks are a good buy, it is starting to look like the last refuge. Loving stocks because interest rates are low is a really weak reason.

“But wait!” some will cry, “what about the ‘Fed model’?”

The so-called “Fed model” proposes that there is a relationship between equity values and interest rates since like any other capital asset, equities can be appraised as the present value of future cash flows, and present value calculations depend rather heavily on the rate of interest used to discount the flows (e.g., the Gordon growth model is a spare model that declares the value of a stock to be equal to the current dividend discounted by the difference between the required return r and the dividend’s assumed growth rate g; obviously, the required return is related to other returns available in the market). So, when interest rates are high, equity multiples “should” be low; when interest rates are low, equities “should” be high.

But this confuses the problem of explaining the level of P/E multiples with the problem of deciding whether such a P/E multiple is an appropriate level – that is, whether stock values are priced to return an adequate return to compensate for the risk. The “Fed Model” does a passable job of explaining why high P/E multiples might be associated with low interest rates, but it tells us nothing about what happens next. A fantastic article by a man far, far smarter than me is “Fight the Fed Model” by Cliff Asness, which appeared in the Journal of Portfolio Management in 2003. Mr. Asness argues persuasively (and with his usual biting wit) that (a) the Fed Model explains a historical relationship, (b) the rationale given for the Fed model (one version of which I just provided) is wrong, which means that the historical relationship just illustrates a systematic investor error, and (c) there are much better ways to predict the likely future return to stocks, for example the simple level of P/Es themselves. It turns out that historically, the higher the starting market P/E, the lower the subsequent return.

Mr. Asness is right, but I don’t even think you need to get to perfect theory to see that relying on the level of interest rates as a reason to buy stocks is faulty logic. When interest rates are low, and therefore equity multiples are high, what comes next? As the old Marty Zweig commercial says, “if you can spot meaningful changes…in interest rates and momentum…you’ll be mostly in stocks during major advances and out during major declines. [emphasis added]” Rates are low, and the Fed will keep them low as long as they can. But what’s next? Are they going lower? Short rates simply can’t go any lower, and if long rates go lower it’s probably indicative that we are in a depression. No, the next major move in interest rates is far more likely to be to higher rates than to lower rates.

According to Mr. Zweig, that means we need to be mostly out of stocks.

Personally, I don’t have a strong opinion that stocks need to go drastically lower in nominal  space. With a decent rise in inflation, they could “correct” to much lower real values while chopping sideways for a few years (which is what happened in the 1970s of course). But again, such thoughts are not much solace.

On Thursday, Durable Goods (Consensus +1.5%/+1.0% ex-transportation) is expected to follow a positive print with a positive print. Many years ago, I examined whether I could beat the consensus by always forecasting (-0.5 times last month), so if last month was +2%, my forecast would be -1%. At the time, it turns out that such a strategy actually did beat the consensus by a small margin, which mainly goes to say that Durable Goods are extremely volatile and it’s hard to make much out of them. That doesn’t change the fact that the market enjoys reacting to Durables.

Also due out is Initial Claims (Consensus: 460k, after the surprise 473k last month). Optimism reigns supreme as Claims keep exceeding the Consensus week after week. At some point, forecasters are going to have to adjust, or the numbers are going to have to start improving. Which is more stubborn, economists or the economy?

Of course, the last piece of news is that another storm is supposed to hit the New England/New York area and bring a lot of snow. That probably won’t have a lot of impact on trading early on, but expect conditions to thin somewhat as the day goes on.

The 30y TIPS auction on Monday appeared to be sloppy. With a 2.229% clearing rate, the issue was priced considerably south of where the WI market had been priced at the bidding deadline. Dealers, leading into the auction, had reported thin customer books, and clearly ended up owning the issue.

But looks can be deceiving, and this is one ‘Dutch treat’ that really should be a treat. This sloppy bond, I think, will clean up nicely over the next few days into month-end and should be easy to distribute. Some investors probably shied away from the auction because it was the first of a new series (30y TIPS); some because the indices do not include the issue until month-end; and some because the February maturity is a first for a TIPS issue and, although the 30-year tenor tends to blunt the impact of seasonality investors cannot really know where the market will price Feb seasonality compared to the usual Jan, April, and July maturities.

(For the uninitiated: since TIPS settle to non-seasonally adjusted CPI-U, or NSA CPI for short, the pricing of the bonds reflects the relative advantage of receiving inflation compensation based on October/November prices (for January maturities) compared to January/February prices (for April maturities). Because consumer prices generally decline in December in the U.S., and because the final payment on a bond is based on final price index, principal redemptions in January are higher, all else equal, and April maturities trade at a discount to January maturities. But although derivatives folks can tell us where February maturities should trade, that is a far cry from telling us where they will trade since the bond market does not fully price seasonality).

But there are lots of customers who need long-dated inflation protection, and excepting a few old TIPS that trade relatively infrequently there was no source of long-dated inflation protection in the U.S. If this had been a 30y nominal issue, the long tail would have sent the market down hard as dealers scrambled to monetize their Dutch treat (also for the uninitiated: a “Dutch treat” is the result of the auction method the Treasury uses, which awards all bonds to bidders at the lowest price accepted, even if the actual bid placed by the auction participant was stronger. The difference between what a bidder was willing to pay and the actual award is termed a “Dutch treat” because this type of auction is also called a “Dutch auction”). But TIPS held up fine, and the auctioned issue closed around 2.20% so buyers went home with a profit.

Now, if it turns out that a few days pass and the distribution isn’t going so well for some reason, then the bond could fall out of bed but I suspect it will be quickly spoken for.

That was really the day’s main excitement. The 10y Note futures ended unchanged, and stocks -0.1%.

Tomorrow, the data calendar holds the S&P – Case/Shiller Home Price Index at 9:00 ET and the Consumer Confidence data (Consensus: 55.0 from 55.9) at 10:00. Neither of those is likely to be a major market mover. With less noise, perhaps we can discern the signal a little more clearly. Both upward and downward trends seem to be losing momentum in different time frames. That could spell a very boring day, or it could indicate multi-time-frame uncertainty, which can sometimes precede an explosive situation. Personally, I’m going with boring, but stay alert.

The CPI release on Friday amply demonstrated why inflation trading folks tend to ignore PPI. The PPI figure had scared people into thinking that the rise in consumer inflation, long-awaited (and coming!) was nigh.

It wasn’t. Headline CPI rose+0.2%, but the miss was entirely due to the miss in core inflation. Core CPI at -0.1% missed the consensus guess by a full two-tenths, which is a bit like a three-touchdown favorite losing by two touchdowns: it happens, but not very often. I, however, was delighted, since the model I follow had been giving a much lower central tendency to the year-on-year number.

Ex-housing, core inflation was +2.8% year-on-year, down just a little bit but obviously still indicating inflation higher than the Fed would like to see. I don’t generally create ex- numbers unless there is a good reason; some elements of inflation are always running faster and some are always running slower than the average, so all you do in most cases when you remove “outliers” is produce a number that happens to agree with your forecast. But in this case, we have a large part of the CPI number which has been very obviously polluted by the existence first of the housing bubble, and now of the lagged response to the housing bust. It makes sense to see what “everything not coming off a bubble” is doing.

Now, while 2.8% is above the Fed’s target range, and I am sure they would be uncomfortable if they thought core-ex-housing was something worth looking at, there really isn’t anything they can do about it. There is no way, politically, that they can tighten with 10% unemployment and core inflation at 1.6% and declining (even if that’s not the right way to look at it). If Bernanke wants to make sure he spends the next several years in hearings before Congress about the necessity of having an independent Federal Reserve, tightening monetary policy right now would be a great way to ensure that.

Even if core inflation begins to head higher (which it will, probably in late Q3 or early Q4 if not before), it’s just not really likely that the FOMC can defend its decision to pursue price stability by slowing an economy that still has 9% or 10% unemployment and needs to gun the engine a bit just to have a chance of achieving a sub-trillion-dollar deficit. (Heck, Bernanke is testifying on Monday before the House Financial Services Committee on the topic “Prospects for Employment Growth: Is Additional Stimulus Needed?” Can you imagine the FOMC hiking rates at the same time the Congress is preparing another big stimulus?) The Fed may try and sneak rates up away from 0% in the context of “removing unusual stimulus measures,” but with low capacity utilization of labor and capital, PIIGS instability, continuing bank seizures and a dollar that doesn’t seem to need any help right now for some reason, that is one pork chop that’s going to be hard to throw past the hungry wolf. Short rates will not move very far from zero for some time, if they move at all.

I am also sure that most policymakers, in their private thoughts, wouldn’t mind a slightly higher inflation rate than their stated goal. Inflation of 3-4%, if it were contained, wouldn’t be a disaster from a resource-allocation perspective and would certainly be useful in terms of helping the nation grow out of its liabilities. But the problem, as ever, is that while it is simple for a monetary authority to create inflation, it is devilishly difficult to create just a little inflation.

Regardless of whether the Fed and the Congress and the President would like a little bit of inflation or not, we can count on them to keep saying loudly that they don’t, and that they’ll be aggressive to address inflation. Absolutely the worst outcome is that bond vigilantes figure out the game early and start pushing up rates. Every government auction that clears at these rates is an unmitigated victory for a legislature committed to living beyond its means. But you know what? I think the bond vigilantes seem to be getting a clue. Friday’s CPI might throw them off the scent for a while, but…rates seem to me likely to be heading higher.

Speaking of auctions, on Monday the Treasury will be auctioning off $8bln of 30-year TIPS. It isn’t a big auction, but these are big DV01s and this is the first 30y TIPS auction in many moons. At a real yield of a bit above 2% it isn’t a fabulous must-own bond, but it’s not too bad and there are a lot of investors who need long-term inflation immunization. I suspect it will be a good auction.

Interestingly, and again illustrating my obsession with all things inflation, implied volatilities on inflation options have been sneaking higher recently after sliding a very long way since last summer. Options on inflation (caps, floors) are very expensive to buy, and fairly illiquid although the interbank market the last several months has seen some action, so I don’t really suggest anyone run out to buy inflation caps even though it seems like the right thing to do. But they had gone from insanely-expensive last summer (option prices implying that inflation by itself would be several times as volatile as nominal rates) to only very-expensive a month or so ago. But some buyers seem to be pushing vols higher again. Needless to say, nervousness about inflation variance implies a better environment in which to be auctioning long inflation-linked bonds!

I suppose that we ought to deal with the last things, first. The Federal Reserve this afternoon hiked the discount rate to 0.75%, prompting a further selloff in Treasuries after what had already been a less-than-stellar day (TYH0 closed down 15/32nds, and another 5 ticks after the announcement). What is the Fed up to?

The discount rate increase has no practical, economic significance. Although use of the discount rate window no longer carries quite the stigma it once did (partly because the Fed, during the crisis, tried hard to encourage banks to use it), it is still a fairly unattractive source of funds when uncollateralized 3-month rates (LIBOR) are lower.

The hike in the rate also has no signaling significance, since the FOMC can (and has) be very vocal about what their plans are for removal of accomodation: to wit, they have no plans to remove it any time soon.

The Fed itself confirmed these two points in the press release announcing the change, which said in part “The modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy.” It is hard to get clearer than that.

So then what is the point of this move? I see three possibilities:

1. There really is no point. They were bored, knew they had to do this eventually, and did it.
2. The hike in the discount rate – changes in which are initiated by member reserve banks – might be a small sop to Kansas City Fed President Hoenig, who has been dissenting hawkishly of late. I think that this is at least partly a consideration.
3. The Fed wants the yield curve to be flatter, since a curve this steep tends to imply expectations of higher forward inflation; moreover, psychologically an optically-more-hawkish FOMC might keep long rates from moving up too much. By adding another hint that 0.9% 2-year note rates are untenable, the Fed hopes to scare money into more productive uses or at least further out the yield curve.

If this latter possibility is any part of the decision, or even if it isn’t, the Fed is playing a dangerous game right here. Long rates have been threatening support (as I showed yesterday), and markets already are nervous about the removal of a major buyer of this paper. Hinting that tightening policy may be coming sooner than people think – even while saying the opposite – risks causing a technical break higher in long rates while short rates stay relatively anchored since the Fed is certainly not going to do anything while Greece burns, the EU dithers, and European banks sweat. The Federal Reserve is firing blanks, because they can’t afford to risk firing real bullets…but the noise can still stampede the cattle.

The technical condition of the market is looking pretty poor. Initial Claims today rose back to 473k, dashing hopes that last week’s surprising drop to 440k reflected the true trend. Claims have now been 472k or above in four out of the past five weeks. It is hard to ignore the implication that the underlying run rate, if it isn’t worsening from the 435k-455k rate seen in mid-Dec to mid-Jan (which, because of the difficulty of seasonally adjusting, have larger-than-normal error bars), certainly is no longer improving. This is worrisome, because if the U.S. isn’t the engine of growth for the world right now, who is? China, who is actively tightening policy? Europe, dealing with Round 2 of the banking crisis? The dollar is rallying because people are reaching the conclusion that we are the engine, but this engine is still pretty weak.

–

On Friday the BLS will release the monthly CPI figures. I wrote about some of the common cognitive errors people make when thinking about CPI on Tuesday (see article here), but a good friend (thanks DW!) sent me something that will appeal to the people who are concerned that we are on the brink of a crazy inflationary episode in the U.S., and I thought I would share. Specifically, he sent me almost eleven trillion-one dollars. Zimbabwe dollars. These currency notes were printed over a period of just two years, from 2007 to 2008, and the sequence will tell the story better than economic statistics can:

1 dollar, Zimbabwe

A Zimbabwean Buck isn't what it used to be.

"I remember when this cost only 1 dollar. A few months ago."

"This is nothing. You should see my coin purse."

Yesterday this bought a car. Today, a sandwich.

"I only have a 10 trillion. Can you make change?" "Sorry, since you started that sentence the price has gone up."

I think this is a terrific rebuttal of the Keynesian interpretation of inflation. Zimbabwe certainly didn’t inflate because it is pressing on the limits of its potential output. It inflated because the reserve bank dumped lots of money into the system. I think that people who are cavalierly unconcerned about domestic inflation right now because of the output gap need to explain how Zimbabwe happens. Inflation is caused when too much money is matched up with too few goods, so the price of money in terms of goods declines (or, equivalently, the price of goods rise).

Strictly speaking it isn’t only the amount of money, but the amount of money that is spent and that involves a quantum called money velocity. In this country, the only thing which has saved us to date from the inflationary consequences of the money printing has been the decline in money velocity (which never collapsed, thanks to the Fed’s efforts to add leverage in addition to money). MV=PQ, and in this case the decline in V immunized the rise in M to some degree. But V will not contract ad infinitum.

Indeed, if you look past the housing price collapse, which pressured rents, the rest of core inflation is rising at better than 3%. I have talked about core-inflation-ex-housing in the past and I will do so again in the future because it is a useful way of looking around the immediate effects of the deflating housing bubble. But here is the simplest form of the question: if the economy narrowly averted a depression, and brandishes a capacity utilization statistic in the low 70% range with 10% unemployment, then how is New Jersey Transit – which itself is certainly not at capacity – able to contemplate a 30% price hike, as they are currently doing? You might object to that example, since demand for transit in the New York City environs is fairly inelastic (although there are ample substitutes to NJT!). But that isn’t the only example. What about beer? See the story here from last year (ignore the part about prices being increased to make up for volume declines. Anyone who has gotten an MBA – and I imagine that includes the management of Anheuser Busch – knows that only works if demand is inelastic and that probably doesn’t apply to the demand for Bud).

You won’t find any forecasting-by-anecdote here; some prices are always going up while others are going down (at least, in low-inflation environments), so those anecdotes are proof of nothing. But they are illustrative of the concept I want to get across: focusing only on endogenous supply and demand without considering exogenous factors like a crate of money washing up on the beach (or in the macroeconomics sense focusing on aggregate supply and aggregate demand without considering the quantity of money) will not produce the right intuition, reasoning, or forecast.

Speaking of inflation forecast, CPI is released tomorrow with economists expecting 0.3% on headline and 0.1% on core inflation, bringing the year-on-year change to +2.8% overall and +1.8% on core. The headline seems a touch low to me, although not enough to worry about. The forecast for core seems about right or even a smidgen high. The model I follow expects core CPI to keep declining slowly through Q3, but actual year-on-year core CPI is already above the model forecast and another +1.8% result would actually be somewhat of a concern to me as it would suggest the disinflationary tendencies are ebbing a bit ahead of schedule.

As usual, I will calculate the core-ex-housing number, which isn’t part of the release, and talk about it in my next post.

This January number has special implications for the TIPS market. The April 2010 TIPS bond, which matures April 15th with a notional amount tied to an interpolation between the January and February CPI figures, will see half of the uncertainty go away when the Jan print is under our belts. Accordingly, if NSA CPI is much different from the 217.05 implied by the current price of the Apr-10 TIPS (and ironically, that level matches the economists’ forecasts as well), you can expect that bond to move rather sharply.

Most folks won’t care as much about the April 2010s, a two-month piece of paper that will be half nominal as of tomorrow, when there are $8bln in 30-year TIPS to prepare for next week. But I care. I care, dang it!

On Wednesday the Housing Starts and Industrial Production data both seemed slightly better than expected, continuing the February trend of blunting the signs of weakness we had seen in January. As I noted yesterday, these improvements still don’t rise to the level of actually being good, but the market is pleased with less-bad. Stocks rallied 0.4%, while the 10y note contract fell sharply, by 20.5 ticks, to end up clinging (somewhat unconvincingly) to recent support (see Chart, source Barchart.com).

The prospect for higher rates sooner rather than later is growing.

Bonds also were pressured by the extent of the discussion in the FOMC minutes about the methods the Fed is considering employing when it chooses to shrink its balance sheet and drain reserves from the market. This should not be very mysterious, since Fed officials have been speaking quite openly about how they may propose to do this – I wrote something back in December describing Brian Sack’s outstanding speech to the Money Marketeers on this subject (Mr. Sack heads the Open Market Desk at the NY Fed; my thorough discussion of that speech may be found here).

However, every time the headlines hit about the “eventual withdrawal of policy accommodation,” the market seems to think it’s a hint that such a withdrawal may be soon (clearly, the Fed is trying to get the market used to the idea so that it isn’t such a shock when it happens; the market’s insistence on reacting to such headlines indicate they have more preparation to do so I wouldn’t expect those headlines to stop!). I really don’t think that a significant withdrawal of that accommodation will occur for some time, for several reasons. I discuss several of them in that column I just referenced and they are still valid, but I think one of the biggest is that I have no idea who might want to buy the assets they want to sell. As a reminder, one of the reasons the Treasury was able to sell the huge amount of debt they dumped on the market last year was that the Fed bought some $300bln of it and indirectly caused a bunch more buying when they Hoovered up better than a trillion dollars of MBS. It will be hard enough for Treasury to sell the greater supply they need to sell this year without  the Fed’s complicity; they certainly don’t need the competition of the Fed selling bonds too.

(A more interesting technical reason may be that the Fed will likely have to realize a loss on securities that they sell which they otherwise don’t mark-to-market, as they likely will have losses on at least some of the portfolio simply by virtue of buying a trillion and then selling a trillion. If I was a market-marker and had to bet which securities would be sold first, by the way, I would look to see on which tranches the Fed is showing a profit).

I expect the FOMC will push up rates at some point, fairly gradually; I will be surprised if they reduce their balance sheet in any meaningful way soon. But all of this helps to put more weight on the bond market. I expect we may see a pretty decent move to higher rates by summer.

On Thursday, economic data kicks off with Initial Claims (Consensus: unchanged at 440k), which fell a large amount last week after several weeks in which it had been trending higher rather than lower. The consensus call tells you that economists think the rise in Claims in January was entirely technical, although I am not so sure.

Also out at 8:30 EST is the Producer Price Index (Consensus: +0.8%/+0.1% ex-food-and-energy). As an inflation guy, I am generally unexcited by the PPI and tend to ignore it.

Economists expect the Philadelphia Fed Index at 10:00 (Consensus: 17.0 from 15.2) will extend the general trend-like bounce from the lows. This is another index that pulled back in Janaury, and the sanguinity of economists in projecting all of these trend-continuations from pre-January numbers is impressive. Consider me still skeptical – I think much of the recent improvement is from “all heck breaking loose” to “average recession levels,” and the real question is whether the economy can take the next step up.

Finally, the Treasury tomorrow will announce 2y, 5y, and 7y Treasury auctions and (ta-da!) the new 30y TIPS auction. How exciting! I continue to think the Treasury should go the extra mile and issue an inflation-linked perpetuity, but 30 years isn’t bad. Keep hope alive!

The markets might just be going through a mild jittery patch, or it might be something a bit bigger. Certainly, the PIIGS situation is something which is likely to be a concern over a longer period of time, but it isn’t completely clear whether it necessarily must end with a bang rather than a whimper (although many, including on Friday noted economist Martin Feldstein, feel that the Euro “isn’t working” or in some cases fundamentally cannot work). It certainly isn’t clear whether, even if it is going to end with a bang, that the bang will be now, and given the predilection among equity investors for riding the roller coaster until the very moment when it is leaving the tracks and is difficult to exit, it may be that we can steer past these jitters.

It doesn’t help when the jitters compound, though, and the news on Friday that China hiked reserve requirements again makes some people nervous. It doesn’t really do that for me, since although China is among the fastest-growing of decent-sized economies it isn’t growing in a sustainable way and it is better in the long run if she slows down and works off some of the speculative froth. (There are those, too, who think it’s too late for that speculative froth to be brushed away without a bubble popping, but this is something we will find out.) At least, it is interesting to see a monetary authority actually try to deflate a bubble rather than insist it doesn’t exist.

Still, the investors of the world are doing a reasonable job of skimming past these issues without looking like the Wide World of Sports “agony of defeat” guy. On Friday, the March TNote rallied 10 ticks and the S&P slipped a mere 0.3%. Yawn.

I think the market is also a little jittery because some recent reports have ceased getting better, and some (Initial Claims, for example) have suggested that a period of somewhat worse growth might be returning after the first post-stimulus steroidal surge wears off. Personally I wouldn’t read too much into the weakness, but then I also didn’t read too much into the prior strength and I think the true picture of the economy is of one that is limping along absent government stimulus. I don’t think that the jump start provided by the stimulus money has yet turned the engine of growth over into a self-sustaining rhythm, and so I rather think that the equity market is on some thin ice at the moment as we see whether the folks who survived round 1 in 2008 can ride out round 2.

But the real vulnerability of the market isn’t to changes in the true underlying trajectory of growth – which as I said is rather banal and boring and flat – but to changes in the perception of that underlying trajectory from the “liftoff” suggested by gussied up Q4 numbers to, instead, a sputtering, coughing, wheezing, limping economy. Expectations don’t have to become negative, that is, to threaten the stock market. They just need to come back to the underlying reality.

(As an aside and to people who haven’t read my columns for very long: I think the most common error made by professional and amateur forecasters alike is that the data are taken as truth rather than as “experiments” that should be interpreted in terms of their error. That is, a data point only is useful in the context of the null hypothesis, and it can only reject that hypothesis by deviating substantially from what would be expected from that experiment if that null hypothesis were true. If Pr(this data point is produced | Ho is true) is sufficiently low, then we can reject the null and accept the alternative hypothesis. This is all a very long-winded way of saying that ‘Claims being high or low only matters if you can tell me what you were thinking beforehand and whether this is different enough to change your hypothesis. Because investors do not usually interpret data in this way, they usually overreact. In most cases, data doesn’t tell us much in any one release but gradually accumulates to affect one’s view of the trend rate of economic activity).

The coming week promises several more data points to inform that view. On Tuesday the Empire State Manufacturing Index is projected to rise to 18.0 from 15.9 last month. This is a good test, since the January figure represented a big jump from 4.5 in December, and the consensus forecast is looking for a continuation of that jump to something more reminiscent of the post-cash-for-clunkers spike last fall, rather than a retracement to the weak December level. Empire is a pretty volatile series, which means that by itself it can almost never tell us anything, but weakness here would be another small twig on the camel’s back.

Housing Starts and Industrial Production on Wednesday, and Philly Fed on Thursday, are also useful releases. Part of the problem with all of these, though, is that almost anything looks good compared to what it was at the nadir of the crisis. It was that euphoric realization – that the abyss didn’t swallow us all – that propelled equities from the bottom; the baton of the bull was handed off to stimulus-induced improvement; and here we are wondering “what’s next?”

One of the things that is next is CPI on Friday. Tomorrow, I will talk a little about why the CPI number is really a pretty well-done number and how we can feel pretty comfortable that the government isn’t “fudging the number” as many people seem to believe.