E-piphany

The water is getting a little choppy, and perhaps dangerous enough to consider not swimming for a little while. Today the June 10y note gave back 3/5ths of its Tuesday gain (21/32nds, to be exact, with the 10y Treasury at 3.77%) while stocks recovered 0.7%. This retracement came as incrementally more aid was offered to Greece. However, that financial aid is contingent on keeping at least a ‘B’ average this semester – just kidding, sort of. As usual, the aid was too little and with too many conditions to even be relevant, but even a small sense of taking the kettle off the boil is welcomed. But the kettle won’t stay off the boil long; this ball has rolled too far downhill to be pushed back over the summit.

Already, politicians are working on their scapegoats, and since they all golf together they pointed at non-politicians. The European Commission is very ticked at the rating agencies, you see, because the downgrades are helping to stoke the crisis. I think the ratings agencies ought to take a page from Casey Stengel, who famously said that the art of being a manager is “keeping the people who hate me from those who are still undecided.”

The Federal Reserve, as expected (considering the European turmoil), remained on hold and reiterated that rates will remain low for an “extended period.” Here, the monetary authority actively wants things to boil but the statement read like a classic economist “on the one hand, on the other hand” waffle. In part:

…Growth in household spending has picked up recently but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software has risen significantly; however, investment in nonresidential structures is declining and employers remain reluctant to add to payrolls. Housing starts have edged up but remain at a depressed level. While bank lending continues to contract, financial market conditions remain supportive of economic growth. Although the pace of economic recovery is likely to be moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability.

With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.

…Thomas M. Hoenig, who believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted because it could lead to a build-up of future imbalances and increase risks to longer run macroeconomic and financial stability, while limiting the Committee’s flexibility to begin raising rates modestly.

The fact that they retained the language about being on hold “for an extended period” is not surprising, especially if you think they believe their press about there being no inflationary pressures because of the output gap. While Hoenig is right in principle to object to the open-ended liquidity promise, there is too much downside today to hiking rates or even indicating that a hike is eventually coming, and no matching upside. If and when the fear of those imbalances outweighs the fear of what will happen to the economy when they tighten, they believe, then they’ll tighten.

Of course, the real issue is that by the time those imbalances scare them, they may also be scared of taking action to correct the imbalances. The history of the Fed, especially in the Greenspan/Bernanke era, has been to pretend that since they cannot know with absolute certainty that a bubble is forming, it is best to ignore it completely. This strategy, of selling policy options with small upside and big downside, is exactly what they are avoiding today by not making the language more hawkish (I discuss the notion of monetary policy “options” in my book. Greenspan was perennially taking big gambles for small gains). When the bubble – equity, fixed-income, real estate, or whatever – forms, I suspect they will not have the fortitude to take a sure, small loss rather than the wager between a small gain or a big loss.

Maybe that is a reason to bet on stocks. Wager that the Fed will continue to provide costless capital and drive risky assets higher. Perhaps bullish investors are merely turning their sails to the wind. There may be merit in this approach, but it isn’t my approach. I am a value investor, and when there is little value then I don’t default to riding the most-recent momentum. If you row crew, then you don’t hoist a sail just because it looks easier sometimes.

It is interesting that bonds retraced more of their rally than equities did their selloff. Perhaps a “flight to quality” no longer automatically means Treasuries – perhaps they just serve as a liquid stopover for money while it finds a true safe harbor. But what would that be here? If sovereign bonds are iffy, top quality credits are better investments…but if you’re really a top quality credit, then you haven’t issued many bonds (after 2008, the last thing I would want to do is introduce bonds to my portfolio that depend on the issuer being able to roll its existing debt when it comes due. No matter who it is, if the market shuts down again then levered companies are vulnerable. Equities have problems, the most notable of which at the moment is valuation.

That points mostly to real assets (and folks, I am not saying “gold”). As I have written here before, I don’t much care to own commodities directly, since they can’t have much more than a 0 real return in the long run, but commodity indices are worthwhile. However, they are volatile, and too dangerous to stick too much of your assets into. I suppose the answer is the answer that is usually right: diversify, diversify, diversify. Deposits in New Zealand, bonds in Canada, real estate, certain hedge funds, inflation bonds in your home currency (I would avoid nominal sovereign bonds), commodity indices, junior bonds or preferred stocks in high-quality firms, some high-dividend stocks of companies that produce real stuff and are not highly levered. Not helpful, I know.

I think one of the reasons to look for inflation protection under every rock right now, especially if you can find a way to source it cheaply, is that the Fed is likely to be (a) slow to respond to price pressures, when they begin, for all the reasons above and (b) they are likely to accelerate much more rapidly than they have in the past…partly because pretty much everything is happening faster these days, and partly because the lower level of private debt lowers the economy’s natural resistance to inflation.

Tomorrow, there is a bit more data from the Chicago Fed (Consensus: -0.20 vs -0.64 last) and Initial Claims (Consensus: 445k vs 456k). Again, economists are calling for an improvement in ‘Claims to near the best levels of the year. The last time we got such prints, it was apparently due to faulty seasonals, but hope springs eternal (and they’ll eventually be right). I will watch with some disinterest – the important stuff is happening in Europe.

I can now add to the long list of reasons I won’t let my kids watch C-SPAN the following: those Senators are nasty!

Carl Levin chose to emphasize the fact that Goldman traders referred to the Abacus deal in internal emails as a “sh*tty deal,” hammering that phrase over and over. I suppose you can do that on cable TV. The Goldman guys sat there looking cool under pressure (well, they should, they’re traders and they’ve heard lots worse on the Goldman floor I assure you), but I suspect that those folks who wondered whether the SEC really had a case against Goldman are now wondering how many other emails like that there are. Part of what drove the post-equity-bubble research settlements after 2000 was the discovery of internal emails showing that research was saying one thing when they really felt another.

Of course, these are traders, and while they bowed to the Committee and said they had a duty to their clients, that’s not technically true of the market-makers. Goldman as a firm has a duty to clients to not defraud them and not misrepresent the facts (or their opinions), but especially with institutional customers their legal duty is to maximize value for the shareholders (within the rules). Enlightened traders understand that you maximize long-term value for your shareholders by cultivating good relationships with customers, but that isn’t the same as the legal duty to clients. I remember very clearly one customer who wanted me to add a “synthetic AAA CDO tranche” to juice up the returns of an inflation strategy I was talking to them about. But the end client was a municipality with a post-retirement benefit (OPEB) plan. I made clear in every way that I could, orally and in writing, being sure to have witnesses present, that the yield of that “AAA CDO” clearly indicated that it shouldn’t be considered “AAA” in safety and was in my opinion not a suitable investment. I lost the deal. It was one of my finest hours (especially considering what happened to synthetic “AAA” CDOs.

Now, I am not a lawyer, and perhaps these Goldman guys pushed the envelope just exactly to where they could justify it. I suspect, though, that they did not anticipate how the law might be interpreted in the middle of a populist backlash against Wall Street. This is one of the problems when you let activist judges interpret the law: the law probably means something a little different today than it did three years ago, especially if the judge lost a bundle in his IRA. Even if Goldman has a rock-solid case by the letter of the law, I suspect they are already realizing that this is gaining momentum faster than they’d like.

Speaking of gaining momentum faster than anyone would like, European bourses took a pounding today as the implications of the Greek unraveling began to dawn on people, and for that matter on some rating agencies. S&P downgraded Greece to junk, which I think means that Greek bonds can no longer be hypothecated as collateral at the ECB; moreover, they downgraded Portugal as well with a negative outlook. Usually, when the ratings agencies finally get out in front of a problem, that problem is almost past…but in this case, I think S&P moved a lot earlier than I (and many other people) expected them to.

Stocks here in the U.S. dropped in sympathy, -2.3%. That’s still not a “plunge,” but closer to being worth worrying about. Bonds rallied on a flight-to-quality bid, with TYM0 up 1-02+ and the 10y yield down to 3.69%. Whatever my reasons for being bearish on fixed-income, a collapse in European markets wasn’t one of them, and I’ll wait until that plays out before getting bearish again. I don’t think getting long is a great idea, because when the situation settles the flight-from-quality will be even faster than the flight-to-quality. As traders and investors, we don’t have to make a bet until we feel the odds are in our favor. The pot odds don’t favor any bet right now.

And while this is happening, the Federal Reserve is wrapping up its 2-day meeting tomorrow (the post-meeting statement is the only important economic announcement of the day). Whatever their plans were prior to this, I think it is pretty unlikely that they will choose this meeting to remove the “extended period” language and throwing gasoline on the fire – although, having said that, there is some argument to be made that making such a change when bonds are bid, rather than offered, makes some sense. I think it would be foolish, since any significant turmoil in Europe will raise questions about the impact on our economy, and preserving options here should be the Fed’s modus operandi. There is little upside, and much potential downside, to sounding hawkish at this meeting. But sometimes, they do stupid things.

The Committee might be forgiven if they are cheered by the Consumer Confidence figures, which jumped today to 57.9, much higher than expected. Most of that rise, however, was in the expectations component. That doesn’t mean the rise in confidence doesn’t matter, but expectations are probably enhanced by the stock market’s performance so I would put a lower value on that than the “current conditions” subcomponent (which is some 50 points worse than the expectations component). Moreover, the “Jobs Hard to Get” response to the employment situation question declined but only to 45.0. As the chart below (Source: Bloomberg) illustrates, this is better…but probably not enough to be confident yet that the job market is on a medium-term healing path.

Looks toppy, but hard to say for sure yet. Not exactly strong improvement.

According to Investors Intelligence, cited in Alan Abelson’s column in this weekend’s Barron’s, only 17.4% of advisory services are bearish on the stock market, the lowest reading since 1987. I hope that readers recognize what a rare experience they are being treated to when they read this commentary!

Speaking of a rare experience, a Seattle cartoonist has launched a movement among cartoonists for “Everyone Draw Mohammed Day” on May 20th. Because really, what could go wrong with that idea?

It seems like the populace is too busy making up stupid celebrations to eat their cake. Today marked the celebration of “Boob Quake,” which was started by an atheist college student who believes that if women show excessive immodesty today and there is no earthquake, then the mullah in Iran who is the target of her ire will be forced to recant his statement (the thrust of which was that earthquakes are caused by women showing too much skin). Now, like any red-blooded American male I am generally in favor of college co-ed bosoms, but in this case it appears they caused a magnitude 6.5 earthquake. Nice job, ladies. I sense more government safety regulations in the offing.

Should it be disturbing to us that enemies of this country, scattered around the globe, arrange terrorist strikes on our citizens and allies, and our response is to draw cartoons and show our boobs? Well: eat, drink, and be merry, for tomorrow…

None of that affects the market, of course; but then again, almost nothing seems to affect the market anyway. As I warned on Friday, despite all of the good feelings about “a Greek solution being near” – which seems to happen every Friday – the situation is no more resolved than it was. The German Finance Minister told the Bild am Sonntag newspaper over the weekend (reported here and elsewhere),  “The fact that neither the European Union nor the German government has taken a decision means it could be positive or negative.” Darn it, there goes the apple cart again. As the chart below shows, 2-year Greek yields are up to over 13%…but the 10y is over 10% too. The market gives Greece about a coin flip to survive without default.

The Greek 2y Is High, But The 10y Is Nearly 10% Too!

In the U.S., however, the failure of a major nation-state and the potential for a run on similar nation-states isn’t cause for alarm, apparently. True, equities did surrender 0.4% after trading higher initially, and the 10y Note contract did struggle to a 4/32nds gain (3.81% 10y yield), but this does not look like the stuff of panic.

The irrational exuberance is again winning the tilt against rational lugubriousness. As the latest exhibit in support of that proposition, let me point again to Barron’s, this time their survey of money manager views on the economy. The survey question whose response jumped out at me was this: “What are the odds of a ‘double dip’ or second recession in the U.S. this year?” The responses were:

• Odds: 100%    Responses: 4%   Makes sense; no such thing as a sure thing.
• Odds: 75%      Responses: 19%  A fair number of pretty bearish folks, but they know that 100% is crazy.
• Odds: 50%      Responses: 13%  A little less.
• Odds: 25%      Responses: 2%    Still less. Looking kinda bearish tilt so far.
• Odds: 0%        Responses: 62%

Wait, what? Fully three-fifths of money managers feel there is no chance at all for a double-dip recession this year. That is crazy. Of course, 2008 taught us that there is no such thing as a certainty, and the bears in the survey seem to understand that, and there is no such thing as an impossibility, which the bulls don’t seem to understand. Even if we are generous and recognize that this includes all the 1% and 2% answers, it cannot be very skewed, with 5% and 10% answers, or the “25%” answer bucket would have more in it than a mere 2% of respondents.

That’s either irrational exuberance, or the stock market is being driven higher by people who can’t do math. Or maybe both.

It is always nice to remember why I am so glad that I am not an equity guy, but in fixed-income. I wonder and worry about the equity folks, but for the most part it’s like having an ant farm. It’s fun to watch them looking so busy, and yet so single-minded and uncreative, and it’s fun to occasionally watch them scurry about when someone taps on the glass.  “What the heck was that?!? Let’s get out of here! Save the queen! (I told you that you were showing too much thorax!)”

Not that we are always so sober and sedate in the fixed-income world, but since we’re worried about a return of principal rather than a return on principal as our primary constraint, we spend much more time thinking about what could go wrong than about what could go right. Which is probably why bond people hang out with other bond people, because no one wants us at parties. And as for the inflation people, forget it. But I digress.

The FOMC, who has a meeting over the next couple of days, keeps talking about unloading its mortgage portfolio to shrink its balance sheet. I mentioned on Friday that I think this is a very bad idea, since the market is not likely to be able to handle another trillion-dollar-seller with aplomb, but there’s another issue to be aware of as well. The Fed’s purchase of $1.25 trillion of agency MBS not only took a lot of duration out of the market, it also took a lot of negative convexity out of the market. Owners of mortgages get higher coupons than on similar-duration Treasuries because of the embedded optionality in the payout: when rates fall, the security pays back principal; when rates rise, it pays off principal more-slowly than expected. In both cases, you have your money sitting at a lower-than-expected rate if there’s a decent move, and this is compensated for through a higher coupon.

Many holders of mortgage securities therefore hedge these prepayments and extensions either by delta-hedging (this is what is meant when we say there was “convexity-related selling” in the market) to add or subtract duration lost or gained by the MBS, or by buying actual options. So when the Fed took all of those MBS out of the market, they greatly decreased the demand for vol, and as a consequence of that vol fell further, and faster, than people expected it to in the wake of 2008-2009.

But when the Fed starts selling those securities, the exact opposite will happen. Not only will it add duration to the market, but it also will increase the demand for volatility (as well as actual volatility, as investors hedge the embedded options or dealers hedge the real options that they sold to investors). This is one reason I like out-of-the-money puts on Treasuries – if the Fed starts selling mortgages, your options may rise in value due to an increase in implied volatility even if rates don’t rise.

Tap, tap, tap. Wonder what will happen when rates begin to rise and vols start to creep up too. Tap, tap, tap.

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The 5y TIPS auction today tailed 2.75bps from the pre-auction mark, which wasn’t too bad for a 5-year TIPS auction. Of course, it wasn’t great, and a low-ish indirect bid means that the Street owns a lot of the issue. I think it will clean up okay, though.

Tomorrow, Consumer Confidence (Consensus: 53.5 from 52.5) is due out; as usual, I will be looking at the “Jobs Hard To Get” subindex, which remains very high. That index needs to be moving to 40-42 before I get very excited about the employment situation improving. The Case-Shiller index is also out, but that isn’t a market-mover; however, Chairman Bernanke is due to speak at 10:00 at the “Obama Debt-Reduction Commission,” and will likely tell everyone there that deficits are bad. On the chance that he says something else significant, however, be alert!

I am not sure what game it is that equity investors are watching. Overnight, Greece formally asked for aid from the EU and the IMF. Stocks rallied, I suppose on the theory that the drama is finally over. But of course, the drama is just beginning (I think that in Greek tradition the drama isn’t over until someone marries his mother). It would be over if the EU’s pledge had been backed by actual commitments from legislatures, and if the money was easily disbursed, and if, in fact, there was money to disburse. This is evidently false:

• Bloomberg cited the Belgian magazine L’Echo as saying the country may find approval of their tranche of the loan “problematic at the very least.”
• German Prime Minister Merkel said that Greece needs to finish talking with the IMF before money is disbursed, and that the money will be tied to “very strict conditions,” including approval by the EC of the assistance and a recovery plan drawn up by the IMF. “Only when these two steps have been completed, can we talk about concrete assistance, including what kind of aid and how much.” (AP) Really? I thought there was already a concrete assistance plan! Whoops.
• The Prime Minister of the Netherlands said the “need for restructuring Greek finances has increased.”

None of this sounds like the response I thought the market was expecting, which was more like “Where do we send the cheque?” At this point, two things can happen: (1) European governments can close ranks and start talking again about how yes, there is a deal – in which case we will get to start reading about all of the groups who are going to fight it on basis of the anti-bailout provision of Maastricht, or on country-first arguments (“why are we sending our money to Greece?”). Or (2) the EU can change its mind and say no (or are unable to reach a united opinion). Either way, the drama hasn’t ended; it has barely begun, and there are more PIIGS (and investors therein) who are waiting to see the outcome. And how long will capital stay in Greece, waiting to hear the outcome? This can still turn to crisis quickly, which isn’t to say that it will but that the potential range of near-term outcomes is widening. In my view, the “assistance” proffered by the EU was mostly an expression of confidence designed to persuade investors to buy Greek debt, thinking there was a “backstop.” But no one ever got legislative approval, so the confidence game was fairly transparent. Greece is actually pulling on that lifeline, and I think we will shortly find that it wasn’t tied off. In the meantime, however, stocks wrestled higher on the day, finishing with a gain of 0.7%.

Bonds were a little lower on a slight diminishing of a flight-to-quality bid when they were smacked by an early-morning report by CNBC that a “growing bloc of the FOMC” wants to sell assets and reduce its balance sheet. As I’ve noted here before, such a decision would be likely to lead to much higher interest rates; instead of last year’s Treasury issuance, minus Fed purchases, you would have this year’s issuance (higher anyway, since the deficit is larger and more debt is maturing) plus Fed sales. Moreover, if the Fed is selling and rates start to rise, then the banks will need to start lightening up on their hoard of Treasuries too, rather than continuing to pull more down in the auctions. In short, rates appear to be currently in equilibrium but it is a very unstable, very top-heavy equilibrium. 10-year Note futures closed with a loss of 12/32nds, with the 10y yield at 3.81%.

Prices are determined at the margin, and from past market experience we know that much smaller changes in supply dynamics can lead to large changes in yields. Mortgage-related convexity phenomena in the early 2000s led to a couple of 100bp swings in rates in somewhat-illiquid markets in Q4 of several years. Between November 12th, 2001 and November 21st, 2001, 10-year yields rose from 4.30% to 5.01%: 71bps in 7 trading days. Between October 9, 2002 and October 17th, 2002, 10-year yields rose from 3.57% to 4.20%: 63bps in 6 trading days. In 2007, the month of November saw 10-year yields decline relatively gently from 4.47% to 3.94%. We do not need to review what happened in 2008.

While market liquidity conditions right now are not what they were in 2008, in relative terms they may well be similar to a typical Q4. The overall float being held by ‘traders,’ if you include banks and the Fed, is positively massive compared to the underlying volumes. As long as movements are slow and stately, liquidity is more than adequate. I have very little confidence, however, that liquidity would respond to a 50bp selloff in any way other than to flee like King Arthur’s knights confronting the killer rabbit.

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Wow, was I ever wrong on my skepticism about Durable Goods! Core Durables not only registered the biggest gain in a couple of years (+2.7%), but last month’s number was revised upward as well. Transportation orders pulled the headline figure down to -1.3%, but the strength in core Durables for consecutive months is impressive. New Home Sales also surged more-than-expected, although it is still being kind to call the pace “anemic” at 411k. The combined pace of Existing Home Sales and New Home Sales (see chart below, source Bloomberg) definitely has ticked higher, and even though the sales figures are still muddied by the tax credits it seems likely that the worst sales rates are behind us. Knock wood.

The latest bounce is noticeable, but not impressive yet.

Now, I don’t think that means that housing is about to take off, mind you, but if it is then inflation can’t be too far behind since the main thing holding measured inflation down is the decline in housing costs. As I have written (a few times) before, core ex-housing is already in a multi-year rising trend (it recently peeked over 3% before dipping back). All that is needed for that trend to begin asserting itself in the overall inflation figures is just for housing prices (and therefore rents, with a lag) to stop falling. Q3-Q4 is looking good for a bottom in core inflation.

The only scheduled event of note on Monday (aside from the Dallas Fed Manufacturing Activity Index, which which doesn’t usually move markets) is the $11bln 5y TIPS auction. The issue, like all April 5y TIPS issues, is expensive because the market overvalues the “deflation put” and undervalues the seasonality, but it doesn’t seem too expensive for an April 5y TIPS issue. It may be hard to believe that the Treasury can sell $11bln at a real yield of only 0.50%, but your alternative is a 2.59% nominal 5y note. The only way that note outperforms TIPS is if inflation is in the narrow range of 0%-2% over that 5-year period; if it is below 0%, they’ll perform about the same since they both pay off par, while if inflation is above 2% or so then the TIPS clearly win. That mainly speaks to how expensive Treasuries are, that only unlikely inflation scenarios make 5y notes pay off, but I think the auction will go fine. (That may be a first for me. I usually hate the 5y TIPS auction!) There are a lot of people who want to invest in inflation-linked assets, but are not comfortable buying real duration at these yields. To them, the current low yield is an opportunity cost of waiting, a lot like the subzero yields of TBills during the crisis was a cost of waiting for better investing conditions. If I am right about that, then buying a liquid on-the-run note that is short in duration will be attractive right now, in the way that buying only 5-year inflation protection rarely is.

A bit of volatility today, but not really attributable to economic data. A round of applause for economic forecasters, who were very close to PPI (+0.7%/+0.1%), Claims (456k), and Existing Home Sales (5.35mm). Now if only they can explain why we shouldn’t be concerned that the Easter blip apparently occurred from a level around 460k rather than the 430k – and declining – they were forecasting a few weeks ago…

The volatility came from the continuing rout in Greece, where the various policymaker attempts to convince us that everything is okay are becoming increasingly easy to see through. Greece was downgraded (belatedly) by Moody’s, but the real judgement comes from the market where Greek bond yields are shooting higher. I said a month ago, when Greece was complaining about not being able to finance at the sub-6% rates to which it thought it was entitled, that the PM ought to hit the bid at 8%, if there is such a bid. That bid is evidently not there. Not even close. Look out – this is picking up speed as it rolls downhill.

Stocks took a bath overnight and opened weak on the Greece news, but then managed to rally for most of the day and end up positive. The S&P finished +0.2% after a bad open for good reasons. This is beginning to look more and more like bubble action, with two implications: first, it might go on for a long while (although it may also break tomorrow); second, the break may be ugly when it happens. Stocks are just not supposed to rally no matter whether the news is good or bad, especially when they are already at valuations that are stretched (to be kind).

Bonds did poorly, with TYM0 down 11.5/32nds and 10y yields up to 3.77%. The data, as noted, wasn’t particularly strong and news out of Europe would seem to enhance any safety bid, but the trading was the mirror image of stocks – open with a gain (although modest) and sell off throughout the day.

The Treasury announced that it will auction $11bln five-year TIPS on Monday (along with $44bln 2y, $42bln 5y, and $32bln 7y next week, plus bills). So what’s the inflation backdrop as we head into that auction?

The dollar is strengthening against the euro, and that is helping our relative inflation outlook (that is to say, helping to hold it down) compared to Europe’s. But our system isn’t exactly on a sound and stable basis; investors aren’t fleeing to our currency because it is the prettiest but because, at the moment, it is the least-ugly.

Inflation, fundamentally, has two sources: global inflation, and idiosyncratic (country-specific) inflation. If the latter is what threatens, then your currency ought to depreciate as well so that holding foreign securities provides a partial hedge. Similarly, if there is no underlying global inflation then a rallying currency can hold down domestic inflation (basically “exporting” it to weak-currency countries). In such a case, inflation is kind of a zero-sum game, as my deflation is your inflation and our currencies tend to reflect that.

But if what is threatening is a global inflation, then currencies may not move at all if there is no change in relative inflation outcomes at the same time that absolute inflation rises. What is suffering then is not your currency, on an exchange-rate between it and other currencies, but rather all currency compared to real goods. The price index is, after all, essentially an exchange rate between fiat money and real goods. This is, I think, what our current situation is. All countries are “stimulating” their economies, and all central banks are adding liquidity to a lesser or greater extent. In this case, a rallying dollar is solace, but small solace. Keep in mind that in the early 1980s, despite high inflation in the U.S. the dollar strengthened (the magazine cover below is from 1984). I am not significantly more sanguine about inflation now that I was before the dollar’s recent surge.

Inflation won't kill a currency by itself

On Friday, the economic data is in the form of Durable Goods (Consensus: +0.2%/+0.7% ex-transportation). Last month, Durables were strong (+0.5%/+0.9%), but it is unusual to have two back-to-back strong readings on core Durables even during expansions (see Chart below, source Bloomberg). Accordingly, I am cautious about the chance for a downside surprise.

Durable Goods, even core Durables, is highly mean-reverting.

Due out an hour and a half later (at 10:00 ET) is New Home Sales (Consensus: 325k from 308k). The consensus calls for a slight bounce from all-time lows. That doesn’t seem unreasonable. A further decline may be viewed with some alarm. At some level, I think what is happening is that distressed sales of existing homes are out-competing the sales of new homes, so that we ought probably to look at the sum of the two, but however you slice it the housing market still looks punk.

The stock market is set up to take a tumble at some point on growth disappointments. I don’t think tomorrow’s numbers are sufficiently important to trigger that, but I am on guard. The bond market, despite today’s trade, is certainly not falling apart and 3.75% 10-year yields seems to suggest bond traders are more sensitive about the chance of a growth surprise. I am bearish on bonds. I think stocks are expensive and bubbly, but from a trading perspective that makes me neutral and cautious. I don’t want to sell into a bubble (or if I do, I want to get out quickly) if one is forming; there will be plenty of time to sell a break once it happens.

Another slow day, with the equity bears/fixed-income bulls winning this time. The bond market ended up at 3.74% on 10y yields with TYM0 up 13.5/32nds. Stocks were roughly flat.

Inflation swaps rose slightly (1-2bps), despite falling yields. Forward inflation swaps continue to hover at levels around 3.0-3.2% for periods 5 years and out. It is surprising to me that inflation-linked bonds and inflation swaps are doing so well despite impending supply – tomorrow, the Treasury department will announce the size of Monday’s 5y TIPS auction (more on that below), but there is more. The Wall Street Journal reported in this morning’s edition (story for subscribers is here) that the Treasury is expected to announce in early May that it will increase issuance of TIPS in the second half of the year, potentially auctioning 10y TIPS every other month on a January-July cycle with two re-openings of each. This is welcome, and good strategy (as I argued in a column last December, if Treasury really wants to try and persuade buyers of nominal bonds that they are not planning to inflate away the debt, increasing the size of the TIPS issuance, rather than de-emphasizing it as they had been doing, has a great value in ‘advertising’ terms). And at these real yields, why shouldn’t the Treasury issue as much as they possibly can, especially if they’re not planning to monetize the debt?

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Because I am often talking to people about inflation, I run into a lot of fans of gold who ask my opinion. My opinion is generally simple: gold does not pay a dividend, and its real return is approximately zero over time (you start with 10 ounces of gold, you end with 10 ounces of gold: real return=0%). While commodity indices offer interesting returns and an interesting pattern of returns, these come less from the movement of spot commodities and more from the other components of return: collateral return, risk premium, rebalancing return, convenience yield, and expectational variance.

Usually, people who like gold and own gold ETFs don’t like to hear that it’s a zero-real-return game (as an investor; of course, there are always profits to be had for successful speculators, balanced against the losses to be had for the unsuccessful), and sometimes they get sort of mad. So I am really happy to be able to present this link, from the Fama/French Forum. These two luminaries (Krugman has a Nobel, and Fama/French do not?!) answer the question of whether gold belongs in a portfolio. Their summary:

To summarize, gold makes sense as a portfolio asset only for investors who also get the consumption dividend from gold, since this “dividend” lower gold’s expected capital gain. Thus, for investors who do not value the consumption dividend, the expected return on gold does not cover its risk as a portfolio asset, (which takes account of its value for portfolio diversification).

I had never thought about the convenience-yield angle. I am a little skeptical of the pure theoretical markets arguments that Fama/French crowd puts out sometimes, because the market isn’t that efficient, but it’s a point worth considering.

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On Thursday, we will finally get some economic data. PPI (Consensus: +0.5%, +0.1% ex-food-and-energy) is not a market-mover since we have already had CPI last week, but Initial Claims could be interesting. After large surprises higher in the last two weeks, the consensus estimate is for a return to 450k (from 484k last week). But that’s very timid, if in fact 450k or below is the true run-rate (two weeks ago, the forecasts were for 435k; last week they were for 440k), since the explanation for the prior misses – seasonal issues related to Easter week – should be smoothed out if we average over four or five weeks. If they are not, then that excuse doesn’t really cut the mustard. With the last two weeks a cumulative 44,000 over the 450,000 that economists are now forecasting, we should be in the low-400s anyway. And if the true underlying pace of Claims is what they were forecasting before, 435-440k, then we could see a sub-400k print.

Personally, since confidence indicators have been weak lately I suspect the jobs picture is not improving as dramatically as economists have forecast, but either way this week’s data point is important. If we get another 460k or 470k, it starts to look implausible that Easter could cause a three-week rise and we need to start wondering if perhaps the true pace of Claims isn’t still around 460-470k, where it has been all year. It would not be the first time that economists had prematurely trumpeted a robust expansion.

Finally, at 10:00 Existing Home Sales (Consensus: 5.28mm) will be released. Recall that EHS had spiked on tax incentives to purchase homes; the thought seems to be that we will get another minor taste of that this month as those incentives are expiring. The recent volatility in this data series makes it almost possible to have a number that meaningfully changes our perceptions, unless it is very weak.

As I said earlier, the Treasury is also due to announce the size of the 5y TIPS auction, which will occur on Monday. The 5y auction is always subject to being a dog, but the level of real yields on TIPS suggests that the market could use a few more at the short end. I suspect the reason that the real curve is so steep, with real yields negative out for 3 years, is less because the market perceives expected growth as being negligible than because investors prefer to reduce duration risk until inflation is about to pick up. That is, with 20-year TIPS yields below 2%, a buyer of long TIPS will likely have a mark-to-market loss when inflation first picks up and all yields rise. Better, perhaps, to take a very low expected return (and negative in real space) with low duration risk, and then move out the curve once yields rise. It is basically the same dynamic that is causing such steepness in the nominal yield curve, although in the TIPS case the Fed doesn’t have direct control because they set nominal, rather than real, interest rates. In any event, I think the unusual demand for short-duration TIPS right now will help the Treasury sell a lousy tenor at a lousy yield (roughly 0.55% right now in the 5y area).

It was a relatively quiet day in the markets, despite the fact that stocks were weak overnight (partly because Greece’s Prime Minister said the country was on an “inescapable path the IMF” but mostly because of the continuing reverberations from the SEC-Goldman tiff last week). Stocks shrugged off the impulse to do something important and closed +0.5%. Supposedly the rally was partly due to the news that the SEC’s decision to sue Goldman was the result of a “secret” party-line vote of 3 (Democrats) to 2 (Republicans). Investors took comfort in knowing, I guess, that there was a difference of opinion based on raw partisanship. Yep, that surely is better news for Goldman, because one little contribution can make everything all better. But is it good news for the market? I think I saw the same approach on the Sopranos. There is lots of reasons these deliberations are supposed to be secret…that’s one of them. The purpose of ballot secrecy is not just to protect you from negative consequences if I know your vote; it is also to protect the system from the consequences if you can prove your vote (and thereby sell it) to me. Which is, by the way, the reason that giving receipts at the voting booth is a very, very, very bad idea.

TYM0 fell 9/32nds; the 10y yield rose to 3.80%. The fact that Europe is still preoccupied with the question of how to ship out all of the folks who are stuck there due to the volcano (limited flights reportedly to begin tomorrow) probably doesn’t help market liquidity. By the way, instead of calling the volcano by its proper name, Eyjafjallajökull, which I am pretty sure involves glottal clicks and other strange sounds I am incapable of making, can we non-Icelanders just call it E*, pronounced E-star? In exchange, we will allow Icelanders to call Obama “the big O.” Either the letter or the number, your call.

Since the markets are relatively quiet, yields have retreated from any immediate sign that I need to reconsider my near-term bearishness on fixed-income, and therefore my working hypotheses need little adjustment at the moment, I want to touch on two other topics that are broadly relevant to the market these days but not necessarily breaking news. I’ll tackle one today and perhaps one tomorrow.

Price Serves A Rationing Function (Normally)

I think that when we teach economics in school, especially at the high school level when economics isn’t generally being taught by economists, we tend to do a decent job of indoctrinating students with positive economics verities (positive in an economic sense, as opposed to normative) but a relatively poor job of teaching why those verities are in fact verities.

[This is one reason that I like to read books and articles by Thomas Sowell (I do not recommend that you read him if you are not conservative, or open-minded to cogent argument, or both). I think he does a terrific job at demonstrating just why economists believe certain things, and doing it in a way that doesn’t involve graphs. Personally, I love graphs and I ‘get’ them, but it doesn’t work for some people.]

Ironically, I think one of the things that most people forget about is one of the first things that is taught in microeconomics: the function of price. Why is it that the demand curve slopes downward? That is, why is it that the market wants more gold if the price is lower?

The answer is that we have more uses for gold at a lower price. We can make coins with it; at a lower price we can hammer it into fillings; at a lower price still we can use it in lieu of toothpicks. So if you ask me how much gold I need at $1,000,000/oz, the answer is zero; at a price of $0.01/oz, the answer is “I’d love to have a desk made of solid gold.”

The price that a consumer is willing to pay is related to the marginal utility of the good to that consumer. So how is the actual price set? Well, in a one-period model where the quantity supplied is given – which allows us to consider just the demand side – we can think of price being set in a big auction with all of these consumers bidding against one another. There is a limited quantity of gold for sale, and I am just not going to be able to get any of it with my 1 penny bid (drat! No gold desk). In short, the gold ends up in the hands of the people who have the highest-valued use for it. Price, in short, serves a rationing function that routes goods and services efficiently to their highest-valued uses, if the market is free.

I like this explanation, which comes from the Wikipedia entry for the Paradox of Value:

The reasoning goes like this. If someone possesses a good, he will use it to satisfy some need or want. Which one? Naturally, the one that takes highest-priority. Eugen von Böhm-Bawerk illustrated this with the example of a farmer having five sacks of grain. With the first, he will make bread to survive. With the second, he will make more bread, in order to be strong enough to work. With the next, he will feed his farm animals. The next is used to make whisky, and the last one he feeds to the pigeons. If one of those bags is stolen, he will not reduce each of those activities by one-fifth; instead he will stop feeding the pigeons. So the value of the fifth bag of grain is equal to the satisfaction he gets from feeding the pigeons. If he sells that bag and neglects the pigeons, his least productive use of the remaining grain is to make whisky, so the value of a fourth bag of grain is the value of his whisky. Only if he loses four bags of grain will he start eating less; that is the most productive use of his grain. The last bag of grain is worth his life.

So why do I mention this? I think it is useful to think about this in order to understand why Western civilization doesn’t collapse with $100 or $200 oil. Life changes, to be sure, and the economy bears large costs as a result of that change. But it isn’t as calamitous as it might seem because the highest-valued uses tend to be filled first. The first thing to go are the joy rides; more commuters car-pool; sooner or later the Vespa becomes a popular mode of transportation in the U.S. as it is in many cities in Europe.

Moreover, price serves a signaling function. At $200, many other forms of energy become economical. Most “alternative energy” is not economical because fossil fuels have a much higher energy content than switchgrass (for example), so you need a whole lot of switchgrass to replace one barrel of oil and that simply costs too much. But if oil costs three times as much, voila! Other forms of energy come online.

The pain from spikes in energy prices are because of just that – they’re spikes, and supply takes time to adjust (at least one season in grains and livestock but lots longer than that when we’re talking about mines or wells or nuclear or alternatives). We are experiencing a long-term bull market in many commodities because the low prices of the 1990s led to decaying infrastructure. Roughnecks who made gobs of money on drilling rigs in the Gulf of Mexico in the early 1980s have retired, and no one replaced them because in the late 1980s and 1990s there was no money in oil drilling. So now we want to drill new wells, and we’re out of roughnecks, tankers, etcetera. New nuclear plants take ages. Storing wind energy is woefully inefficient. And the list goes on. That is why an oil spike is a problem.

There will be a big economic shock, to be sure, if oil spikes to $200 especially if we haven’t developed the capacity in those alternative sources and the price adjustment happens suddenly. This will be a big problem in a levered economy that has as many imbalances as this one does. I’m quite concerned about that. But price will to some degree help solve the problem – rapidly in the demand (rationing) case, and somewhat more slowly in the supply (building) case. Civilization won’t collapse. We’ll just wear out more shoes.

There is no meaningful economic data due out tomorrow, so I suspect I will tackle my second topic: what if our access to our money was cut off suddenly, for example in a financial collapse? I will respond to William Poole’s argument  in recent Financial Analysts Journal writings (his sentiment shared by many in government) that the economy would utterly collapse and there would be mass starvation if we couldn’t use our credit cards for a week or a month. This argument is at the heart of the question of what “too big to fail” and “systemic risk” means.

What Wall Street really needed right now, as they attempt to mobilize against the potentially-disastrous Volcker Rule and any number of other populist nostrums, was for one of their number to be caught with its hand in the cookie jar. To be sure, Goldman generally acts as if it owns the cookie jar, but pride goeth before a fall and…whoops.

Of course, Goldman will survive and probably settle for what amounts to a slap on the wrist, as will any other firms later charged by the SEC in similar actions; I suspect this is mostly about the government gaining a tempo¹ over the finance industry.

Prior to the SEC’s announcement, it was looking like another day of the same in equities. Indices were lower overnight, and bonds considerably higher, as further details on the latest Greece ‘deal’ makes it appear that it isn’t really much of a deal, and as investors start to must about the impact on commerce of the dumping of Icelandic ash all over Europe, grounding planes across the continent. Housing Starts were stronger-than-expected, while Michigan Sentiment actually declined unexpectedly, so you can get whatever you want out of the data. But once the market opened, sure enough stocks rallied. It is disturbing when this happens every day, because it implies that investors have come to fear “not being long” more than they fear losing money because the market falls. If we are not already at that stage, we were getting there.

But after the SEC announcement that it is suing Goldman, the market went into retreat…not just Goldman, and not just financials, but lots of sectors that have nothing to do with them. Nearly 7 stocks on the NYSE fell for every 1 that rose. That would seem to indicate some people are treating this as if they have suddenly concluded that “aha! This is the thing that might do it.” (It was interestingly not on the list of worries I posted yesterday, which is probably a sine qua non for it actually being an important event.)

CNBC provided its usual humorous background chatter, with talking heads debating whether stocks were down because “they” (retail investors) “feel they don’t have a fighting chance on Wall Street.” “This is their big fear, that the game is rigged.” Come on, folks, the S&P was down 1.25% at the time (-1.6% at the close), after being up around 80% from the lows a year ago. It is probably true that retail investors in aggregate don’t have a fighting chance to be active traders against professionals, but…this is presently a hiccup. Sometimes the market goes down, even in bull markets.

That being said, an overextended market doesn’t need a lot of encouragement to pull back, and so perhaps this turns into a modest correction. If it does not – if investors jump right back in to “buy the dip” on Monday – then the psychology really is starting to get over-the-top and bubbly.

Curiously, bonds responded aggressively to the selloff in stocks, +22/32nds on the day for TYM0 with the 10y yield all the way down to 3.77%, and the VIX also jumped from 15.89 to 18.36. These both seem to be outsized reactions to a fairly minor selloff in stocks, and this might indicate a stronger undercurrent of risk aversion is at work (finally). Oil prices dropped $2.27, but that is probably unrelated: commodities generally were mixed.

I am still medium-term bearish on bonds. The market has now rallied back enough that an imminent breakdown is unlikely, but as the chart below (source: Bloomberg) shows, bearish fixed-income traders can consider leaning short at this level with risk fairly well-defined. Anything more than a handful of basis-points of further rally, however, would make me near-term neutral at least (and if we were not in a fairly bearish seasonal period, I’d probably be turning bullish on a break through).

Bearish traders can consider leaning on this level with technical value

There is no data of note on Monday (just Leading Indicators, which is an amalgamation of lots of indicators we have already seen), so technical factors and news events (further SEC filings, further Greece news) will be more important.

Footnote:

¹This is a term from chess (wikipedia entry). The side that has the initiative is the one which is making the moves to force the opponent’s response, essentially driving the action; when one side gains a tempo he is more in control of the game than he was previously.