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Oh Rats

Foreword: I need your help! Please read to the bottom of the post and participate in the poll: the bigger the sample, the better!


Stocks did actually decline today. The decline started last night; the conventional explanation is that investors were discouraged by the Fed’s dour outlook (the Bank of England also cut its growth outlook, today). Volumes were light (although Wednesday’s volume was the highest of the month), but the vector was clear and the arrow pointed downward. Bounces were feeble, although that is doubtless due to the fact that it’s August. The S&P index fell 2.8%, and the VIX rose to a level last seen in mid-July.

While I think the proper level for the indices, if the Fed is going to stoke inflation, is lower (the result of lower earnings from slower growth combined with lower multiples associated with higher inflation), I don’t think investors were selling because of a fear of inflation. They sold because they’re worried the Fed may be right about deflation. Look at the dollar: it rallied hard, despite a very weak Trade report (more on that in a monent) that would ordinarily cause the unit to sag. Look at the bond market, where yields on the 10y note fell to 2.69% despite a $24bln auction and the 30y yield fell to 3.93% as well. And of course, look at the inflation curve where inflation swaps dropped 4-5bps across the curve.

So the equity market had the “right” response, but for the wrong reason. Deflation isn’t our problem, inflation is (or will be, if the Fed pursues QE as they seem bent on doing).

The Trade Balance was much worse than expected, and not just because imports were higher. If the deficit is expanding because we are importing more, that’s not so bad because at least it signals domestic demand is okay. Imports rose 3%. But exports fell 1.3%, the worst performance in more than a year. Sputtering global growth is bad news for everyone. The big miss on the Trade Balance for June implies that the GDP figures for Q2 will need to be revised substantially lower (recall that GDP = C + I + G + (X-M) ). I haven’t seen the extent of the revisions yet, but I noticed that one shop lowered not only their Q2 figure but also their Q3-4 figures since it is harder to envision a strong second half if the first half was already fading.

There has been building a not-so-subtle tension between the bond guys, who apparently saw weak growth ahead and priced yields accordingly, and the equity guys, who saw sunny skies, kittens, and hugs. It looks like that disagreement is being resolved right now in favor of the bond guys, although it helps that the Fed is going to be buying about $18bln in Treasuries and TIPS (mostly the former) over the next month.

This is about more than just Fed buying, however. Nominal yields can be low either because inflation expectations are low or because real yields are low, or both of course: the Fisher equation says (1+n)=(1+r)(1+i), where n is the nominal yield, r is the real yield, and i is expected inflation over the horizon. In the teeth of the crisis, in late 2008, real yields were very high and implied inflation very low; when nominal yields plunged it was mostly because expected inflation was dropping as the market priced in deflation. Real yields remained fairly high, partly because deflation makes for pretty high real yields.

But now, real yields have fallen to within a whisker of the all-time lows at the 10-year point (see Chart, source Bloomberg). They reached those lows during the Bear Stearns crisis, when the extent of the housing slowdown was becoming apparent.

10-year real yields are near all-time lows

Real yields are not that low again because the Fed is restraining nominal yields. The Fisher equation implies that movements in nominal yields are an effect, not a cause, of movements in real yields and inflation. Real yields are low right now because there is slack demand for capital, and they are a symptom of economic malaise. Low real yields will also be part of the cure, of course, as an automatic stabilizer in the same way that low oil prices in a recession help stabilize growth. But the bond market is telling us that investors think real growth will be low not just for a year or two, but for a long time.

Thursday’s Initial Claims data may recall this to mind. Remember that last week saw a wholly unexpected jump to 479k. The consensus expects a retracement to 465k, which strikes me as a little timid if economists still thought we were in an improving trend. Evidently, confidence in that fact is wavering.

Damage has been done technically to the stock market, and I expect a return to the 1040-1050 level on the S&P at least and perhaps a deeper pullback than that. Bonds may be getting a bit ahead of themselves, but it is hard to believe that we won’t see a re-test of the 2008 lows near 2.05% on the 10y note. That is a change for me, incidentally. I still think the secular worm has turned, and we will ultimately see higher rates, but bond bears are on the run for now with the strongest seasonal period of the year (Sep-Oct) approaching quickly.


I want to ask a favor of readers of this column. I have been working on a paper recently and I want to test a hypothesis I have. I’d like to take a (very unscientific) poll about your perceptions of what inflation is like for you. Below you will find a poll I’ve created, and I’d appreciate it if you’d take a few minutes to reflect on your answer and to record your perceptions. To quote Count Rugen in The Princess Bride as he begins to torture Wesley: “and remember, this is for posterity so be honest.” I appreciate your time. If you’d like to help further, feel free to post the direct URL for this poll – http://poll.fm/25auj – to friends, family, and Facebook. Thanks a lot!

Categories: Uncategorized
  1. August 11, 2010 at 5:02 pm

    I voted in the middle, 4% to 5%, based on my own very unscientific observations. Certainly there is a mix of higher and lower prices. I buy a lot of things without really paying attention. I can’t tell you the price of bread, milk or eggs. What I do know is that beer is up and pizza is up a lot! I still feel a shock when I fill the car with gas and it’s $50. I am a Cubs fan and tickets went up just as the team fell apart. Pizza here is double what it was a few years ago and several of my favorite pizza parlors closed in the last year. Restaurant tabs are higher while business is slow. Airline tickets are higher and service is abysmal.

    Most golf courses are discounting green fees on line. Some of the premiere courses are not so we go there less. Of course houses are much cheaper and there is still a supply overhang. Parents with older kids at home would love to help reduce that stockpile but jobs are a necessary prerequisite.

    My guess: The voters are fed up with Obama and the Democrats. Their “stimulus” didn’t work to the surprise of no one with an understanding of economics and a healthy skepticism of Keynes. Now the rest of the open minded understand that the Democrats are trying the same failed policies that deepened and extended the depression. The current GOP is not ready to seize this golden opportunity but the tea party activists are having an impact.

    After decades, the “throw the bums out” movement has real traction. While many of the ancient hacks like Rangel refuse to go gently some others are smartly retiring before the extreme damage they caused during their long careers becomes apparent. It is not going to be “fun” to be in charge now that the party is over. Hopefully the seriousness of the situation attracts more serious politicians like Chris Christie who know that the economy is very sick and requires strong medicine. The voters are willing to listen to tough talk and take the medicine. Hopefully the rest of the GOP sees his dynamic poll numbers and follows his lead.

    When the right policies are implemented the economy will expand and all that extra money they’ve printed will start to circulate. Until the producers can catch up and hire help and ramp up production we will have “too much money chasing too few goods”. Then things that have been getting cheaper due to productivity gains and slow economy will start to rise along with the other commodity driven goods.

    Inflation is coming. Gold says so.

  2. August 11, 2010 at 6:29 pm

    Thanks – that’s exactly what I am hoping to find out. I don’t think most people calculate modified Laspeyres indices in their heads. It’s the impression I am trying to get at. Perfect.

    I think you’re right on the political economy, as you might expect.

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