E-piphany

Preliminary: My column from yesterday didn’t get posted in some of the places it usually does. If you missed it, and if you care, you can find it here.

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Stocks probed lower again this morning, with the S&P bouncing again off the 1040 mark. I suggested before my vacation that the 1046-1070 range was the “indecision zone,” while below that level it would be obvious to all that further declines are in store. It is starting to look more like the narrower 1040-1046 range is the Maginot line that the bulls are defending and the bears seeking to overrun. The data were supportive at the margin, with Consumer Confidence actually rising – but that was only because the “expectations” component rose from 72.5 from 67.5. The “present situation” component, which is the one that is actually correlated with stuff, fell to 24.9 from 26.4, and the “Jobs Hard To Get” subindex (which is correlated with the Unemployment Rate) rose to 45.7, the highest level since March although the chart below makes it plain that this is better considered to be a range trade itself.

Well, jobs ARE hard to get, after all

The long end of the yield curve was well-bid out of the gate, and the curve flattened with the 10y yield falling to 2.48%.

Neither stocks nor bonds responded meaningfully to the release of the Fed minutes, which said approximately what we all thought they would. “Many Fed officials” said the downside risks to the recovery had increased, and “several members” said the Fed should plan for more easing if needed. “Some FOMC Members” said that “waning fiscal stimulus may impede the recovery.”

It is clear from these small excerpts, although it was not so clear from Bernanke’s speech last week, that the FOMC basically “gets it” that the economy is slipping. I don’t think they get the extent of how badly it is slipping, but perhaps in the last couple of weeks they have (remember, these minutes are from early August).

This tends to mesh with my evolving view of how the Fed is likely to act (I referred to this evolution in my view in my comment yesterday), and when it is likely to begin to act, to support the economy. Until recently, I have held that since Congress is going to be hamstrung by politics and an empty purse from turning aside the tax increases that will slow growth in a very predictable way early next year, the Fed would employ QEII late this year by purchasing Treasuries rather than mortgages. I still think the most-likely meeting at which to expect some definitive move in this direction is the November 3^rd meeting, which happens to be the day after the election and so absolves the Fed from appearing to act politically (and also gives them a chance to see if the results of the election makes further fiscal stimulus more likely by, for example, letting most of the bums stay in office). But I also think the Committee may act sooner, perhaps as soon as the September 21^st meeting, because the economy seems to be deteriorating fairly quickly (an inter-meeting move the following month is also possible, but unlikely as it would smack of a political “October surprise”).

However, on careful reflection I think that outright Treasury purchases are not necessarily the first order from the FOMC. I think it makes much more sense, and is more opaque, for the Committee to lower the Interest On Excess Reserves (IOER) that the Fed currently pays banks for their excess reserves, not just to zero but to a negative number. That is, the Fed may effectively tax banks for holding excess reserves.

When the Fed pumped liquidity into the system in 2008-09, much of the liquidity ended up in excess reserves rather than being lent. We all know that, and much ink has been spilled analyzing the fact. This lack of transmission from narrow money to broad money is the reason that inflation didn’t respond, and moreover the reason that the stimulus mostly helped banks and not so much anyone else. Bank lending has been falling, and has continued to fall (see Chart), as excess reserves have remained very large. Banks are not lending because the expected return to lending is negative due to a high default rate and what is perceived as a high opportunity cost if inflation rises so that the bank is forced to fund low-rate loans with high-rate short-term money.

Bank credit is still contracting, albeit more slowly.

Much of the analysis over the last year has been done on the question of “what will happen to inflation if the excess reserves are lent out?” and the related question of how the Fed can prevent that. This is one reason the Fed is paying IOER: to stop the money from turning into an inflationary pulse. But that is no longer the dominant concern! And thus, if the Fed is going to pursue more quantitative easing, the first thing that ought to be done is to release the first quantitative easing. They can do this by making the IOER, currently 0.25%, significantly negative (say, -1.0%). What happens then? Even though the bank expects loans to have negative expected return, they now are relatively more attractive than losing a certain 1% by holding excess reserves.

(Incidentally, notice that the bank can’t meaningfully do the same thing to your savings account, because you always have the option to hold your money in cash. The bank can’t do that. The excess reserves are electronic journal entries, not currency, so the Fed can merely mark the value of the reserves down a little bit every day to effect a negative rate).

So why would the Fed do this? Notice the effect: instead of sitting in balances at the Fed, the reserves will be spent on Tbills, Treasuries, other securities, or loans. If the money is lent out, even (or especially!) at negative real yields, then you have your quantitative stimulus. If the banks buy Treasuries, then it is either the equivalent of the Fed buying those same Treasuries from the Treasury itself (that is, monetization – consider it delayed monetization since it is with the proceeds of the easing of 2008-09) if banks are buying those securities at auction, or banks are putting the money into the hands of former owners of Tbills or Treasuries, and those former owners may in turn buy stocks, or commodities, or spend it.

Any way you slice it, that is, a negative IOER will reduce the huge excess reserves pile and put those excess reserves into circulation. I suspect a zero IOER and then negative IOER is likely to precede the actual direct purchase of bonds by the Fed (which is more obviously monetization of the debt but not much different, really).

Now, Bernanke seemed to cool this possibility in his speech last week, but I think he left a door open. Here is the relevant passage:

A third option for further monetary policy easing is to lower the rate of interest that the Fed pays banks on the reserves they hold with the Federal Reserve System…The IOER rate, currently set at 25 basis points, could be reduced to, say, 10 basis points or even to zero. On the margin, a reduction in the IOER rate would provide banks with an incentive to increase their lending to nonfinancial borrowers or to participants in short-term money markets, reducing short-term interest rates further and possibly leading to some expansion in money and credit aggregates. However, under current circumstances, the effect of reducing the IOER rate on financial conditions in isolation would likely be relatively small. The federal funds rate is currently averaging between 15 and 20 basis points and would almost certainly remain positive after the reduction in the IOER rate. Cutting the IOER rate even to zero would be unlikely therefore to reduce the federal funds rate by more than 10 to 15 basis points…Moreover, such an action could disrupt some key financial markets and institutions. Importantly for the Fed’s purposes, a further reduction in very short-term interest rates could lead short-term money markets such as the federal funds market to become much less liquid, as near-zero returns might induce many participants and market-makers to exit. In normal times the Fed relies heavily on a well-functioning federal funds market to implement monetary policy, so we would want to be careful not to do permanent damage to that market.

It isn’t clear to me why the Federal funds market would function less well if rates were negative. If I am going to lose 1% if I hold excess reserves at the Fed, my market is -1.01% at -0.99%. Money market funds would have issues, but so what? We’re eliminating liquidity in the rest of the market by prohibiting proprietary risk-taking at dealers (JP Morgan today announced the closure of its commodity prop trading desk, and is reportedly planning to close all prop desks – which isn’t surprising, since this activity is basically prohibited under the Volcker rule. It isn’t clear whether this is near-term good or bad for the equity, since it will lower earnings but presumably raise the multiple, but it is certainly bad for market liquidity).

Moreover, in a later part of the speech the Chairman says, apparently off-handedly, “It is worthwhile to note that, if deflation risks were to increase, the benefit-cost tradeoffs of some of our policy tools could become significantly more favorable.” For example, if I may be so bold, the policy tool of negative IOER.

Money market funds might have negative yields. Banks cannot make deposit rates negative because then people would just pull cash from banks, and some money funds might similarly just pile up currency in a vault and yield zero (sort of like GLD), but most money funds will buy negative-yielding short Treasury debt. Retail accounts will take their money in currency, and the industry will shrink.

I don’t see why this is a big problem. If deflation really is a problem, then even negative yields can be positive real yields. Who cares about the nominal yield, anyway? That’s money illusion in action. And anyway, this is unlikely to be a long-term problem, since the whole point is to create inflation and this will bring higher rates.

So, in short, I think it makes lots more sense for the Fed to start with dramatic action on IOER than to increase the size of its balance sheet by buying Treasuries and creating more sterile excess reserves. Merely announce that IOER is going to be negative and people will connect the dots rather quickly, I predict.

That connection of the dots will ultimately lead to higher interest rates, either in anticipation of the inflation that would follow successful monetary stimulus or in response to it. And I think that’s where the next big let of the equity bear market comes: not when the growth outlook gets worse, as it is doing (although that will set prices back somewhat), but rather when the inflation outlook worsens due to the Fed’s activities. This may be a stair step lower, but the way you get equity prices lower is in response to an increase in investors’ long-term required returns…and the most-likely way those required returns will increase is if inflation expectations rise appreciably. That isn’t today’s trade, which is all about slower growth, a (misguided) fear of deflation, negative real returns on capital, and a conditioned reflexive response to “do something” in response to further recession. These are not equity-positive events, although they are bond-positive events. But the Big Trade is when both stocks and bonds decline as inflation expectations rise.

I’ll talk tomorrow about how I would position for that possibility.

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Ordinarily, when I come back after a week or two of vacation I feel mentally refreshed and I feel as if I have a clearer view of what is going on in the economy (not that this sense actually improves my forecasting any, but it feels better). Well, I still feel mentally refreshed, but I am not sure I have any clearer a view of what is happening in the economy.

That lack of clarity is itself a cause for reflection that might be clarifying. I think there are two reasons that I still feel somewhat muddled about what the future holds.

The first reason is that there is a natural tension between what I want to believe and the evidence of my own eyes. I want to believe that after more than two years of recession, we are pulling out of it. I want to believe that, while this is a long recession and deep by postwar standards, it is not an epic contraction.

Unfortunately, the prevailing evidence seems to be that while we have exited the deep dive of 2008 and early 2009, we are still encountering a lot of turbulence and there is more ahead (one might have differing opinions about whether a different pilot or ATC might be better at routing around the turbulence, but the clouds stretch horizon to horizon and there seems no way through but…through.

Last week, while I was on vacation, we saw some dramatic housing numbers. They weren’t just dramatically bad; they were also a dramatic illustration of the proposition of fiscal neutrality. The chart below shows the combination of Existing Home Sales and New Home Sales (which looks mostly like the former since the number of sales of existing homes dominates the number of new homes, but NHS is at an all-time low so this is flattering in the positive direction). I have a 12-month moving average on the chart. For all of the stimulus, all of the programs directed at buttressing the housing market, all of the billions thrown at Fannie and Freddie, the net effect of the tax incentives was clearly and almost solely to move demand forward. That is dramatic – money was transferred from one taxpayer to another, but with no significant overall effect on the level of housing sales. The inventory of homes available for sale is still around 4mm units, about midway between the July 2008 highs of 4.6mm units and the lows earlier this year of 3.3mm units but far above the 2-2.5mm standard of earlier in the decade.

The pink line is the 12-month moving average. Gee, thanks for the stimulus!

Durable Goods Orders were abysmal, with core orders among the worst prints we have ever seen. Initial Claims were slightly better-than-expected (for a change) but remain well above where folks think they “should” be at this stage in the cycle. All in all, it was a good week to be away from data, but a rough one if you were inclined to be an optimist.

So on the basis of the data, the story I would like to be telling is substantially different from the one that needs to be told. I have been operating with a null hypothesis that while the economy wasn’t coming unglued, it also wasn’t improving the way that most Wall Street economists were expecting; we have never left the primary recession, and only by moving demand forward did we make it appear that the primary recession was over. That put me decidedly on the pessimistic end of the spectrum, which influenced my negative view of equities. However, the data of the past week is enough that I need to consider rejecting that null hypothesis, and starting to operate on the assumption that the stimulus not only proved served to pull demand forward, but that it didn’t even pull it very far forward.

There is a second reason that the current picture is a little foggy, however, and that is that the economy itself is in an intermediate state. We are coming off the fading stimulus, and “repaying” that stimulus out of current demand. At the same time, consumers are bracing for the well-advertised tax increases and other fiscal contractions due early next year. It is a healthy thing to do, in a sense: consumers seem to be no longer waiting for Congress and the Administration to “do something” but recognize that there may be nothing to be done and it’s their own responsibility to hunker down. At least, I think that is part of what is happening – growth is stalling in rational anticipation of what is going to happen early next year. But here is the problem. I don’t know how much of the current lull/contraction is due to the mathematics of fiscal neutrality and how much is due to the hunkering-down phenomenon. If it is more of the latter, then we can expect a further period of flattish growth as we move through the actual fiscal contraction and payback. But if what we are seeing so far is only the payback for fiscal stimulus, with the hunkering down yet to come, then the implication is for a much deeper (but perhaps less protracted?) near-term hit to growth.

If the latter, then equity markets have a long ways further to fall both because current pricing clearly doesn’t contemplate this sort of growth trajectory and because a second tsunami wave may well provoke some measure of revulsion among the investing classes.

I think the next few months are going to be potentially quite brutal. I still think that the Fed is going to act where Congress is unable to since the coffers are mostly barren. Dr. Bernanke’s speech last week did nothing to diminish my expectations in that regard. His declaration that the Fed can act if there is “significant deterioration,” which stocks enjoyed even though these prices cannot sustain even moderate deterioration, left unanswered the question, “deterioration from what?” From now? From when he wrote the speech a few weeks ago? We don’t know from what perspective he is measuring that deterioration. (My belief is that he is trying to prod the Congress to do whatever it can rather than lean on the Fed, but he also said that “regardless of the risks of deflation, the FOMC will do all that it can to ensure continuation of the economic recovery.” If that is the case, then the Fed will need to act, and soon, for the reasons noted above. The economic “recovery” isn’t, and arguably never was.)

Before my vacation, I thought 1046-1070 on the S&P was an indecision zone, while “below 1046 it becomes pretty obvious that the early July lows will be tested and probably broken.” The S&P probed below 1046 three times last week but closed no lower than 1047.22, so we are still waiting. Today’s close was 1048.92, and I think the failure to move appreciably above this zone probably means we are about to move appreciably below it. Tomorrow’s Chicago Purchasing Manager’s Report (Consensus: 57.0 from 62.3) or Consumer Confidence (Consensus: 50.7 from 50.4, this seems very optimistic to me) may be the precipitating factors.

When I left, the 10-year yield was at 2.61% and I expected further consolidation; it ended the week at 2.65% although today saw a rally to 2.54%. So far, so good.

Over the last week I did have some evolution in my thinking about how the Fed is likely to act, and when it is likely to begin acting. I will share these thoughts tomorrow. (Note that tomorrow the Fed also releases minutes from this month’s meeting; this is unlikely to change my view but will be interesting reading since that was the meeting at which they agreed to change their policy about the SOMA portfolio to “not contractionary” by deciding to roll the proceeds each month.

It was a great day in the Northeast for golf, but not so much of a good day to be a bull…in anything. Stocks (-0.4%), bonds (-13.5 ticks on the TYU0), commodities (GSCI -0.9%), gold (-0.5%), oil (-1.3%), the VIX (-0.95)…you name it, it was falling. The only reason currencies didn’t fall is that both sides of a currency pair can’t.

The good news is that the declines were small; the bad news is that on a day without very much news, it seems to suggest the market bias is to reduce positions.

Interestingly, today there was a story on the AP (see the story here) which might give one pause for reflection about today’s “sell everything” phenomenon. According to a report from Fidelity Investments today, a record number of workers made hardship withdrawals from their 401(k) and IRA accounts in the second quarter, and the number of workers borrowing from their accounts reached a 10-year high. In the second quarter of 2009, 45,000 people made a hardship withdrawal from Fidelity; in the second quarter of 2010, well into the supposed recovery, the total was 62,000. Moreover, of the people who took a hardship withdrawal last year, 45% took another one this year.

This is a very understandable measure of the stress on the citizenry this far into the recession/depression/recovery. It also could be one reason that markets have been a bit soggy. It’s hard to invest that money in stocks when you need it to pay this month’s mortgage.

This factor – that Americans are drawing down liquid wealth as their illiquid wealth has shriveled and the job market has been unable to compensate – may be why stocks have been having trouble and are feeling very heavy here even in the neighborhood of reasonable support. I think 1046-1070 on the S&P is an indecision zone; below 1046 it becomes pretty obvious that the early July lows will be tested and probably broken.

Bonds are making me a little bit nauseous with the altitude, and although they haven’t done anything particularly wrong technically yet it is fair to say the 140bp, four-and-a-half-month rally (from the April 5th high yields at 3.99% on the 10y note) is overdue for a pause and some consolidation.  The next couple of weeks is an ideal time for such a pause as the calendar turns very friendly to bonds beginning in early September. The most-dependable seasonal pattern in fixed-income is typically the September-October rally; while I have a hard time thinking such a rally will unfold in its typical dimensions I simply won’t short bonds in those two months unless I have a very good reason (or, more likely, two or three good reasons).

In the big picture, the rally hasn’t violated any of the long-standing trends (see Chart). I continue to believe that the low yields in the crisis marked the end of the secular bull market, as I said at the time, but the market seems to want to challenge my belief.

The secular bull in bonds: still alive and well?

Incidentally, the lower trendline on that chart (which is on a logarithmic scale, as is appropriate for such large moves) comes through at 2.47% right now. These are monthly points, but if I am wrong about the market’s consolidating over the next couple of weeks then we might well pierce this level at month-end. The real test for the “secular bull market is over” thesis doesn’t come until the market reaches to new low yields, and that is still a bit away.

As am I – away for a bit, that is. I will be vacationing for the next week, out in Colorado. This comment will not be produced in my absence but shall return on Monday, August 30th. In the meantime, you will have some home sales data (both new and existing), another Initial Claims figure, the Chicago Fed index, Durables, a 30y TIPS auction, and a big revision lower to Q2 GDP, currently expected to be 1.4% versus the original 2.4% print.

Thanks to all of the readers and subscribers who have given me so much to think about in your carefully-considered comments to my column. I definitely enjoy the friendly posts and ripostes, and look forward to resuming our dialogue in a week!

Well, the economists kept their streak going; they have now under-forecasted claims for 18 of the past 21 weeks (including revisions). That is impressive. For comparison, the odds against flipping 18 or more “heads” on a coin in 21 flips are approximately 1341-1 against. So economists can take solace in that their recent consensus forecasts have been statistically different from a coin flip. Worse, as it turns out, but at least different.

That being said, I wouldn’t have had the timing right either if I was forecasting the weekly number. On the other hand, I probably wouldn’t have been consistently low, either.

The count of initial unemployment claims looks as if it has started to climb again (see Chart). As an aside, the current level of 500k exceeds the level seen in every week of the last recession save for one, the week of 9/28/01. I would have some sympathy for the view that this recent upturn may have something to do with the end of Census employment, with a delay – perhaps the Census was employing some folks who would otherwise have been joining the unemployment rolls, and they’re now drifting back – except that other signals are starting to look worse as well. Case in point: today’s Philly Fed index.

If I believed in technical analysis on economic indicators I'd be long here.

The Philadelphia Fed composite Business Activity index, expected to come in at +7, instead came in at -7.7 (see Chart). The subindex for Number of Employees was the lowest since late last year; the Workweek index was the lowest since last summer. There is not much ambiguity here when you combine this with the Claims number. It isn’t looking great (see Chart).

It's a volatile index, sure, but this is too deep a dip to dismiss.

Now, note that the Philly Fed index is pretty volatile. So this is a good time to think in terms of rejectable hypotheses. Last month, I would have said the dip is concerning, but at the limit of what might be acceptable volatility for an economy still expanding. This dip, however, is sufficiently large that I believe we can dismiss the hypothesis that the economy is still growing as strongly as it was in Q1 and Q2 (when the government was stimulating the economy, that is). At -7.7, given the volatility of the series, we can’t be sure the economy is actually contracting, but at least in the Philadelphia region it is probably pretty close to zero.

Markets didn’t take this news well.

The 10y note declined to 2.58% (actually, not a very strong showing all things considered) and stocks fell 1.7%. The minor melt-up on Tuesday has been fully erased. Volumes remain weak, but they did expand today compared to that seen during the up days. The VIX reached the highest level since early July. Inflation swaps and TIPS breakevens declined, although that was partly because the Treasury announced a $7bln reopening of 30y TIPS for next Monday’s auction, and that was towards the upper end of dealer estimates. The current yield of bond TIPS is 1.75%, which while low is a heck of a lot higher than the 0.11% of the 5y TIPS. The issue will pull demand from investors who would rather take some bond price risk than guarantee a negative real return – long-lived accounts, like pensions, endowments, and non-US pensions. Will it be enough to place that much duration? I think it will be, but we’ll see. The dealers will be timid and cheapen the issue up before the auction, and it is August.

On Friday, there is no data due but that doesn’t mean the panicky government reactions cannot begin. Today President Obama said that the week’s jobless claims data showed that Congress should act on a new jobs bill. You know, the last one worked so well. How about working to reduce costs on business and reduce the barriers to hiring? Just a thought, but as that would imply smaller government it isn’t likely to get much of a hearing. I expect to hear more great plans over the weekend, and I expect the stock market won’t much care for it. Frankly, I doubt the bond market will like it very much either.

There is nothing to say that the panic in the government and the central bank needs to lead to a market panic, but I would not be very surprised if things started heading that way.

The stock market came into the day a trifle weak after a miserable Japanese GDP number overnight (is there any other kind of Japanese GDP number?) forced investors to confront the possibility of another front in the war against global recession. Economists had been looking for 2.3% annualized; they got 0.4%. That’s a miss!

The indices weren’t off very much, but bonds on the other hand were very well bid. While the S&P floated around unchanged for most of the day and ended there, the 10y yield fell to 2.57% as the September 10yr Note contract rallied 20/32nds. Moreover, interest rate volatility was also up sharply today.

It is odd that the stock market seemed so sedate when the rates market was moving significantly and seeing a sharp rise in options premia. This suggests that the phenomenon in rates is not global macroeconomic in nature, but more centered on rates space (if stocks go bananas tomorrow, I may have to edit that statement of course). On the one hand, it could be a positive sign if the surge in implied volatilities and in bonds was caused by mortgage servicer activity. In the “old days,” before the economic crisis began, movements in rates occasionally took on a life of their own when mortgage portfolios extended (in a selloff) or prepaid (in a rally), causing servicers to sell more in a selloff and buy more in a rally. When we would hit an inflection point in rates, it would also tend to trigger a volatility rise.

This would not be awful news, on some level. Prepayments are generally caused by refinancings, and the refi market has been pretty dormant for a while because credit has been scarce (it is hard to refinance if no one will extend you the loan at the new rate). The chart below of the Mortgage Bankers Association Refi index shows that activity has been picking up recently although it remains well below the standards of previous refi waves.

Refi index is showing some life - not lots, but some.

However, in mid-August that could be enough especially when you combine it with another fact: banks, under directions to constrain their proprietary risk-taking operations, are less likely to serve the market-smoothing function they have in the past. Historically, the big refi waves would leave dealer casualties because the size of demand was huge and the direction known to all – so if you were just lifted on a yard (that’s $1bln) of 1y10y swaptions or 10y swaps, it was very likely that the guy you are meeting in the broker market saw the same flow and he is likely to prefer to buy with the flow rather than sell to you (moreover, he probably is still trying to lay off his risk as well). The net result would be big rate movements in short periods of time, usually associated with vol spikes.

These moves would be exacerbated when they happened in November or December, because some dealers had fiscal year-end in November and others in December, so the aggregate trading liquidity was smaller due to shrinking year-end risk budgets.

The problem now is that risk budgets are being seriously constrained, partly by rule, whether it is year-end or not. I don’t know if this is really the beginning of a significant refi wave (indeed, I’m a little skeptical because I think credit is still pretty scarce), but if it is then rates may quickly go lots lower. Less liquidity means this will happen more often too, by the way.

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A friend who doesn’t like me to sleep much, apparently, sent this link to a story (and video) on Yahoo! Finance. In the story William Black (at one time he was associated in a senior capacity with the Federal Home Loan Bank Board, FSLIC, FHLB-San Francisco, and Office of Thrift Supervision) claims that the FDIC is letting banks skate by as solvent when they know that with an accurate assessment of the assets there would be many more insolvent banks. Black claims that the FDIC doesn’t have remotely enough money to pay for such a disaster – that part isn’t news; we all know the FDIC doesn’t have the funds and most of us feel it’s pretty likely the FDIC will need (and doubtless will get) a bailout at some point. It is an interesting argument that the FDIC is delaying that point as long as possible (a bailout would surely be easier in December than in October!) by ignoring banks that would otherwise be insolvent. You can read the article/see the video and assess Black’s credibility for yourself.

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Tuesday’s data includes PPI (Consensus: +0.2%/+0.1% ex-food-and-energy), which is especially irrelevant in months when it follows CPI; Housing Starts (Consensus: 560k from 549k); and Industrial Production/Capacity Utilization (Consensus: +0.5%/74.6%). The latter is likely to be reasonably strong because of the heat wave that swept the country in July, so be sure to look ex-utilities.

This is ironic given that I just wrote a piece defending gold as a not-yet-bubble, but it does remind me of the sort of responses I got when that piece was published. Follow this link to see the humorous 2 minute short.

It was Friday the 13^th, but nothing particularly spooky happened. As far as I know.

I suppose there was one little spooky thing that happened with CPI (this is called “building suspense”). Although the number was generally about as-expected, with headline rising 0.3% and core +0.1%. (Can you feel the suspense building?)

Actually, Core CPI would have printed a tenth higher – it was +0.13% unrounded – except for a  very interesting development (here it comes!): medical care prices fell last month (and now you feel disappointed. Robbed. I waited for that? Oh well…after all, it is economics).

How unusual is that? Well, that is only the third decline in the last 29 years, and only the second that was actually large enough to round to -0.1%. The last time medical prices fell further was in 1971. It is probably too early to celebrate the success of Obamacare and write letters of condolences to your doctor. The year-on-year inflation rate is up around 3.24%, and hasn’t been below 2.48% since 1972. Oh, and that was in the middle of Nixon’s wage and price control regime; two years later, once the shackles were taken off and official prices could rise to black-market prices, the rate of change for medical care was 12.3% and it peaked at an all-time high of 13.9% in mid-1975.

Medical care inflation is around 6% of the consumption basket, so if medical care prices had merely gone up at the +0.3%-per-month rate of the last year, core CPI would have printed at +0.2% and I wouldn’t be the only person murmuring that we are probably close to a bottoming in core inflation. Sure, there are always lots of one-off ups and downs, and I’m not going to read very much into the one month wiggle of medical care. Over the long run – decades, that is – Medical Care CPI has tended to run around 2% faster than headline CPI. I very much doubt that is permanently changing right now.

There was another peculiarity in the data today, and that was that the University of Michigan confidence number was stronger-than-expected at 69.6. That’s odd because confidence usually goes hand-in-hand with jobs, and recent indicators on that front have been decidedly unfortunate. Actually, this is a good time to point out how my approach to the data has changed recently.

I try to always remember that economic data are not “truth,” but rather little samplings of the underlying reality. We’re not testing the whole Martian landscape; we’re taking a few tiny scoops of sand and conducting tests. As with the test of Martian soil, when we get a result we should not suddenly declare that “this is so,” for after all it is just a tiny sample of a vast and complex landscape. What those results can do is to give us some clues, and actively refute some theories we may have had. If we thought Mars was made of feathers, a single scoop of soil should be sufficient to reject that hypothesis. Most hypotheses, of course, are close enough to reality that it can be difficult to refute hypotheses, and in economics (unlike in the multibillion-dollar interplanatary science packages) we don’t get to design our tests to address the questions we want to have answered. That does not diminish, however, the importance of an operating hypothesis.

Until recently, my operating hypothesis was that the economy had pretty much returned to the state of weakness it had displayed prior to Lehman’s demise and the general disaster that was Q3-4 of 2008. The financial crisis, and the huge fiscal and monetary policy actions, sculpted a deep drop and a sharp recovery, but the recovery wa only sharp because the drop was so deep. We were stuck at 460-470k Initial Claims, and just going nowhere. In that context, I would simply have ignored the Michigan number completely as being irrelevant.

Recent data, not just Claims but some others as well, have changed my operating hypothesis to being that the economy is fading further. Whether this is because the stimulus continues to ebb, or because monetary policy has been too tight with M2 growth in the 1-2% range, I don’t know. It may also be that businesses and households are hunkering down to prepare to ride out the big tax hike that everyone knows is coming in early 2011. But the point is that the trajectory is downward again, or anyway that is my operating hypothesis.

The Michigan number doesn’t cause me to seriously question that hypothesis, because even with the bounce it is well below the number of 2 months ago and floating around year-ago levels (see Chart, source Bloomberg), but in the context of my hypothesis it bears observation as a tiny discordant note. Enough of those notes would cause me to reject my hypothesis – but it will take quite a few.

A Michigan bounce, but not nearly enough to change my current hypothesis.

On the week, stocks fell four out of five days and ended nearly 4% lower. Moreover, the VIX rose and yields fell with the 10y down to 2.69%. The Fed’s operating hypothesis, too, appears to have changed; we will now find out how quickly their actual operations will change. It will not likely be quickly enough to prevent further losses in equities during another late-summer week. After all that has happened, “sell in May and go away” seems to have turned out to be the right idea after all.

Thanks everyone for your help on the poll this week. I am up near 300 responses and still looking for more, more, more. The URL to the poll is http://poll.fm/f/25auj and it is embedded below – feel free to send it to anyone. It will be open for a few more days, and so far the results tend to support (or rather, to not reject) my hypothesis. I will write about that hypothesis when I describe the research next week.

Then again, perhaps the fact that stocks are going down (-0.5% today) because future earnings are likely to be punk if the Rec/Depr-ession continues…makes sense. Initial Claims today printed at 484k, above the highest estimates and the highest number since February. Over the last 20 weeks, the consensus forecast has been too low 15 times (and two of the five times they were too high, the actual print was later revised to be higher than the consensus). At some point, if the “wisdom of the crowd” means anything, shouldn’t the crowd begin to catch on? Or is the economist crowd just full of slow learners?

The deflation scare has started to gain adherents. I noted yesterday that the prices of inflation-linked bonds suggested slow-growth more than they did deflation; today, the linker market got pounded like the tackling dummy during two-a-days. The inflation swaps market prices 2014 as the first time headline inflation is expected to exceed 2%, and 2019 before it is expected to exceed 3%. (Actually, it’s even worse than that, because presumably there is a longer “tail” to inflation than to deflation. Ergo, the market level, which is more of a mean expectation, is probably higher than the median forecast would be from the same market participants). 10-year inflation swaps are below 2.25%, and 10-year breakevens (which measure the same thing but are generally lower for some technical reasons) are only 1.56%.

Golly. If you’re holding 10-year Treasuries at 2.73% rather than TIPS, you are implicitly betting that compounded inflation will come in below 1.56% for ten years…because otherwise you’ll do better holding TIPS. What is the upside on that bet? It seems to me the downside is worse. Yes, TIPS at a 1% real yield aren’t cheap, but they’re better than nominal bonds.

Speaking of inflation, I want to thank everyone who has already taken the poll at http://poll.fm/25auj , and urge you to take it if you have not. Also, please send the link to friends. The poll is to test a hypothesis for a paper I am writing, and after the poll is closed (about six more days) I will disclose the results and the reason for the poll here. I don’t want to prejudice the results, however, so you’ll have to wait for me to explain the motivation!

In the news: this is the second time this has happened in the last couple of years: California is preparing to issue IOUs instead of paying its employees (link).  Now, technically these are short-term bonds, but they are very close to money. The last time this happened, the IOUs were accepted for goods and services at some stores. It goes from being a rediscounted bond to being scrip when California decides not to pay them off at 100 cents on the dollar. Can it happen? Is there anything about the last couple of years that makes you think it cannot happen?

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Tomorrow’s economic data consists of Retail Sales (Consensus: +0.5%, +0.3% ex-autos), Michigan Sentiment (Consensus: 69.0 vs 67.8 last, but given the last couple of ‘Claims numbers I would take the “under” on that), and CPI.

On CPI, the consensus call is for +0.2% on the headline and +0.1% ex-food-and-energy, which would bring the year-on-year rates to +1.1% and +0.9%, respectively. These numbers look about right to me, with perhaps a smidge of upside risk on core inflation. As usual, I will be calculating year/year core ex-housing, which last month was 2.6% and should drip somewhat on base effects. That doesn’t look even remotely like deflation to me. Sure, M2 money supply is growing an anemic 2.5% over the last 52 weeks, and that won’t scare anyone inflation-wise, but it is up at a 5.3% rate over the last 13 weeks.

And yes, August is almost half over but we are setting up all the mischief for the fall. Today the new EU ambassador to the United States said he will be speaking for Britain on foreign and security policy in America (link). And Ireland and Greece are back in the news as well (link). Europe is vulnerable to a U.S. slowdown; the impressive-sounding but de facto flimsy bet by the EU not so many weeks ago to save Greece was a measure whose best chance of success was if they happened to get lucky and nail the bottom of the economic cycle so that investors could choose to believe the fiction without much risk. It increasingly looks like that is not the case. As Terrell Owens has proven over and over again, teamwork is easiest when the team is winning. When the crowd begins to boo…it’s every man for himself.