E-piphany

First things first: for my money, the last 20 minutes of “Armageddon” is probably the most effective emotional cinema there is.

That is in stark contrast to the boring spectacle of the market in the middle of Employment week. There was a chance at some excitement today with the ADP report; had that number been strong, then I thought we could see rates move significantly higher. However, versus expectations for a gain of 40,000 jobs, we got -23,000 with a further mild downward revision to last month’s number. Well, isn’t that a fine kettle of fish? With expectations from the bow-tied set for Non-farm Payrolls on Friday running near 200,000, a significant undershoot on ADP will be cause for some soul-searching. Add the expected 75,000 Census hires (not included in ADP) to the -23,000 and you get up to the neighborhood of +50K; after that, it becomes an article of faith that weather only affects the BLS count and not the ADP count. And how much will that weather-related snap-back be?

Deutsche Bank, which I pilloried in this space last month when they forecast 350,000 for March Payrolls, is standing by their forecast. If we get close to 350k jobs, even counting weather pay-back, you will be able to knock me over with a feather. Though they had some company in their original forecast (although no one quite so high, many people saw a big weather effect), I would expect that their company is going home for the evening right about now.

It isn’t just the miss on ADP that should make one skeptical that the ranks of the jobless are suddenly going to be deserted. There has been almost no meaningful improvement in Claims this year, and typically a precursor to strong hiring is that firms stop laying folks off (the improvement from the peak Claims numbers, as I’ve written previously, is mostly a mere correction to pre-Lehman rates and thus an unwinding of the acute stress of the financial crisis rather than a sign of fundamental healing). On Monday, the “Jobs Hard To Get” response in the Consumer Confidence report remained mired in the 40s, continuing to show few signs of a broad improvement although we can probably say comfortably that things have stopped worsening.

It may seem unrelated, but think carefully on this: a number of companies have been reporting anticipated charges to earnings that they are taking as a result of the passage of the healthcare bill (I thought this was supposed to save everybody money?). Companies which were aware of the probable cost to them of the new mandates…$250mm here, $1bln there…are less likely to have been aggressively hiring until they knew exactly what the cost of hiring was. That uncertainty is now gone, but it wasn’t for most of the month of March.

Stocks did what we would expect them to do when confronted with a downward growth surprise, and the S&P closed a teensy bit lower (-0.3%) to end the quarter. ADP is usually just the prologue, of course, and if Payrolls actually confirms Payrolls down around, say, 100k then stocks may finally begin to reprice to the tepid outlook somewhat. Meanwhile, bonds did well with TYM0 +10/32nds and the 10-year yield at 3.83%, but that’s still not far enough away from support to make bulls feel very comfortable, I’ll wager!

But good news there is (pardon the Yoda-ism). The first quarter is over. Japanese year-end is past. The Fed has stopped its buying, and the world did not end. I will add the caveat “yet,” but clearly the biggest risk is in the days right around quarter-end. Give me another week and I’ll really breathe a sigh of relief, but March 31st and the days leading up to it were the days I was most concerned about.

I still don’t know how the Treasury is going to sell the trillions they need to sell and roll while the Fed is no longer taking competing paper off the Street (and is thinking about putting it back on the Street, supposedly), but there has been no immediate debacle. I know: I am easy to please. Anything less than Armageddon is appreciated (hmmm, I hadn’t meant to tie that back to Armageddon; it just happened).

Tomorrow, the Labor Department could make Deutsche Bank feel a little more comfortable with their forecast if they announce Initial Claims of lower than the 440k consensus. That represents only a modest improvement from last week’s 442k, but “only a modest improvement” is what is warranted. I am not sure how much information would be contained in a 430k number – not much, given the volatility of the data – but it would give both bulls and bears something to hang their respective hats on going into Friday. As it is, there is much more balance in the risks after today’s ADP data, which mostly means that if Deutsche is somehow right there will be much more carnage. It’s like pairing your queens on the turn when someone else has a flush – that queen improves your hand enough to make you want to stick around but ends up costing you money.

Also tomorrow, the ISM (Consensus: 57.0 from 56.5) is due. The regional surveys have been mixed, with Chicago today weaker-than-expected and Milwaukee stronger. Nearly unchanged makes sense.

Meandering March continues, with the bond market taking this rainy Monday in New York to drift mostly sideways. June 10y Note futures lost 0.5/32nds, with the 10y note yield at 3.87%. Other markets, however, were not as quiescent. In a rare quin-fecta, the top five percentage gainers among commodity markets included one meat, one industrial metal, one precious metal, one soft, and one energy (Hogs, Nickel, Silver, Sugar, and Crude Oil, respectively), each of which gained 2.95% or more.

Front Crude, at $82.50, is flirting again with the post-crisis highs. Surprisingly little is being made of the doubling of oil prices over the last year. Partly, this is because oil at these levels is comfortably between the $40 lows and the $150 highs and doesn’t look as extreme as $82 oil did the first time around; partly the casual attitude in the market is due to an assumption that “this time, the economy can handle it – we’re not teetering on the edge like last time.” But while Crude in USD has retraced only 44% of the bust from $147 to $32, oil in Euro has rebounded 54% of the way back to the high, and oil in sterling has recovered 64% of that loss. It is reasonable to ask whether those economies, with the pressures they are already under, may sustain meaningful damage from the rise in petrol. And, as we know, what happens in Europe doesn’t necessarily stay in Europe.

Nevertheless, stocks continued their recent ebullient run, rising 0.6%. The talisman chant of “canary in the coal mine” helped. Last week, former Fed Chairman Greenspan uttered the opinion that the recent rise in interest rates was a “canary in the coal mine” warning that current deficits are dangerous; as a direct result, every fourth word on financial TV today was “canary.” By “confronting” the issue, financial cheerleaders and some investors believe that they have disarmed it. This subconscious approach, which I remember being used in the early 2000s with “corporate governance” (as if talking about it and blaming the equity weakness on corporate governance issues would make it go away), is either a sign of nervousness about the market’s actual vulnerability to the development or a sign of weak creativity genes. It may be the latter. Last year, no one could think of any other way to say “green shoots” for months on end. One thing you can say about Greenspan…he did not, and does not, lack for creativity.

Whatever happens on Monday and Tuesday, though, is mere prologue with a highly-anticipated Payrolls release due on Friday. I think the bond market will be hard-pressed to stay steady until then, especially if ADP on Wednesday shows any strength at all. With bond yields clinging to recent highs, probably the biggest jobs gain in months on tap, and anticipating thin market conditions with the stock market closed? If I was long, I’d be trimming positions here; if I was short I’d be more confident that the pot odds are in my favor (since a small selloff might well cascade through several support levels). I suspect that we may see these higher yields before the Payrolls number ever prints.

In the meantime, though, Tuesday brings a couple of less-crucial reports that still have the potential to move markets. First, the Case/Shiller home price index is expected to fall -0.6% from a year ago, versus last month’s -3.1% year-on-year figure. Failure to fall isn’t the same as rising, but if somehow a flat number shows up the bears will be in control. More important is the later Consumer Confidence release (Consensus: 50.0 vs 46.0), which plunged 9.5 points last month. The consensus is expecting a retracement, which seems reasonable but is still pretty miserable. Unlike a number of other surveys, 50 isn’t the dividing line between expansion and contraction in the Conference Board’s measure; it is indexed so that the level of confidence in 1985 is equal to 100. The record was nearly 150. So a level of 50 is merely a little less grim. Still, a positive surprise here won’t be overlooked.

As always with the Consumer Confidence figure, look at the “Jobs Hard To Get” response. That response is very well correlated to the Unemployment Rate for the simple reason that normal people responding to the confidence survey are much more in tune with what the employment situation is than a bunch of ivory tower economists in Brooks Brothers suits on Wall Street. (I shouldn’t contribute to the class warfare that is so currently en vogue, even for a cheap laugh. The real reason is that simple binary situations – can I find a job, or not? – are much more effectively evaluated by the collective observations of thousands of survey participants than by the isolated wisdom of a few really smart economists). The chart below (Source: Blooomberg) shows that that indicator has made no move to roll over yet, although it at least has stopped rising.

Why Do People Say Jobs Are Hard To Get When Economists Say They're There?

A final event to be aware of tomorrow is the talk around noon by former Fed Chairman, former Legend, and former Rational Thinker Paul Volcker on the topic of financial reform. One side effect of the passage of the health care bill has been that the Administration has been able to turn its attention to other ways to damage the economy. Higher taxes on capital gains, financial reform that will have the effect of limiting risk budgets among market-makers and driving up transactions costs and driving down liquidity for every investor in the market…these all sound like great ideas in a recession. That’s what the canaries in the coal mine are really afraid of.

The bond market didn’t care much more for the 7-year Treasury today than they did the 5-year yesterday. While there wasn’t as much of a tail, we have to remember that is partly because yields were up 25bps over the two days prior to the auction. Although the market rallied off the worst levels of the day, TYM0 was still -17.5/32nds on the day and the 10y yield hit 3.89%. It is a little early to be sure, but it certainly appears as if the 4% psychological hurdle will be tested. Some people, in fact, will begin to see an inverted-head-and-shoulders pattern in the charts; suffice to say that the formal projection of such a pattern would project to well over 5% in nominal yields.

I’m not a big fan of technical analysis, although it was working for a technical analysis firm that I got my career started. But some patterns are so very obvious on the charts that you just know other investors or traders will notice them and pay attention to them. The definition and interpretation of head-and-shoulders patterns is very subject to the eye of the beholder, as is most of this stuff, but when you look at the chart below (Source: Bloomberg) it’s hard not to notice. When it’s “hard not to notice,” I tend to take notice.

Chart: If the techies have their way, this could get ugly.

Today’s Initial Claims data didn’t hurt the bear case, although 442k isn’t exactly a sign of overwhelming strength. It was still stronger than the consensus expected. When trends begin, sometimes reinforcement from otherwise-innocuous data and news carries greater weight since investors tend to exaggerate the importance of information that supports their views (a.k.a. confirmation bias).

The general increase in rates helped drag stocks down after a hot start to the day. The S&P ended -0.2%. Swap spreads bounced very mildly from yesterday’s levels; “close to unchanged” is probably a better description given the extent of the recent decline.

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The fact that rates are suddenly starting to act as if they aren’t excited with the prospect of huge deficits as far as the eye can see…and the fact that we don’t really have any alternative at this point to the plan of running huge deficits as far as the eye can see…is one reason to fear and despise the corner that we have painted ourselves into. Higher bond rates are painful if, for example, you are a bond investor, but also of course for borrowers of all stripes. But even if you’re primarily an equity investor, you should also worry about these deficits.

One of the reasons that large structural deficits (rather than small, cyclical deficits) are so damaging to an economy is that the pool of savings is not unlimited. When the government borrows money for unproductive enterprises (in the sense that they don’t produce, not that they don’t “work”), it is competing for that money against private borrowers. When deficits are small, relative to GDP, this is not a large problem. But as deficits grow more substantial, this “crowding out” raises the cost of capital for other borrowers. One can easily imagine how that may cause private borrowing rates to be higher than they otherwise would be, but what is interesting is that we can see this effect quite clearly in the stock market as well – as the deficit increases, the cost of capital in the equity market rises (that is, prices decline). The chart below (Source: Bloomberg, US Treasury) shows how the 3-year annualized return to stocks is strikingly correlated to the 3-year change in the budget surplus/deficit as a percentage of nominal GDP.

If you're an equity investor, you too are affected by 'crowding out'

Now, we ought to be somewhat careful about attributing causality here. When the economy tanks, the deficit clearly worsens (Keynesian automatic stabilizers), and we might expect stocks to do poorly as well. Moreover, when stocks decline then capital gains tax receipts decline and (therefore) the deficit tends to increase. But this relationship is too good to shrug off entirely to those alternative explanations. I believe you can make a pretty reasonable case that running very large deficits (a) tightens credit spreads to Treasuries as the latter cheapen, (b) tightens swap spreads to Treasuries for the same reason – see yesterday’s comment, and (c) by competing for a larger share of the available savings, raises the cost of capital to firms across the entire capital structure…including equity capital.

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On Friday, the final revisions of Q4 GDP figures should not have any market-moving implications. Nor should the revision to the monthly Michigan Confidence figure. So technical pressures, rather than economic news, should rule the day I think.

CNBC loves its “countdown” toy, and uses it whenever possible to give the time remaining before economic releases or market openings or closes. But when today it began using the clock to count down the moments until the signing of the health care bill it seemed oddly inappropriate. It was as if one could almost hear an oddly metallic female voice intoning pleasantly, as in a movie, “Your economy will self destruct in…ten minutes…and…fifty-two seconds…” The false precision in the countdown-meter, which included hundredths of a second for a bill signing ceremony whose timing is probably measured no more accurately than whole minutes, took on added ironic meaning when one considers the likely error of the many estimates of costs and revenues in the bill. I don’t think “close enough for government work” was ever meant to include hundredths of a second, and plus or minus 500 billion dollars for this landmark legislation would have to be considered a triumph of forecasting given the historical reliability of cost and revenue estimates.

It was yet another quiet day overall, although a 3-4 basis-point drop in swap spreads (probably due to the large amount of corporate issuance, which tends to pressure swap spreads when the issuer desires to translate the fixed coupon into a floating coupon) pushed the 10y swap spread to where only the 30y had previously gone: negative.

Some observers may get distressed by this: a LIBOR swap with a bank counterparty trades at a lower interest rate than 10-year government debt! Under the traditional explanation of swap spreads, which actually was true once, this would be cause for concern since if the swap spread is a credit spread, it implies that bank credit is better than sovereign credit. However, swaps now generally trade on a fully-collateralized basis, which means that the difference in credit is slight – the LIBOR rate is fully collateralized, while the Treasury rate is backed by the full faith and credit of the U.S. Treasury. Even if we still used the credit notion of a swap spread, it isn’t clear why negative spreads would be too alarming since after all, a collateralized obligation is generally better credit than an uncollateralized one for the same credit.

However, the conventional understanding of swap spreads observes that the main difference is in the floating rate. The receiver of the fixed rate on the swap also pays 3-month dollar LIBOR, which is a rate that does have some credit implications when things are really bad but most of the time is just a generic funding rate. On the other hand, the owner of a Treasury bond receives the fixed coupon but also has the benefit of being able to use the bond as high-quality collateral, thereby funding the security in the “repo” market at an attractive price. If the bond is “general collateral” (that is, it’s just any ol’ Treasury), the repo market will trade a few basis points below LIBOR, but Treasuries occasionally can go “special” and finance quite a bit below LIBOR.

So this is the main source of swap spreads: Treasuries finance at better rates than LIBOR most of the time, and sometimes they finance at rates much better than LIBOR. Except, that is, when interest rates are already at zero. Although technically negative repo rates are allowed, they are rare, so at low interest rates the possible advantage of the repo rate compared to LIBOR gets compressed. So while it is unusual to see negative swap spreads, it isn’t likely to signify anything about the quality of Treasury credit.

It does happen to be the case, by the way, that swap spreads tend to compress when Treasury supply increases. This happens because the chance of a Treasury security being scarce, and therefore going “special” in the repo market, is much lower when issue sizes are monthly at $15bln than when they are quarterly at $8bln.

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Existing Home Sales came out today near consensus estimates, although as I noted yesterday the “consensus” is a term used loosely in this case. There isn’t very much in this report, especially given the recent noise, to get excited about but I thought I would give a longer-term perspective. I have been pointing out for a while that if you take Shelter out of core inflation measures, to get a look at what is happening to the non-bubble part of the economy, inflation has been accelerating for some time. This is of less concern if the deflation of the bubble is to continue for a while, but in many ways it looks like housing is approaching levels that reflect a more-normal historical relationship to the rest of the economy. For example, the chart below is a slightly-updated version of one that appeared in the December 2009 CFA Institute Conference Proceedings Quarterly in an article by Earl Webb entitled “Assessing Real Estate Markets: Pothole or Sinkhole?” It illustrates the bubble that the Fed was unable to discern.

Housing May Be Nearly Done Correcting, versus Median Income Anyway

The source for the median home price data is the National Association of Realtors’ Existing Home Sales report (and thus slightly differs from Mr. Webb’s chart in that he included all home sales, I believe); the source for median household income is the Census Bureau. The latter is reported with a one-year lag, so only 2008 is available, but we can make a reasonable guess and extend the chart to 2009. Note that all of these figures are in nominal, not real terms, but since inflation is operating on both values it shouldn’t have an impact on the ratio. I have also shown the long-term ex-bubble average.

The bottom line is that while housing might yet overcorrect, it looks like it is getting close to fair relative to incomes. That, in turn, means that unless incomes take a meaningful dip in real terms, the downward pressure from declining shelter costs are probably all in the pipeline by now, and the downward pressure on rents should gradually diminish over the next year.

If that is the case, then core inflation with shelter will over that period of time begin to converge with core inflation ex-shelter, and that implies much higher core readings a year or so from now.

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With the exception of swap spreads, there was little excitement in the fixed-income markets today. The 10y note contract ended unchanged, with 10y yields at 3.58%. The S&P rose 0.7%, further confounding those of us who don’t see the nationalization of health care as a positive thing for the market (see my comment yesterday for a quick explanation of why it is very unlikely to be a net benefit to the market).

Tomorrow, the economic docket carries Durable Goods (Consensus: +0.6%/+0.6% ex-transportation following -0.6% ex-transportation last month) and New Home Sales (Consensus: 315K vs 309K last month). The 309,000 number was the lowest ever for New Home Sales, so the consensus call isn’t exactly looking for an aggressive bounce, but a further record would be somewhat distressing.

I doubt either of these figures will be market-moving. The best bet I think is for another fairly dull day.

Do you really want to read another comment that concerns healthcare and Greece? Really? Then read on.

The healthcare bill passed the House of Representatives on Sunday. Technically, two bills passed: the Senate bill, and a reconciliation bill that the Senate theoretically will now also pass (although the GOP is making it sound as if there are parliamentary reasons that bill may not pass, I am skeptical that the Democrats would go so far off on a limb only to have it sawed off).

Obama crowed, after the passage of the bill, “This is what change looks like!” The statement of course prompted the large majority of Americans who oppose the plan (54%-41% according to a Rasmussen tracking poll here) to enthusiastically support change, starting with da bums in Congress.

Whether you’re a Republican or Democrat, if you’re an American it must turn your stomach to read (See Bloomberg here) that the vote was won partly because some Democrats who have decided not to run for re-election switched sides after previously having voted “no” on a version of the bill in November. Those Democrats decided that, with no election to worry about, it wasn’t so important to represent their constituents. If I was one of those constituents, I’d be upset…Congresspeople are starting to behave like star athletes. “Hey pal, I don’t care if you are a free agent next year; right now you’re still under contract.”

But now, barring something odd happening in the Senate, this bill is the Law of the Land and we ought to brace for its ultimate impact (which I believe will be quite inflationary, which is the usual impact when the government gets more involved in a sector).

Stocks did well today, after being lower on Friday in anticipation of the bill and again overnight after its passage. I am a bit confounded as to why they should be higher today rather than significantly lower. I suppose I can understand how a giant bill like the healthcare bill can create winners and losers (although since it raises taxes right away without making sweeping changes for a number of years, it would seem that everyone is a loser in the short-run). But it doesn’t make sense that there is a net gain that would help stocks broadly.

Suppose that Big Pharma somehow benefits, even though the government will push people to use generics. The Pharma bulls will say that such a benefit springs forth because the new health care system will bring them so many new clients. Those new clients will spend more money…except that the whole point of the health care bill is that it will somehow save money overall. If it does save money, then health care providers will provide more services for the same (or less) money. That doesn’t sound good for the stocks. If the bill doesn’t save money, then that might be good for health care providers, but that money is being taxed from someone or borrowed from someone or printed. That means it is spending that is being redirected to the health care companies from what would otherwise be spent on other things, stuff bought from companies that represent the rest of the market. In that case perhaps it is good for health care companies, but bad for the market generally. I sure as heck can’t see how the bill can help both health care goods and services providers and the market, unless somehow the government correctly determined that the prior distribution of consumption, settled upon by billions upon billions of individual transactions, was “wrong” and that the new distribution of consumption represents a better use of societal resources.

Sure.

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Meanwhile, in Europe, the Bundesbank (which was the central bank of Germany when that meant something) suggested that IMF loans – which some had felt was the solution for Greece – should be restricted to countries with temporary needs. According to the story in the Wall Street Journal:

“According to its mandate, [the IMF] can only use the reserves at its disposal to overcome short-term balance of payments problems,” the Bundesbank said in its monthly report for March. “By contrast, a financial contribution to the solution of structural problems that have no implicit need for foreign currency—such as the direct financing of budget deficits or the financing of bank recapitalizations—is not to be reconciled with [the fund’s] monetary mandate.”

That sounds like a big whoops, since if the ECB won’t do it and the IMF can’t do it, there aren’t a lot of solutions for Greece if it can’t sell enough of its debt. However, German Chancellor Merkel later in the day sounded as if she was still open to the idea. The point is, though, that the whole matter is far from being settled; it is most decidedly unsettled despite the brave pronouncements of the European finance ministers just a week or so ago. Possible outcomes still range from a smooth resolution to a punting of Greece out of the Euro and/or a withdrawal by Greece and a return to the drachma.

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As a quick aside, I want to thank the readers of this column who have brought to my attention the fact that several other analysts/journalists are now using the “core inflation ex-shelter” analytical tool (after I first wrote about it on October 16th of last year). I am told that the King Report quoted Jim Bianco’s observation that “Core CPI less OER (owners’ equivalent rent) and RPR (rent of primary residence)” is running near 12-year highs. Also, thanks to a friend for this March 18th reference in The Economist.

Of course, readers of this column will know that this insight is months and months old. And I thank all of you for noticing and giving me some credit! I think Dolly Parton sang something about this…I guess it’s enough to drive you crazy if you let it.

On Tuesday, a skinny week of data kicks off with Existing Home Sales. If you like roller-coaster rides, Existing Home Sales has been a blast (see Chart, source Bloomberg. See? I cite my sources). After bottoming (maybe) at a 4.53mm unit pace in November 2008, sales skyrocketed to 6.49mm in Nov ’09 before plunging again. The consensus guess is 4.98mm from 5.05mm last month, but if you think that’s anything but a wild guess, think again. New Home Sales recently has been plumbing new lows, but Existing Home Sales depend a lot on how fast the bank repos are moving and whether the home buyer credit is having a second effect. Lower is still a decent guess (but emphasis on “guess”).

Wheeee!

The economic data in my view right now are playing a back seat to the drama in Greece and in Congress. (Actually, I suppose that would be a tragedy in Greece and a comedy in Congress). Bonds, being generally traded by sober, risk-averse folks, are hesitant to make a meaningful move lower (higher yields) on the modest improvement in economic data and the promise of much more future supply until the chance of a blowup in Greece have fully receded. And perhaps that’s the formula for bonds, since the risk of a blowup somewhere is likely to be with us, and nearby, for a long time. The 10y Note contract traded +9/32nds today, with 10-year yields at 3.66%.

Stocks, however, are mostly traded by frat boys and they’ll tend to keep partying until the police come to break up the kegger. I am exaggerating, but the trading character of the two asset markets could hardly be more different even if some bond traders can be cowboys and some equity investors can be staid and sober. Stocks really do seem to ride on waves of sentiment that can have lives of their own, rolling along until being knocked down. Stocks have gotten near enough to completing their technical work on the upside. I don’t think the reward outweighs the risk of being long.

March Madness has begun, and as if on cue market volatility is evaporating. Despite a fair amount of economic data, stocks ended the day unchanged. Stocks have had a nice run, but seem extended; a period of time in which the attention of many investors is on the bracket is probably not the best prescription for an extension higher…

Bonds had a bit more action, with the 10y note finishing -8.5/32nds (10y yield at 3.67%), but of course CPI is more directly relevant for fixed-income. It is rather interesting that rates went up, and not down, on a day when inflation fears (the way people conventionally measure them) went into retreat. How much in retreat? Well, 1y inflation swaps fell 10bps (the yield of the April 10s, which is effectively a T-Bill after today’s print, rose 93bps), and longer inflation expectations retreated 2-4bps. Declining inflation expectations are usually associated with declining rates, which means that real rates actually rose more than nominal rates today.

That is a knee-jerk reaction to weak-seeming inflation data, but it isn’t right. Changes in real yields should track changes in the outlook for real economic growth; those expectations certainly shouldn’t have leaped today, with Initial Claims and the Philly Fed both near expectations (the general index of the Philly Fed was up, but the New Orders index fell to 9.3 vs 22.7 and the Employment question drew 8.4 vs 7.4 last month) and Greece looking like it’s out of the frying pan and back in the fire. And, besides, if investors really were marking up their expectations for real growth, then equities would have done better.

No, real yields rose because the knee-jerk response to the inflation data was to dump TIPS. Dumping TIPS in favor of Treasuries (which would be selling breakevens) is the theoretically correct move if your expectations of inflation have declined; in theory, real yields should be roughly unchanged and nominal bonds should improve so that the spread tightens. But investors can’t help but think of TIPS as having inflation “protection,” when a more-accurate statement would be that TIPS are merely neutral on inflation and shouldn’t react to changes in inflation expectations. Remember, the Fisher equation says

(1 + n) = (1 + r) (1 + i) (1 + p)

or, approximately, that nominal yields are the sum of real yields and expected inflation (plus a risk premium we usually ignore because we can’t analyze it independently with 4 unknowns and 2 instruments). TIPS have a real yield, and the Fisher equation tells us they are independent from expected inflation; on the other hand, nominal yields respond to changes in both real yields and expected inflation.

The market isn’t efficient, though, so that when inflation expectations are declining what usually happens is that TIPS and other inflation bonds get killed and nominal markets don’t move much, so that smart investors can get some bargains after such a number.

The funny thing is that CPI, while slightly weaker-than-expected (mostly on the headline figure; I had suggested yesterday that headline needed to come back to core somewhat), wasn’t really all that weak. I am fine with forecasters who, by essentially forecasting rents, tell us that core inflation should continue to decline for a while. I agree. But they should acknowledge that the argument begins and ends with housing.

I read a piece by JP Morgan today which included charts of Median and Trimmed-Mean CPI, among others. All of these measures are declining, and conventional analysis says that this confirms the fact that core inflation is really “nosediving.” In JPM’s words:

“The basic idea behind robust, or ‘hard-core,’ measures of inflation is that while one can always subjectively strip out certain inflation categories to tell whatever story one wants to about what’s happening with inflation, in the robust measures categories are removed systematically to arrive at the underlying trend in inflation.”

But these measures in fact say nothing of the kind. The problem here is not the problem that trimmed-mean and median measures were meant to solve. They were designed to take care of the problem that it is always the case that some measures are rising faster and some slower than core inflation, and sometimes these “outliers” can have meaningful effects on the average inflation number. By “trimming” these outliers, the basic trend is revealed.

But that isn’t at all the problem here. The problem here isn’t that housing, a very large part of the index, is moving violently and skewing the figures. It doesn’t need to move violently, because it is so big. In fact, it is declining, but gently. However, the weight of housing is so big that it (a) dampens the overall volatility of inflation and (b) can change the average even if it isn’t away from the average very much (by dint of its weight).

And we don’t want to “subjectively strip out certain inflation categories to tell whatever story one wants to.” We want to strip out a category that we know does not represent the underlying trend because it is coming off a bubble. Maybe we knew it was bubbling before, maybe not, but surely by now we all know that housing was a bubble, and is in a period of adjustment. The Fed has no power to push housing prices meaningfully higher without starting a very broad inflation, because they’re gonna go down until the bubble is all the way gone. But the Fed can, and is, pushing other prices higher. We take out housing because it is demonstrably something that will not respond in a normal way to monetary policy. There is no systematic CPI measure that adjusts for this.

It is why we refer to the analyst’s “art,” rather than to the analyst’s “science.” A good analyst knows that “subjective” doesn’t always mean “bad.”

So, when you strip out housing, core inflation is running at 2.6%. That’s down a bit from the recent highs, but a far cry from the 1.3% core inflation including shelter and, more importantly, well above both the recent as well as the secular lows (see Chart).

"Core" inflation is getting increasingly deceiving

The models I follow also say that core inflation (including shelter) should continue to decline for another quarter or two. Duh. You don’t have to be a genius to see that rents are going to remain under pressure for a while, and once you know that then you don’t have to worry about core inflation.

But, as a policymaker, you do have to worry about all those things that are not rent. Inflation is rising, and will very likely continue to do so.

A fairly busy news day made lots of people happy.

Housing Starts came in at 575k, with an upward revision to last month’s figure to put it at 611k. Yay! Builders are probably pleased with the first pan-600k number in over a year (but see yesterday’s comment for the deep significance – not – of the 600k level).

Owners of Euro currency were delighted that a meeting of EU finance ministers produced a “strategy for emergency loans to Greece.” These loans will not be extended right now. And we don’t know how much is being pledged. And we don’t know what will trigger the extension of those loans, and whether the ministers can change their minds. We aren’t even sure that the finance ministers have the legal ability to actually deliver on the strategy. The market seems to think it’s better than a sharp stick in the eye, and I suppose that is true, but it looks to me like a fairly transparent ploy to persuade investors to buy Greek bonds in April and May when many billions of Euro of Greek bonds mature and will need to be rolled. “If they think we’re backstopping them, then we won’t actually need to backstop them; if they don’t think we’re backstopping them, then the investors won’t show up and we’ll have to do something more dramatic.” It seems to me like a cheap option (because talk is cheap); if Greece still founders then the EU is in the same position it was in before, except with a vague promise in place that they may need to deliver on.

My cynicism aside, I have pointed out many times that institutions have a strong survival meme, and we have many examples over the last decade or two that we can point to in order to illustrate the proposition. Not least among these, of course, are the extraordinary actions – of debatable legality – taken by the Federal Reserve during the recent crisis with no real objections, but the list is long. We could include the suspension from time to time of mark-to-market rules when those rules may have made plain some of the more-serious damage the crisis had done to some firms (and the suspension of which rules, in fact, healed no one but amounted to a wink and a nudge), the adoption in the early 2000s of Fannie Mae’s “skip a payment” policy, which greatly improved delinquency optics since missing a payment was no longer automatically a delinquency, the entire phenomenon in Japan of “zombie firms” in which banks keep lending to dead firms to pay off their existing loans rather than recognizing the loss, and so on. But the point is that, as empty as the EU finance ministers’ gesture actually is, the market understands that the institution of the EU is willing to bend some rules (such as the rule against bailouts) when necessary, and it is dangerous to play cards with someone who might change the rules on you. (This is also, of course, why respect for the Rule of Law is so important, since in the long run the people who are leaving the table because the EU is willing to change the rules may not return to the table. There is, for example, no guarantee that these folks will actually buy Greek debt).

But for now, the dollar’s run-up is looking tired. This is a good thing for the Greece, as it prepares to sell a few tens of billions of Euro debt. It is not such a good thing for a country that has a few trillion in debt to sell and has benefited from currency unit strength that has helped dampen inflation pressures.

Stocks and bonds both enjoyed (the S&P to the tune of 0.8%; TYM0 by 16/32nds) the Fed’s decision to stand pat on rates and to repeat its “exceptionally low levels of the federal funds rate for an extended period” construction. Not surprising. Rates in the short end are going nowhere fast, despite Mr. Hoenig’s protestations (he dissented to the statement, preferring to remove the ‘extended period’ language, but as I said yesterday I doubt the Fed feels like now is the time to experiment very much). And, as rates are nailed to the floor at the short end, rates at the long end are somewhat constrained if only because it is very profitable at these spreads to buy bonds at 4%, pledge them as collateral on a repo loan at 0%, and lever that a few times for “easy money.” This carry trade, like all carry trades, contains the seeds of a future blow-up, since once the Fed begins to tighten short rates it isn’t going to be very easy for everyone to get out of the carry trade at once. Think Orange County, or…well, any carry trade.

With the sort of economic slack we currently have in labor and land markets, either there will not be any inflation for several years (Keynesian model) or there will be inflation once the velocity of money starts to recover, regardless of what the output gap is. If the monetarists are right, then there is a sinister side to the beginning of the tightening campaign. By killing the carry trade and provoking banks to lend money rather than to earn carry, a hike in rates could plausibly cause inflation to increase at least at first, as such a development would help generate an increase in money velocity.

This is just one of the interesting twists we may have to navigate as we exit this recession. And we are going to get some interesting “experimental data” as well that we don’t normally get to see. One of the reasons that Keynesians can claim that growth in excess of capacity causes inflation while monetarists say that inflation is caused by excessive money growth is that in normal recessions, these things occur more or less at the same time (given the lags inherent in the inflation-generating process, they don’t need to be simultaneous, just close, for us to have trouble disentangling the effects). We have experiments in other countries where there are large output gaps and too much money, or negative output gaps and not enough money, and it seems to me that these experiments support the monetarist view…but this will be the first time in a while that we may have a discernable difference in the US economy. In this case, the upturn in the rate of growth and the increase in lending and velocity will ultimately occur, when it does, while there is still a very large output gap. If inflation follows, then the Keynesians will have a difficult time explaining how; if inflation does not follow until the output gap is fully closed, then monetarists will have a tougher time of it.

None of this will have anything to do with PPI, though. The Producer Price Index (Consensus: -0.2%/+0.1%) being reported tomorrow is not a very useful inflation indicator for most applications but amounts to the major data release of the day.

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One more idle observation: I heard on the radio that there is a move afoot to get the Nobel Prize committee to award the Peace Prize to … the Internet. This strikes me as crazy, since not many inventions have done more to encourage global friction than the Internet. Ask the Danish artist who caricatured Mohammed if the Internet contributed to peace. To say nothing, of course, of the financial crises that have been encouraged by the increased inter-asset correlations made possible mainly by light-speed information exploitation. Would Greece’s meltdown have happened, at least in the manner it happened, without the Internet? A faster news cycle is not a contributor to peace. Flames must be fanned or they go out. A faster and more global news cycle is a contributor to war.