Archive for July, 2010


Initial Claims was reported as-expected at 457k; some observers tried to make much of the fact that the 4-week moving average fell to its lowest level in a while, but of course that’s because of the very low number recorded two weeks ago when the seasonal adjustments looked for an auto shutdown that didn’t happen.

I guarantee that the 4-week moving average will jump the week after next (when that data falls out). After all, each week only adds 1 data point. It doesn’t matter how you smooth it: every week has the same informational content. Focusing on the 4-week moving average is a way of keeping one’s self from getting too excited about this week’s number, but the easier method is…don’t get too excited about one week’s number. Each data point is the result of an experiment, measuring an unknown (and unknowable) underlying reality. Each data point, or collection of data points, has more value when those numbers start to diverge from those suggested by your operating hypothesis, causing you to question or reject your thesis. In this case, the operating hypothesis that the underlying rate of Initial Claims is approximately stagnant at roughly 460k per week is not threatened by this week’s 457k number, nor by the 464k number last week, nor by the 452.5k 4-week moving average. The jobs picture is the same as it has been: tepid.

Now, we did have an exciting (for an inflation guy) unscheduled release today, when St. Louis Fed President James Bullard released a pre-print of his suggestively-titled “Seven Faces of ‘The Peril'”, an article scheduled to appear in the September/October St. Louis Fed Review (the article is available here). In the abstract, he says “In this paper I discuss the possibility that the U.S. economy may become enmeshed in a Japanese-style, de‡ationary outcome within the next several years.” As you might expect, it hit the headlines immediately.

I have yet to read the whole paper (tonight’s chore), but from a scan it looks very interesting. I don’t agree, at the outset, with some of his conclusion, but I am willing to be swayed on the reading. The conclusion reads, in part,

“During the recovery, the U.S. economy is susceptible to negative shocks which may dampen in‡ation expectations. This could possibly push the economy into an unintended, low nominal interest rate steady state. Escape from such an outcome is problematic. Of course, we can hope that we do not encounter such shocks, and that further recovery turns out to be robust— but hope is not a strategy. The U.S. is closer to a Japanese-style outcome today than at any time in recent history. In part, this uncomfortably close circumstance is due to the interest rate policy being pursued by the FOMC.”

Specifically, he is critical of the policy of the FOMC to pledge to leave interest rates very low “for an extended period,” and instead says “A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.”

It certainly seems that Fed officials are starting to try and make it clear that they are willing to gun the motor a bit to make sure inflation achieves ‘escape velocity’ and doesn’t keep falling back to the neighborhood of zero. As readers know, I think that they are misguided, since ex-Housing, there is nothing approximating deflation in the U.S., but with money growth low and money velocity probably leveling out but with steady pressure on financial leverage (which is a concept related to velocity), it is not ridiculous to be worried about it. My models suggest core inflation is already beginning to bottom, and as I have written recently I think the “negative shock” about which Bullard speaks – he may even explicitly have the coming fiscal contraction in mind – will be addressed by the Fed as the only arm of government left that has any bullets. And I think that means inflation has potentially a lot of upside, as the Fed in Q1 will probably be pushing prices higher along with the already-generated upstroke.

But I am always disheartened to see policymakers look at Japan and despair of being able to force prices higher. Japan was extremely conservative in their pursuit of ZIRP, and then QE. I will say it again: it is trivially easy to get inflation. Add zeroes to the currency and you are absolutely, 100% guaranteed to get inflation. It is targeting responsible inflation that is the challenge. Japan did the monetary authorities of the world a great favor by conducting a dosage experiment. They didn’t give the patient a big enough dose. Just because the patient did not respond to 1cc of penicillin is no reason to throw out penicillin as a helpful medicine. It may require 2cc. Or maybe 10cc.

It is a little concerning to see quack theories gaining credence before we have tried a little harder to get the proper dosage of a medicine we know works. But what do you expect, I guess? Monetary policymakers today are barely a generation removed from the monetary policy witchdoctors of yesteryear.


I was musing today about investments. We know, of course, that we live in a “low return world,” as Mauldin would say it, or the “New Normal,” as Bill Gross likes to call it. Low returns are the order of the day, which is frustrating to everyone. Yields are low, real yields are low, prospective equity returns are low, etc. But there is one investment that can return you a guaranteed 5% or 6% nominal return with no risk. Yeah, I know we all want 15%, but that’s not available. 5% or 6% with no risk isn’t bad (especially if you believe we are headed into deflation, which I do not, but some do).

Pay off your mortgage. Paying 6% less in interest is equivalent to earning 6% on your investment. (You may say “but you get a tax break on that 6%!” Sure, but you pay taxes on that 6% investment; moreover, I am not sure the mortgage interest deduction is sacred any more…are you?)

Now this leads to a thought that I found interesting and I hope you will too. Could the low-return world be actually contributing to de-leveraging? Look, if you’re borrowing at 6% to buy a 10% investment, it makes sense to do so (well, if you can handle the variance in the investment). But if the investment only yields 4%, then borrowing at 6% to buy it is silly. That’s what you’re doing right now if you’re buying Treasuries at 3%. But if everyone realizes this, then … well, we know that credit demand is falling and the standard story is that Americans are growing more responsible. Could it simply be that they are making the best-available use of their money? (Note this is different than a low interest rate world. If rates are low but prospective returns higher, then more leverage makes sense. But once all returns have been forced down, it makes sense to de-leverage).

I doubt that the average homeowner is performing that calculus. Most of us fall into the common behavioral trap of thinking of our “borrowing” and “investments” as coming from two different pockets. We are not the homo economicus of theory. But perhaps at the margin this is happening, and it makes a more plausible story to me that investors are being somewhat rational rather than (alternatively) suddenly “coming to Jesus” on their borrowing-and-spending ways.


Friday brings some significant data. First we get the first look at Q2 GDP (Consensus: 2.5%; +1.0% on price deflator). Simultaneously, the Employment Cost Index (Consensus: +0.4%) will give a read on wage and benefit growth. Last quarter the ECI was +0.6%, but most of that was from a +1.1% jump in benefits while wages were +0.4%. The question is whether benefits merely drop down into line at +0.4% or +0.5%, or if they overcorrect. I suspect those cost increases were real, and think there’s some upside risk to this figure (although I don’t feel strongly about it). At 9:45ET, the Chicago PMI is expected to decline further to 56.0, and shortly thereafter we get the revision to the Michigan Confidence data (the least important indicator of the day, easily).


The recent hallucinatory rally, triggered by positive earnings spin and the wonderful news that the European banking system is really just fine despite the fact that none of the banks seems to think the other banks are fine, has puttered a bit over the last couple of days. While today’s -0.7% setback is far from catastrophic, neither is it awe-inspiring as the market drifts from levels that would have signaled a technical triumph. The 10y yield is still below 3%. The VIX is off its recent lows, which is the only reason it doesn’t seem like lazy summer trading. 24.25 is a pretty high level for the VIX, historically. Some folks are apparently still nervous.

Soft durable goods orders (-1.0%, versus +1.0% expectations) and durables ex-transportation (-0.6%) may have contributed a little bit to the nervousness, although non-defense capital goods ex-aircraft was positive following a positive spike last month. (And people criticize the leaving out of food and energy from CPI! What about taking out all defense, all non-capital goods, and all aircraft!? There is a reason for it, though; that subcomponent of durables is the most correlated with overall growth, although “most correlated” still isn’t very good).

This news followed the mixed news on Tuesday. The rise in the Case-Shiller Home Price Index put the year-on-year rise at 4.6%, the fastest pace in four years and unmitigated good news (unless you worry about inflation). But Consumer Confidence slumped again, this time to 50.4, and the “Jobs Hard To Get” subcomponent rose to 45.8. Consumer confidence is a decent co-incident indicator. If people are losing confidence, it tends to confirm all of these other tepid readings we are seeing and supports the notion of weakness in the job market. Double-dip? Too early for an official pronouncement, but a stall at this point in the recovery – if it was in fact a recovery, which I dispute – is fairly unusual. At some point the economy, to paraphrase “Red” Redding from The Shawshank Redemption, needs to get busy living, or get busy dying.


In other interesting news today, Visa Inc. reported stronger-than-expected earnings. The spin in the financial press is that “more consumers paid with plastic,” and the number of processed transactions rose 14% according to a Bloomberg article. But at the same time, we know that revolving credit is declining and has been declining for 20 months now (see Chart below). How do we square this?

Revolving credit is declining hard. But VISA is doing just fine. Why?

This might suggest that more people are using credit cards to smooth over short-term bumps in cash flow, but diligently paying down balances so that the turnover of balances is rising. This would be good news for VISA, and for the economy, although the higher velocity it implies would be bad news for inflation.

This may not be a ridiculous interpretation. In May we found that consumer defaults on credit cards – which do not happen until the account is at least six months behind – rose to an all-time record of 9.14% (according to the S&P/Experian Consumer Credit Default Indices, which date only to 2004 – see the story here) before declining to 8.81% in June.

If revolving credit is declining because responsible people are diligently paying off balances, leaving the irresponsible people to default, it could explain the hesitancy of the default ratio to fall very much – the smaller pool of outstanding balances would be lower quality, consisting of more people who were not paying off their cards because they can’t pay off their cards.

Meanwhile auto loan defaults have been declining…because less credit is being extended to weak borrowers. Mortgage loan defaults have fallen…because fewer mortgages are being made to bad borrowers and the worst mortgages have already defaulted. In the case of non-revolving credit such as mortgage and auto loans, there is little incentive for a good credit to pay down early. They are borrowing money at much lower rates than they are on credit cards, and once they pay it off they can’t run the balance back up (indeed, credit is still very tight; you may not be able to get another home loan!). As a consequence, the quality of these pools should tend to improve first, but that also doesn’t tell us a lot about whether people are getting new-found responsibility.

The early rise in delinquencies for subprime, and then Alt-A and Prime loans, and then every other kind of loan, were the signals that all was not right in the economy (and in these pockets of the credit markets). The improvement in revolving credit turnover, combined with a decline (albeit for a single month) in credit card delinquency rates, may be an early sign of something good happening in the economy. Not great, mind you, but a sign that attitudes toward personal credit are returning to more-rational standards. We have a long way to go on this score, but the vector is finally pointing the right way. Maybe.

Tomorrow, the main data is Initial Claims (Consensus: 460k), which as you will recall has been quite volatile lately because of the GM non-shutdown. The turbulence continues to imply we shouldn’t rely too much on this release, although every week that goes by improves the quality somewhat.

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Are The ‘Roads Less Traveled’ Even Passable Now?

July 26, 2010 2 comments

The good news from today’s data (New Home Sales, which rose to 330k from a revised 267k in May) is that the 24% jump was better-than-expected. The bad news is that the resulting rate is still the second-lowest rate on record. Moreover, we had previously thought that May was 300k and 446k for April; the -33k revision to May and -24k to April compares unfavorably with the +20k upside surprise for June versus the consensus.

The inventory of new homes dipped slightly and continues to plumb new depths. This is good news, in that it will help clear the overhang of unsold existing homes by removing substitutes, but remember there are lots more existing homes than new homes…this is a fairly small positive (albeit, a positive). So the release is not an unmitigated disaster. It is just really bad.

That didn’t stop Bloomberg from proclaiming “Stocks Gain, Dow Erases 2010 Losses on Home-Sales Data.” Hogwash. Bad reporting. Puffery. And so on. But yes, the market did rally.

Stocks with their rally today are at the highest level  since June, and breaking above a line of resistance at 1100 or so on the S&P 500 index (the VIX closed at the lowest level since May, 22.70, but Treasuries rallied slightly, so related markets were mixed.). There is one level left, but if the index can climb above 1123 – less than 10 points away after today’s 1.1% rally – then we are likely to revisit the highs from earlier this year around 1225 in the index. Accordingly, it is a good time to ask: how might my thesis be wrong?

My thesis, to review, is essentially that we have been in a recession continuously since before Lehman’s demise; only the dramatic fiscal stimulus made it appear that we had climbed out of the whole through the simple expedient of bringing demand forward. With C+I+G+(X-M) constituting GDP, if you choose an arbitrarily large “G” then you can make GDP growth go positive; of course, if prudential management of the economy were that simple there would be nothing to do but borrow and spend forever. Obviously, while this equivalence is definition in a single-period model, the crux of the Keynesian stimulus plan is that the public spending will increase confidence and trigger organic growth in C or I or (X-M), so that the G can then be paid back in the next expansion.

Unfortunately, that only works if (a) the adjustment from big G to litle G isn’t abrupt, and (b) consumers and investors don’t adjust to the coming little G by making defensive cuts in C and I rather than being stimulated by it. And yet, through this entire surge in spending, Initial Claims has been steady at a high level, Payrolls continues to be weak, and many other measures of the real economy appear to be still behaving as if there is a recession in place. Both (a) and (b) have been false, and the stimulus appears to have been more or less an accounting adjustment moving growth from 2011 to 2009. Earnings have improved over the last year, partly because the huge hits from the financial sector have dropped out of the calculation, partly because the G is buying stuff from somewhere, and partly because earnings quality has been deteriorating at the margin. Increasing earnings by decreasing credit reserves isn’t organic growth.

My thesis is that this piper will need to be paid because taxpayers (voters) are really miffed at having spent so much to get basically nothing, and will essentially insist on a large downshift in G (a big negative growth rate). This will leave the field to the Fed, who will be under big pressure to pull every trick they know in order to offset the fiscal contraction from government that is coming next year. The Fed has very few tricks left. And whether the problem is even tractable depends in significant part on whether central banks just need to pull the US out of the mud, or the world economy. Europe is also in a state of disarray. I am expecting another year of essentially no real growth, with core inflation bottoming in early Q4 before beginning to rise in 2011 (and potentially rather majestically later in 2011, depending on what the Fed does).

So if that’s my operating thesis, where might I be wrong?

Well, perhaps growth really is recovering. Perhaps the organic growth I was looking for…that we were all looking for…is just late, rather than absent. Maybe the Congress can manage to put into place a convincing deficit-reduction plan for the medium term that doesn’t involve a sharply negative near-term hit. The main reason it currently looks like government taxation and spending policy will be a near-term hit is that the electorate no longer believes any 2-year promise, so this lack of credibility needs to be surmounted in some way. Perhaps the changes at the mid-term elections will be dramatic enough that it will trigger confidence in the People (“yes, we can!”) and some concessions from the White House so that everyone can agree on a plan that gradually reins in government. I am not holding my breath, but it is possible. It hasn’t happened in a while, but elections can produce momentous shifts.

However, for that scenario to play out, consumers and investors need to become confident enough to resume their borrowing ways. Saving, after all, pushes current demand out into the future (Keynesian stimulus is supposed to counteract that effect in a recession). I believe that this is frankly good, and we should all be encouraging our friends and neighbors to, in the slogan I see all over the place, “Chase Home Equity.” It is true, though, that the more they chase home equity now, the lower will be current demand.

Now, it might also happen that the “confidence multiplier” begins to kick in at some point. It is, in fact, a measure of the deep malaise that the country is in that confidence remains mired in a slump despite (some would say, because of) the best efforts of policymakers to make people feel better. But we don’t understand human behavior very well. Perhaps there will be some breakthrough technology on the internet that makes people feel like the future is bright. Perhaps there will be a major medical discovery. Perhaps a really cool person will win American Idol. But at some point, it is possible that some exogenous event defibrillates the American psyche and that organic growth suddenly starts to kick in. If that happens, then the economy might well expand even though the fundamental problems haven’t been solved. This happened in 2003-04 – with everything the Administration and legislature and Fed threw at the economy, they managed to pump up the bubble for another go-round. I really hope this isn’t the end game, because as we should have learned by now the successive bubbles are getting worse (and indeed probably must get worse until the imbalances are corrected). I really don’t want to see the next bust if we don’t finish flushing out this one. Watch private debt; if it turns around and begins to expand again as a fraction of GDP, then this scenario may be playing out.

The other part of my thesis that might be wrong is my inflation forecast. Here, there is lots of room to be wrong. My forecast is predicated on my belief that the Fed is worried about deflation and will try very hard to prevent it, even though it isn’t very close at the moment with core-ex-Housing well above 2%. I also believe that the Congress and Administration will be tightening fiscal variables and that the Fed will decide to inject steroids into the economy to try and counteract that effect. I could be wrong on both counts. Perhaps the Fed is secretly worried about inflation and will be more hawkish than we think. Perhaps Congress and the Administration will delay the fiscal tightening. Or perhaps the Fed will say that fiscal tightening or not, they’re going to focus on inflation and let growth be darned.

I also might be wrong in my belief that money, and not growth, causes inflation, or that private debt causes disinflation but public debt leads to inflation, so that the recent tilt of that ledger makes us much more prone to inflation. Certainly, many people disagree.

So there: lots of ways I can be wrong, and I am sure you can think of others. I believe the counterarguments, if I have been fair about them, are based on a lot of hope and speculation, while the simple math of borrowing to spend, combined with the sudden emergence of rational expectations once the scale of the government’s deficit became clear, is hard to dodge. But I may be wrong, and it wouldn’t be the first time.

What we really need to be cognizant of, though, is what would cause me to change appreciably my asset allocation. What needs to happen to persuade me to get back near my neutral weight in stocks, reduce my cash holdings, or change my weighting in inflation-linked assets? It would have to be something that persuades me the game is back on, at least for one more round – for me, I think that means I need to watch private debt and see defaults decline and the total amount of private credit increase appreciably. Stocks are very expensive for my scenarios, somewhat expensive for a slow-growth scenario, and probably about right for a robust recovery (expensive on visible metrics such as trailing earnings, but at the right part of the cycle that strong growth could redeem the person who buys too rich).


Tomorrow, the data includes the Case-Shiller Home Price Index and Consumer Confidence (Consensus: 51.0 from 52.9). It may seem curious that economic forecasters are looking for an extension of last month’s large decline in confidence. Ordinarily, the modus operandi is to look for a bounce following a big decline. In this case, the big decline was just reversing an apparently-unwarranted surge prior to last month, and consumer confidence moved back into the range. I don’t expect either of these indicators to appreciably change my views or force me to reject my operating hypotheses.

I won’t be writing this commentary tomorrow, because I will be in NYC meeting with some potential consulting clients. I will write again on Wednesday.

Categories: Uncategorized

Come On, Seriously?

July 25, 2010 1 comment

I would like to say I am surprised, but how can anyone be surprised anymore by the shenanigans that go on at the highest levels of public policy?

The EU released their report on the results of the “stress tests” applied to 91 European banking institutions to see which of them need capital and which are doing fine, just fune. The over/under on the number of banks that would need capital, before the report, was 10. In the event, only 7 failed.

Honestly, the fact that 7 failed this test is amazing. It is like telling a room filled with 91 high school seniors that they can graduate if they can successfully spell “graduate”…and then  and finding that 7 of them fail. Okay, can you spell “cat?” No? Is there any test you would pass?

All that you need to know about the test is this. Forget what economic trajectory is assumed. Forget everything else. All you have to know is that any sovereign bonds being held by banks – other than in their trading accounts, which are conveniently quite light on these securities – are assumed to be money-good. They pay off at par. The bonds in trading accounts are assumed to have mark-to-market losses; in the case of Greece this is 23% and the other countries are much less. Almost no one thinks that Greece survives without a restructuring of its debt…and folks, you don’t restructure to save 23% of your debt.

This is an impossibly optimistic scenario. The capital required of the banks that failed the test totals 3.5bln Euros, a fraction of the lowest arm’s-length estimates.

The only German bank to fail was the one that the government already owns. But get this: just one Greek bank failed. How dumb do they think we are? The answer, I guess is “dumb enough.”

Just about every central banker came out immediately after the results were posted, trumpeting statements that “the results confirm the solidarity of banks” (as Costa from the Bank of Portugal said). What they confirm is the contempt in which the policymakers hold the rest of us.

Okay, fine. The marketing job from the regulators has been done. It’s time to move on and forget that this exercise ever existed. Invest in one of the 84 passing banks at your own risk – if they go under, no one will give you credit for relying on this whitewash.

Not surprisingly, stocks were quiet in the morning; somewhat surprisingly, the market held its gains in the afternoon and the S&P index by some measures broke out of the top of the range again. I had thought equities would sag after the test results were posted, but maybe American investors don’t have the highest regard for European investors and feared the latter might respond with unbridled ebullience to the news. We Americans don’t understand Europeans, you know.

However, while stocks ended in pretty solid position, the VIX hasn’t yet broken down and the 10-year yield is still south of 3% (albeit just barely south). I’d want to see some confirmation from those two indices before trying to ride one more buck of the bronco.

Because if we do rally, that is all I think it is. And there’s never any question that the ride will end; the only question is whether you’re on the horse’s back, or the horse is on your’n.



Don’t forget! You can get a great deal on my book on-line here. Thanks to all of you who have ordered!

Categories: Uncategorized

…And Today, Unusually Certain

The headlines claim that the rally today was due to improving earnings and earnings guidance. Hogwash. No doubt, there were some positive earnings and spin, but to say that prices would skyrocket on a couple of earnings numbers (Caterpillar being one of them) is nuts.

Initial Claims were somewhat weaker-than-expected but still in a period fraught with difficult-to-adjust seasonality. Existing Home Sales were somewhat stronger-than-expected, although not to say “strong.” Still, we can infer from the fact that Existing Home Sales are holding up reasonably well while New Home Sales are looking awful, along with the fact that the inventory of New Homes is also incredibly low, that consumers are substituting to existing homes that may be distressed sales rather than buying new models. This is good news for the economy, although the overhang of homes is awesome. The invisible hand is slowly clearing the market (and it bears noting that the visible fist of the government has been a complete failure, according to the special inspector general for the financial bailouts (link), who said yesterday that the efforts to help homeowners avoid foreclosure hasn’t “put an appreciable dent in foreclosure filings”).

What is perhaps even more significant is that the median existing home sales price has now exceeded the highs from 2009, and on a year-on-year basis  (see Chart, source Bloomberg) home prices have been reasonably stable  for seven months now and the smoother RPX index confirms this reading. Remember, declining home prices (specifically, declining rents, which lag home price changes) are the main thing keeping inflation “contained” – actually, disguised – right now. By early next year, core inflation will be heading higher…right about the time the Fed begins QE II (Bernanke is begging for a continuation of the Bush tax cuts so as to alleviate the Fed’s burden when it comes time to goose the economy, but I wouldn’t hold my breath).

Home prices are stable again! For how long remains to be seen of course.

But all of this doesn’t amount to sufficient reason, in my book, for a 2.2% jump in the S&P at the opening bell (2.3% by the close). The market was sharply higher overnight. I believe that it is in anticipation of the imminent release of the European “stress tests” that we all know won’t be very stressful. Of the 91 banks being tested, speculation seems to be that 10 or so will be found wanting. Although I think it will be less than that, if it were only 10 and the tests were stringent it would indeed be cause for celebration. But we already know that generous haircuts (meaning, not much) are being applied to the sovereign bond portfolios. And the behavior of funding markets seems to suggest that market participants feel that the true number is somewhat over 10. If we’re lucky, we’ll never know how many banks are actually insolvent. But then, when have we been lucky over the last couple of years?

Well, I wanted better placement for a short, and I got it.

Tomorrow, at 6p.m. Brussels time specifically (noon Eastern), the results of the stress tests will be released, and that is the main event for Friday. I don’t know how the market will react to the results, but I expect that since there will only be a few hours to analyze the results, stocks will trade heavy into the close – the real nuts and bolts of the analysis will be done over the weekend.

In Case You Missed It

In case you missed it, here is one little nugget from the financial reform bill. One of the definitions of an “accredited investor” under the Securities Act of 1933 has been changed. Previously (and this change is effective immediately), you were an accredited investor if you had a net worth of $1mm, including your residence. As of now, the residence no longer counts towards your net worth so to be accredited under this definition you need $1mm in addition to your home.

So if you were an accredited investor on Monday, and able to invest in many of those things that Uncle Sam says only wealthy people should get to invest in, you might no longer be one today. Bad luck. Sorry. Hope you don’t mind, “but it’s for your own good.”

And Now A Word From Our Sponsor

A quick personal note. We have been trying for the last year to launch an investment boutique focused on creative inflation-linked investments (such as Education inflation hedges, which is a concept we were inexplicably unable to sell to any mutual fund company or 529 plan sponsor). We are currently re-purposing the firm to offer consulting on inflation-related topics. I think our insights would be valuable especially to pension and endowment funds and to family offices. If you have interest in discussing what we can add, or know of someone who may, please contact me through our web form at Thanks!

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When Does The Unusual Become The Usual?

July 21, 2010 1 comment

Chairman Bernanke took to Capitol Hill today to discuss the economic and monetary policy outlook for the country. His remarks were, typically, fairly unremarkable. Some observers had expected him to signal a change from what had recently been discussed in the FOMC minutes – the unusual quiet among Fed speakers led to speculation that they were avoiding cluttering the message. Presumably, the change they expected was towards a softer policy, edging more towards a second round of quantitative easing. At least, the response of equities to a fairly dull testimony – they dove – seems to suggest that investors wanted more.

The only real nugget in his prepared statement was that the Chairman referred to the “unusually uncertain” economic outlook. These days, one might argue, “unusually uncertain” is pretty normal. The implication for monetary policy is that extra caution is warranted, because the Committee can be less sure of the effects of their actions.

That is mostly an illusion, though. The Federal Reserve Board suffers, as d0 most individuals and all committees, from the behavioral bias of overconfidence. Given the historical difference between the Fed’s forecasts and the actual outcomes, over many many decades, the Fed should treat the outlook as extremely uncertain. The implication of that observation, however, is simple: the Fed should almost never do anything.

Policymakers fool themselves into thinking that they need to do something, and so they do something, and they very often muck it up in the process. As I argued in my book (have I mentioned recently that I am offering an on-line bargain here?), the FOMC should manage policy to minimize mistakes rather than maximize good outcomes. They are short “policy options” in which doing the right thing offers a little upside but doing the wrong thing promises a huge downside. It is great news for those of us who will bear the costs of their actions that right now they actually know that things are uncertain, and are hesitant to do anything. It’s kind of like “monetary policymaker gridlock.”

It may not be quite as good news for investors in stocks, who are dependent on a further steroidal lift to the market. Recent earnings have been weak in some unusual places, such as at Goldman Sachs: that firm managed to miss earnings forecasts by 60%, which is pretty hard to do since all of the Wall Street analysts tend to give each other easy hurdles to beat, on an 82% decline in profits. There have been a few other banks that have had weak earnings. This shouldn’t be surprising: lower leverage, lower turnover, and lower margins adds up to lower return on equity. I guess it is surprising that it is happening so soon – the banks who are hitting their numbers are the ones that are drawing down their reserves, which is also known as “cheating.”

Monetary policy makers are right to be concerned about the uncertain outlook. A whole lot of that outlook depends on whether fiscal policy gets tight soon, or whether it stays loose and gets even tighter later. It appears Congress is going to extend unemployment benefits, but it has been a challenge to get that bill through. Goldman is calling it “The End of the Road for Fiscal Stimulus” in a recent research piece. Their economics team is assuming that virtually no other major stimulus, other than the extension of the Bush tax cuts for households with incomes below $250,000, will be passed. This includes their assumption that capital gains and dividend rates will go up to prior levels. They estimate that the result of these fiscal tightenings will be a drag on GDP (also known as “payback for pulling demand forward to make the recession appear to go away”) of 0.50% in Q3 and 1.25%-2.5% for each of the next five quarters – that is, for all of 2011.

I, like many others I am sure, was spooked out of being short yesterday. A short feels better today and with Existing Home Sales (Consensus: 5.1mm from 5.66mm) tomorrow it is likely to feel even better (Initial Claims, consensus 445k from 429k, will continue to be polluted by the GM non-shutdown and so not worth much attention). I don’t like the entry point, but when stocks start to move lower the market may well not offer a good entry point.

Categories: Uncategorized

Not Much Of A Parade

Markets gave a half-hearted attempt at retracing some of Friday’s moves, but volumes were pathetic and the bounces unconvincing to this observer.

There was an almost audible grimace when the July NAHB survey of homebuilder sentiment was released. The level (14), lower than expected, is the lowest that survey has seen since April of last year. For those keeping score, too, we are now closer to the all-time lows at 8 than to the May print of 22. Easy come, easy go.

However, there is more-concrete housing data on the immediate horizon: on Tuesday, the consensus for Housing Starts is for a decline to 576k from 593k. The NAHB surprise foreshadows something worse, but it is hard to tell because as the NAHB approaches the absolute lower bound, it ceases to correlate well with the level of Housing Starts. In any event, with Housing Starts tomorrow, investors seemed willing to wait rather than let NAHB rain on the parade.

It wasn’t much of a parade, though. Moody’s cut Ireland’s sovereign bond rating to Aa2 from Aa1 (just last summer, it was a AAA credit). There also was a story on Bloomberg (link) which cited “sources” as saying that a German bank, Hypo Real Estate, had failed the “stress tests” being administered by the ECB. This is a curious leak. Hypo Real Estate has already been taken over by the German government, so whether it failed the stress test or not is fairly irrelevant. But the fact of the link is interesting to me.

I would have put fairly long odds against any bank actually failing the “stress tests,” which results are to be released on July 23rd. After all, the Fed’s “stress test,” meant to add confidence during the crisis, was carefully designed so that it was easy to pass, and then re-designed when some banks allegedly objected that they were likely to fail. The watered-down criteria included a “worst case” in which Unemployment would reach 8.9% in 2009. In actuality, it reached 10.1%. So it wasn’t a very bad “worst” case. Unsurprisingly, everyone passed. This was preordained, of course, because if a bank had failed the test, it would have been immediately shut out from the capital markets. Failure was not an option, because it wasn’t offered as an option.

So it would seem to be quite shocking that some banks in the ECB test might actually fail. It makes more sense, of course, for the test to actually have teeth – why have a test at all, if everyone knows it’s rigged? But, on the other hand, the EU cannot risk panic, and cannot know in advance how the market might react to news that a bank failed the stress test.

Or…can it? One way to gauge the market’s reaction might be to leak that a bank had failed the test – say, a bank who wouldn’t in any case need to access the capital markets anyway. At the worst, this might seem to imply that the test did have some teeth, even if this was the only bank of the ninety-something banks that failed the test. (It would just show that the authorities had had the foresight to have already taken over the weak one!) If the market reacts poorly to the news about Hypo Real Estate, then perhaps the test ought to be softened just a bit….

In the event, European equity markets didn’t fare well, although it is hard to tell whether that might be partly a hangover from Friday’s decline in the U.S. The Eurostoxx 50 fell 0.4%, while the Bloomberg European 500 dropped 0.7%. Certainly not a calamity, but as I said – it isn’t clear why we should care at all about Hypo Real Estate.

Maybe I need to stop looking under every rock for the cloak-and-dagger guy, but it is hard not to be suspicious of the motives of central banks and legislatures when economic pressures remain high and seem to actually be rising again. Institutions have selfish memes. It is reasonable to be wary of motives when the institution itself is threatened, or perceived to be so.

I remain bearish on equities. The speed of the first move down from the top of the range gives me some confidence that a break lower is feasible. It needs to happen reasonably swiftly, lest the bears lose heart and cover near the bottom of the range and the consolidation continues. I’d give it a few days. With IBM missing sales today and Texas Instruments missing sales and profits, with NAHB and Hypo Real Estate, there is potential. I think I detect the redolence of disappointment beginning to grow.

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The Gravity Of The Situation

The sense of unease is growing almost palpable. I am not referring to the epic plunge in the Michigan Sentiment number, which has only been seen a handful of times in the three-plus decade of the survey. Certainly, we already had ample evidence that the economy was weakening and that consumer confidence was growing somewhat stretched. The stock market ended down 2.9%, but it wasn’t because of Michigan: the indices fell all day, fairly steadily. Similarly, we cannot lay the market’s weakness entirely at the feet of the disappointing earnings from Citigroup and BOA, and the results from a couple of other key banks that exceeded expectations only because they pulled the time-honored trick of drawing down loss reserves. These are all negatives, but I think there is something more. Investors are downright uneasy.

How otherwise to explain the curiously upbeat market outlooks we are seeing now, right when the data is looking pretty bad with equities having priced in only a fraction of that evolution in the outlook? The cover story in Barron’s this week is “Google – Why the Stock Could Jump Over 35%!” Sure, and I’ll also tell you why it could go to zero. (The case isn’t that hard, despite the paper’s blatantly erroneous claim that “Google, of course, invented online search.”). That sort of cheerleading is usually reserved for CNBC, although the columnists at Barron’s continue to use the P/E-excluding-losses figure for the S&P P/E ratio to claim it is around 14, even while their very own data section records the actual ratio as being near 18.

We also have Bill Gross, the Bond King, gracing the cover of Bloomberg Magazine, extolling the virtues of…stocks.

Why is everyone trying so hard to sell us on equities? It isn’t like it is hard to find people to buy stocks. It is in fact the default investment for many Americans these days, as the popping of two bubbles has not created very much of the “revulsion” ordinarily seen in bear markets.

And why all the effort to convince us that the Fed has things firmly under control? Right now, there is a camp of people concerned about deflation (mostly Keynesians), with some justification (although I think they’re wrong to worry about something that can be cured with the stroke of a pen, specifically adding a zero to the currency). So Richmond Fed President Lacker gets to the podium and declares (on Thursday evening) that a “double dip is quite unlikely at this point,” which is so far from being a defensible hypothesis I don’t know where to start. Moreover, he summons a mysterious branch of physics that involves inflation expectations as a strange attractor: because expectations for inflation are above zero, he says, this will exert a pull like “gravity” to keep inflation from actually declining into deflation.

He might actually believe that; many economists feel that inflation expectations are a key component to keeping inflation under control – despite the fact, it should be noted, that no one has figured out yet how to measure consumer inflation expectations accurately (n.b., I am working on a paper called “Quantitative Estimation of Perceived Inflation”). In 2007, Dr. Bernanke said in a speech “Undoubtedly, the state of inflation expectations greatly influences actual inflation and thus the central bank’s ability to achieve price stability,” but went on to highlight three important questions that remain to be addressed about inflation expectations:

(1)   How should the central bank best monitor the public’s inflation expectations?

(2)   How do changes in various measures of inflation expectations feed through to actual pricing behavior?

(3)   What factors affect the level of inflation expectations and the degree to which they are anchored?

According to the Chairman, the staff at the Federal Reserve struggle with even the first question of this triad (“while inflation expectations doubtless are crucial determinants of observed inflation, measuring expectations and inferring just how they affect inflation are difficult tasks”), although this has not deterred them from tackling the second and third questions.

By contrast, we have a pretty good understanding of how the real force of gravity actually works, which is why we have reasonably high confidence about predictions involving it.

In point of fact, he has actually probably got the right direction. The CPI print on Friday was a surprise to the upside on core inflation, although everyone seemed to want to focus on the low headline number. Core CPI over the last three months has been +0.0%, +0.1%, and now +0.2%. I certainly don’t expect that sequence to continue, but the argument for inflation beginning to head up from here is pretty good and doesn’t rely on mystic hand-waving about “inflation expectations gravity.” The advantage of pointing to this gravity, of course, is that the Fed needn’t take responsibility for inflation that turns out to be too high…it was just gravity! Ya can’t fight gravity!!

So…since I too see inflation as basically bottoming in the next few months, I guess I am in Lacker’s camp on this one even though I don’t believe in his version of gravity. I am, though, just a bit nervous that he feels he needs to try and persuade people not to worry about deflation. As with the equity cheerleading above: if inflation is going to be drifting up, as he claims, then why do you need to convince people of that? Well, in this case, it is because they feel they need to be sure that inflation expectations don’t collapse.

I wouldn’t worry about that. Ex-housing, core CPI was 2.586%; while that is the lowest it has been for a few months, that is partly because of base effects and if current trends persist core-CPI-ex-housing will be rising again in two months. 2.6% is not deflation, and it is because the whole market basket other than housing (and, lately, energy) is rising that inflation expectations seem to be fairly anchored at a higher level. It isn’t gravity that is going to pull inflation higher – inflation is already higher, just masked by the unwind of the housing bubble. (See the chart below, which I have run before and doubtless will again.)

Core inflation ex-housing remains in an uptrend in stark contrast to the official core CPI.

Investor inflation expectations, however, are drifting lower again. 10-year inflation swaps are at 2.25%; the measure is 1.76% or so on 10y breakevens. Moreover, one-year inflation swaps are 0.60%, which to me seems to have much more upside than downside (unless oil moves sharply lower from here). There is, as I said above, a palpable sense of unease growing. Opinion leaders are trying to convince us that stocks are a good buy at these levels. Fed officials, who recently were worried about pulling back the stimulus, now are explaining why deflation isn’t a concern.

In one sense, I suppose, who am I to question? Bernanke, we are told by the Wall Street Journal, may be the new Maestro (link). (Oh thank you, thank you, thank you! The book almost writes itself.) Meanwhile, I am still selling my book about the old ‘Maestro’ at a discount online through this link. Get one. You need a copy.

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Bond Investors Aren’t Buying It

Bond investors aren’t buying it.

10-year yields slipped below 3% again, to 2.98%, as economic data released today were almost uniformly weak.

The “almost” comes courtesy of Initial Claims, which declined sharply to 429k; as I pointed out last week (link), though, this was somewhat expected since GM eschewed its usual summer shutdown.

Beyond that, though, there was nothing good to say.

Both the Empire Manufacturing index (5.08 versus 18.00 expected and 19.57 last month) and the Philly Fed index (5.1 versus 10.0 expected and 8.0 last month) were below the lowest Street estimates. On Empire, the Employment, Shipments, and New Orders subindices all slipped, and on Philly Fed New Orders were actually slightly negative at -4.3 from 9.0 last month. Both headline indices remain technically in positive territory, but the current reading is indistinguishable from zero – again, signs of an economy that is doing none of the positive things it is supposed to do at this stage of the expansion. That’s the lowest Philly reading since August; Empire barely beat out the December print but is also near the levels of July/August last year.

Industrial Production recorded a +0.1%, in line with consensus expectations, but that was thanks to Mr. Heat Miser: the high temperatures last month pushed utilities output higher, but factory output itself fell 0.4%. Capacity Utilization at 74.1% was steady with the downwardly-revised level of last month. That will help calm inflation fears (or stoke deflation fears) at the Fed, but as I am fond of pointing out: if low levels of capacity use mean we don’t have to worry about inflation, then someone needs to explain Zimbabwe to me. If (money growth * money velocity change) is low, inflation will stay low. If it is high, inflation will rise.

On the question of inflation, PPI was as-expected, but I don’t pay much attention to PPI as it just doesn’t have much explanatory power. We get CPI tomorrow (Consensus: -0.1%, +0.1% ex-food-and-energy), and that’s the name of the game. My models a year ago were projecting year/year core inflation of about 1.1% for the June print, but it looks like it will come in around 0.9%. My models also suggest core should bottom in September-November, around 0.7%. There’s a lot of uncertainty around these models, because we’re seeing an environment we have never seen before, but so far they’re doing well.

Although stocks managed to fight back after getting hit on bad economic news today, the advance is looking tired and, with prices back at the top of the range, I suspect we are ready to head back down again. Certainly bond investors seem to think so.


I am continuing to offer a special deal on my book, Maestro, My Ass!, if you order through my website (link). Only ten bucks, or twenty if you want it signed. That includes “slow way” shipping domestically. My wife wants the piles of unsold books out of the living room. Help her out!

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Running Out Of Options

July 14, 2010 3 comments

It is remarkable how quickly summer set in. In June we were running heavy volumes and spastic, wide-ranging trading, almost no matter what the asset. In July, suddenly, volumes and volatility have dropped sharply. Some of that is probably due to the fact that much of Europe goes on vacation for a good part of July and August, but that surely is just at the margin.

Of course, the news wire has been slow. Today’s report of Retail Sales was as-expected, which is to say a little bit weak. The recent fade in Retail Sales, the ebbing in Consumer Credit, and some other metrics do support the idea that the economy is straddling the growth/contraction line, either growing slowly or not at all, but so far nothing really supports the grimmer expectations of the punditry. I think there is plenty of time for those expectations to be realized (see below), but probably not yet unless something implodes in Europe in the near-term.

The FOMC minutes were also not particularly surprising, although equities initially reacted poorly as the consensus growth estimates at the Fed were revised downward slightly and the Board’s projections for unemployment raised a bit. The tenor of the minutes were captured in the notation that the Committee felt the risks to the economy had “shifted to the downside,” but none of this should be surprising and stocks managed to recover and close flat.

The Fed also “revised down modestly” the outlook for inflation, which is classic since we are pretty close to a bottoming of the CPI. Recall that core inflation, ex-housing, is around 2.8%. It is only the fall in Owner’s Equivalent Rent, which is responding to the bursting of the housing bubble, which is dragging down core inflation. Now, housing is a big part of the consumption basket so this matters, but in terms of asking whether the decline in core inflation has any momentum, whether it will persist into 2011, the question is really all about whether housing will continue to drag. (N.b. We might also consider the argument that, since the Fed can’t control the bubble unwind anyway, the proper policy target may be core-ex-housing, which has shown a significant response to the Fed’s aggressive easing last year).

I think you can make a pretty good case that, absent a secondary collapse in home prices, we are probably as likely to see Rent increases as decreases in the next year. See the chart below, which plots Owners’ Equivalent Rent against the Existing Home Sales Median Price. You can clearly see the bubble, and you can clearly see that the bubble has substantially unwound. This doesn’t mean we can’t continue to implode – after all, the shadow inventory of homes remains huge – and it doesn’t mean that (implosion or not) we have seen all of the mortgage-related losses yet. We surely have not. But it probably means that home prices are back to being somewhat fairly valued against rents, which further suggests that we ought not to count on any further drag from housing to help to contain the core CPI.

It isn't clear to me that housing should drag rents very much lower.

So this is classic. The FOMC is looking at the wrong measure of inflation (core, rather than core adjusted for the bubble unwind), and naively projecting recent trends to continue. I continue to think that core inflation will bottom in Q3 or early Q4.

Now, this forecast has more than the usual amount of uncertainty partly because we have to forecast through a curtain at the moment. That curtain is the November mid-term elections in the U.S., the outcome of which may very well determine how the Congress and Administration responds to the ongoing recession. I noted above that the current temperature readings on the economy are consistent with an economy simply stumbling along sideways. The earlier signs of life now appear to be almost completely due to artificial stimulus and, now that the stimulus is basically over, we can see that it left no mark. It seems to have triggered no organic growth.

It isn’t quite true, though, that it left no mark. It left a big red mark on the checkbook, and a big hole in the government’s pocket. Prognosticators are talking about what the impact will be in 2011 if the scheduled deficit reduction measures (which had to be included in the original stimulus bill to “lower the cost” by increasing revenues in the out years) take place as currently legislated. Economists at Goldman recently wrote that if there is no move to (for example) extend unemployment benefits, the fiscal drag should be around 2% toward the end of this year and the beginning of next year. This says nothing, by the way, about the drag coming from the states themselves, who are in similar position.

Now, here is where the election figures in. We can’t convincingly forecast beyond the election, because unlike in any previous election in my lifetime one of the main topics of debate will be the deficit. Polls indicate that Republicans have gathered considerable momentum not because of their own clever ideas, but because Americans by large majorities want deficit reduction and a repeal of the health care bill.

I think that means that regardless of whether the Republicans gain control of one or both houses of the legislature or not, they are likely to make considerable inroads and the electorate will make clear their point that they are not excited about continuing to rack up huge deficits. That means this fiscal drag is very likely to actually happen, and there could even be multiplier effects on the negative side if consumers, companies, and investors retrench for what looks like it could be a rough ride.

In that situation, I believe it is fairly likely that we will get some action from the only agency with the power to arrest what will begin to feel like a three-year-plus recession with no end in sight. That is to say, I think the Fed will be pushed and prodded to play the only card that we will have left, and to churn out the quantitative easing again.

There are many ways that this could play out, of course, and the elections look like a big wild card. Perhaps, however, they aren’t as big a wild card as it seems. After all, we are running out of options.

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