Archive
You Get What You Pay For
I am not sure if it is encouraging that Fed officials are not singing from the same hymnal, or frightening.
On the one hand, the occasional dissonance helps dispel any worries that the FOMC is succumbing to groupthink. Given the number of crazy ideas that are being floated, it is highly important that the Committee not come to some sort of ill-considered consensus on one of them (for example, the recent proposal that the Fed should raise rates to help the economy). Indeed, in this sort of environment the plethora of wild suppositions might be taken as a positive sign, that policymakers are brainstorming the situation – one cardinal rule of brainstorming, as we all know, is that you don’t immediately reject any idea no matter how crazy it is.
On the other hand, if the metaphor you favor for the economy is of a great and stately ship being steered through the water by the steady hands of policymakers, it is disquieting to picture a dozen hands on the wheel all pulling it in different directions.
I am not entirely sure which hand I favor, but the fact of the dissonance is clear. Today, three Fed speakers held forth, and they sounded three different notes.
Philadelphia Fed President Plosser focused on the “downside” of further easing, and expressed his opinion that there is “a very limited amount of things we can do at this point.” While he said that he would back further easing if deflationary expectations began to emerge, we clearly are not at that point. (I would note that since consumer expectations are usually a couple percent above actual inflation, such timing would arguably be a couple percent too late. Unless, that is, he is talking about economist expectations, but who the heck would rely on economist expectations?) Plosser specifically said that he doesn’t support further asset purchases by the Fed (Large Scale Asset Purchases, LSAP, or simply QE2).
Plosser is one who believes that economies generally heal themselves if given enough time, and if left alone the healing will generally be more durable than if the government distorts the recovery process (as, for example, Greenspan routinely did). He argued quite reasonably that “we should not overreact” to economic data that can be volatile. As far as he is concerned, the Fed has used all of its bullets, but fortunately will not need the bayonet.
In contrast, Boston Fed President Rosengren said that the Fed still has plenty of bullets and should use them “vigorously, creatively, thoughtfully, and persistently, as long as we have options at our disposal…And we do have options, despite having pushed short-term rates to the zero lower bound.” He is worried that inflation is currently so low that it wouldn’t take much to tip the economy into outright deflation, and that this risk is one reason the Fed needs to keep firing. He is certainly not singing from the same hymnal as is Plosser. It’s not even clear he’s in the same congregation!
Providing a confusing middle ground (not to mention comic relief, which is starting to become routine for him), Minneapolis Fed President Kocherlakota seemed to lean a bit more towards Plosser. He pointed out that about $1trillion in excess reserves still sit on bank balance sheets (recall that the Fed bought about $1.7 trillion in securities in QE1), and said “banks are not using a lot of their existing licenses to create money. QE gives them new licenses to create money, but I do not see why they would suddenly start to use the new ones if they weren’t using the old ones.”
I find it hard to believe that a Fed official can say things like this. It is all fine and dandy for weekend economists to moan about the “money multiplier being broken,” but as I said in my speech last night we know who broke it and we know how to fix it. The chart below (source: Federal Reserve H.3) is directly from my presentation last night, and I think makes pretty clear by itself why banks aren’t using their “licenses to create money.”
Pay Interest On Excess Reserves (IOER), get Excess Reserves!
Is this confusing? If you pay interest on reserves, you get reserves. If you want banks to use their licenses to print money, stop paying them to not print. It’s like paying farmers to leave land fallow, and then wondering “why are we having corn shortages?” I continue to think that a necessary precondition to LSAP is to set IOER to zero, or to a penalty rate (negative), and then see what happens. I suspect that QE2 will not be needed if we finish QE1.
When the first quantitative easing happened, of course, the goal was not to increase inflation but rather to reliquify the banking sector. The Fed was more than happy to have banks holding surplus reserves in that circumstance. That circumstance has passed, however, and the FOMC ought to either take back those reserves or release them into the wild.
As it stands now, in any case, it seems to me that if the Fed were to vote on QE2 today the proposal would lose. The economy does not seem to be plummeting, and plenty of Fed officials are skeptical. Core inflation, ex-housing, has been at 2-3% all year; there are no meaningful deflationary pressures. Yet. This may all change if fiscal policy tightens as it is scheduled to do, but as things stand today I think QE2 is growing less likely just as the market seems to be believing in it more and more each day. The dollar went to an 8-month low today, and it is probably not a coincidence that this happens while the chatter about QE2 is increasing.
Incidentally, speaking of the speech I gave last night: I want to thank my hosts – the NY Investing Meet-up chapter – and especially Daryl Montgomery (also a Seeking Alpha contributor) for arranging it. I enjoyed meeting the group, but I was remiss in not giving the link to my blog (http://mikeashton.wordpress.com), indicating my handle on Seeking Alpha (“The Inflation Trader”), or noting that my Twitter moniker is inflation_guy. Hopefully, some of those in attendance will come across this column and track me down!
Because I Said So
Economic data continues to bind our hands. It continues to be good enough that QE2 seems unnecessary (unless, of course, Congress starts being fiscally tight), and yet bad enough that calling this a “recovery” (as NBER has done) seems inappropriate given the usual meaning of the word.
The main data surprise today was from Consumer Confidence, which was much weaker than expected at 48.5. Remember, though, that Consumer Confidence isn’t like the purchasing manager surveys: 50 is not some sort of dividing line. As the chart below shows, Consumer Confidence remains at levels that are lower than at the depths of the worst recessions of the last thirty years.
Hard to be hopeful if the future seems so hopeless!
Consumer confidence is only “recovering” because it was as low as the mid-20s early last year. A significant portion of this lack of confidence derives from the sense that jobs remain very hard to get, as the “Jobs Hard To Get” index remains up at levels not seen since the early 1990s recession.
The folks who are actually lining up for jobs don't see the improving employment picture!
There can be no question that the economy is currently very weak. Some economists believe this is a situation that is in the process of resolving itself as we speak, and the future of course is open to debate. But there isn’t much room for debate about the current situation.
Now, Fed policy is however supposed to be directed at the future. Since it isn’t clear whether Congress will extend the Bush tax rates or not – currently it seems unlikely that this will happen before December, if at all – the Fed needs to begin preparing the ground for whatever their next steps are going to be. They are prudently working to get the system in place to eventually reverse QE, although that isn’t likely to be necessary for a couple of years at least; more-urgently, they are trying to decide what form QE2 will take.
I am on record as saying that purchasing bonds as part of QE2 doesn’t make a lot of sense unless the Fed also eliminates the payment of Interest On Excess Reserves (IOER), but much more discussion seems to surround the question of how big to make the QE2 program if it becomes necessary. An article in the Wall Street Journal yesterday presented St. Louis Fed President Bullard’s argument for incrementalism: making a series of smaller purchases of bonds in an open-ended fashion, perhaps tied to a Taylor-type rule that would guide investors and help them understand that the FOMC doesn’t intend to stop until a certain level of inflation is achieved: “The shock and awe approach is rarely the optimal way to conduct monetary policy…I really do not think it is the right way to go except in really exceptional circumstances.”
President Bullard is apparently not aware of Robert Lucas’ “Policy Ineffectiveness Proposition,” which basically says that if monetary policy is anticipated, then it can have no effect. According to that model, the only thing which works is a significant change which surprises investors (that is, shock and awe).
Since the beginning of the Greenspan era, the Fed has instead tilted increasingly towards glasnost, believing that fully telegraphing their moves as much as possible is the best thing for the economy. Moreover, both Greenspan and Bernanke have acted as if they are afraid to surprise the markets because of the tendency of surprises to cause blowups and unanticipated consequences.
The reason that surprises cause blowups is that they happen so infrequently. A hedge fund that doesn’t need to worry about something odd coming from the Fed without ample warning may be tempted to lever a “carry trade” far more than would be prudent if randomness was part of the landscape. That is, the Fed’s openness causes excess leverage. This is so obvious, and the evidence so unambiguous, that it continues to amaze me that the Federal Reserve seems not to believe it. I started writing about this in the ‘90s (and it is a major topic in my book, Maestro, My Ass!, which is available cheaply to readers of this column here).
I think the Fed should make one final announcement. They should announce that they are no longer going to make announcements, that Fed speeches will be subject to a one week “quiet period” on either side of the meetings during which the economy may not be discussed (the way it used to be), that there will no longer be releases of Fed minutes, etcetera. Since the Fed began its openness campaign, there has been much concern at the Fed itself – as far back as the early ‘90s – that its “message” was not being properly understood by the media and the markets (after all, why be “open” if no one understands what you are saying?). The solution they instituted was more-frequent communications, much like doting parents believe that explaining their actions in more detail to a four-year old will produce better behavior. The four-year old doesn’t need to be informed. The four-year old needs to be instructed, and doesn’t need to understand the reasoning of the parents. The right answer is, sometimes, “Because I said so.”
Now, I don’t have a lot of confidence in this Fed to be a good parent, but that’s just the point. I shouldn’t have enough evidence that they are rotten forecasters who always are misdiagnosing the problem so that I can lose confidence. If their actions were shrouded in mystery, I would never know whether their easing actions were because they thought growth was weak or because inflation is too low or because they know about some bank that is teetering or for some other reason that is beyond my ken. I would have to cut them a wide berth and work into my forecasts the “known unknown” of the Fed. This would be better for everyone.
I don’t have a lot of hope that the Fed will evolve back into the mystery-shrouded institution that it once was. About the closest we can come is when some Fed speakers make a habit of crazy talk. Tomorrow, Minneapolis Fed President Kocherlakota, one of the main sources of crazy talk these days, will be speaking in London around 10:15ET, so be alert. Plosser speaks around 12:30, and Rosengren around 1:15ET. With no other data due out we probably do need to be on the lookout for tape bombs. I suppose, when you think about it, there is one group that is clearly a winner from an open Fed: brokers!
Building Blocks Of The Future
Volume is starting to be a real concern. While the bond market rallied (2.52% on the 10y note), inflation markets and stocks fell (-0.6%), and the VIX was slightly higher, the real story is starting to be the continued slide in exchange volumes. The 60-day average volume just fell below 1bln shares for the first time since at least 2004, which is as far back as Bloomberg has volume figures. Again, this isn’t entirely surprising given the regulatory changes we’ve recently seen – it’s just surprising that it has happened so abruptly.
But this doesn’t necessarily mean the market’s future is bleak. The Stock Trader’s Almanac apparently just came out with a 8-year, 7-year forward forecast (that is, starting in 2017 and extending to 2025) for the Dow of 38,820.
The forward-starting forecast is creative. If the market rallies a lot before 2017, and is sitting at, say, 25,000, is the forecast for a “SuperBoom” over those 8 years also raised? If not, then it’s really a 15-year forecast of 9%-per-year growth.
Mind you, that’s still a fairly optimistic forecast. With 2-3% inflation, 2% dividends, and 2% real growth in GDP-per-capita (see the explanation, especially of the latter, here), 6-7% is what you’d ordinarily expect as a long-run equity return (and that assumes that we’re starting from fair value, not the elevated Q-ratio of where we are). An extra 2-3% per year for 15 years is a big difference.
But since I am ordinarily playing the part of naysayer, I thought I would break form today and give a reason to be optimistic in the long run. I think that the potential future outcome is binary: there is a low but meaningful chance that our country spends the next decade or two struggling with war, inflation, a loss of confidence in the currency, civil unrest, and miserable economic performance, but there is a much higher probability that things work out okay and we come out of the current depression with bright prospects. (The chance that the best fantasies of the equity bulls come true, though, is very low).
How might things work out okay? Note that this is not my 1-year outlook. I am not particularly sanguine on the medium-term prospects, to say the least. But the view from 30,000 feet, a truly macro perspective, isn’t too bad. It doesn’t require blind faith in the American Way or patriotic chest-thumping that we’re the Best Country On Earth; all it requires is some math, one or two good decisions from our leaders (admittedly its weak point) and one small assumption.
Let’s start with this: potential GDP over time is driven by productivity growth and population growth. In Japan and in Europe’s case this is worrisome since population growth is likely to be negative as the demographic bubble bursts, but one great strength of this nation is that, for all the debate about the treatment of illegal immigrants, as a nation we generally support legal immigration. Most of us come from families, after all, that were immigrants at some point in the past. So unless our leaders make a very bad decision and prevent legal immigration as well as stopping the flow of illegal immigrants, we need to make no wholesale changes to our policies to ensure that our population growth continues to be positive.
We will lead aside the productivity question for a moment and come back to it.
Now, let’s look at the building blocks of GDP. The formula we all know is Y≡C+I+G+(X-M); in words that is GDP is definitionally equal to the sum of consumption, fixed investment, government spending, and net exports. We all know that recently, with consumption and investment down, artificial government spending is the only thing that kept GDP from collapsing. But let’s look at the long run. The chart below shows the components of GDP in chained 2005 dollars, their proportions of the economy, and the compounded growth rate for the 10 years from 1999 to 2009 (source: BEA).
Whatever would we do without Uncle Sam??
Contributing to the blistering 1.8% growth in the overall economy was a steady rise in consumption expenditures and a rise in the size of government (especially Federal, and this obviously doesn’t include the new health care entitlement and only includes part of the stimulus money).
This could make one feel afraid for the future, because the populace clearly wants the “G” number to shrink considerably. Doesn’t that doom us to slower growth, if Big Brother isn’t putting a following wind in our sails?
Not at all; in fact, quite the opposite is probably true. The government competes in the capital markets to fund its expenditures; because of its sterling credit, it outcompetes some investment expenditure (“crowds out” private borrowing, that is). It is interesting, although surely largely spurious, to note that over the last 10 years the increase in Federal spending has been $333bln (chained 2005 dollars) and the contraction in private investment has been $328.6bln.
Now, going back to the drivers of long-term GDP growth: which do you think is more likely to inspire productivity improvements, $300bln in federal spending or $300bln in private investment?
If, in fact, the arrow of government size is starting to point lower – and golly, it’s hard to imagine how it could be pointing higher given the size of the deficit – then this is probably of long-run benefit to the economy, and the future growth rate will be higher in such a circumstance rather than lower. Admittedly, this conclusion is subject to the assumption that private investment is more productive than public investment, and some people (roughly 45% of the electorate) seems to disagree with that statement. But in my mind, it isn’t such a big stretch.
.
Tomorrow, the economic data include the Case Shiller home price indices (Consensus: -0.1% month/month, +3.1% year/year) and the Consumer Confidence number at 10:00 (Consensus: 52.1 from 53.5). As always, watch the “Jobs Hard To Get” subindex for signs that the dip in August was a mirage and the employment picture is in fact improving. I don’t entirely buy it, but we’ll see.
Also tomorrow is my presentation at the New York Investing Meetup. My talk will begin at around 7pm, and the topic is “Why I Don’t Worry About Deflation And Neither Should You.” Go here for details. You don’t have to be a member of the group to attend; attendance is only $10 to cover the group’s expenses. I’d love to meet you.
Please Rewind
Blockbuster video declared bankruptcy on Thursday, and today the CEO vowed that he would evaluate “every single store” in the chain. I think we just found out what is wrong with Blockbuster. What was he doing before, if it wasn’t evaluating the stores in the chain?
Of somewhat broader importance were the Durable Goods numbers. Durable Goods ex-transportation were +2.0%, stronger-than-expected and atop a 1% upward revision to the prior month. Capital Goods Orders ex-Aircraft, which helped trigger the double-dip panic last month, was revised from -8% to -5.3%; August came in at +4.1% versus a +3.0% expectation. Equity investors loved the news, but figures like this will certainly decrease, perhaps greatly, the chances of QE2. The Fed isn’t likely to print money just to save housing. We all know housing was in a bubble that is being unwound (New Home Sales at 288k today tied the second-lowest figure on record, although in contrast to Existing Home Sales inventories are very low). If the rest of the economy is sound or at least not worsening, then the FOMC’s decision will get quite easy.
Now, Durables is one of the most volatile numbers that comes out each month. Many years ago, I showed that a forecast of -0.5 times the prior month’s headline figure, with no further analysis, tended to be slightly more accurate than economists’ collective guesses. I don’t know if that is still true, but the point is that it is very hard to get excited merely from Durables. Overall, of course, the data have failed to collapse in the way they were threatening to do last month, although it is fair to say that they aren’t shooting the lights out either!
But equity investors are in a great place right now. If growth may be strong enough so that QE2 is unnecessary, then stocks rally. If growth is weak, that may provoke QE2, so stocks rally (to be sure, it is probably a different clientele in each of those cases). Of course, month-end is approaching and the “cruelest month” is going to show a hefty gain for stocks, so many closet indexers are going to be forced to buy in if they haven’t already. It is hard to fade this rally, and it probably does not make sense to do so. But again the VIX did not go to or even threaten new lows, volume was under 1bln shares, and bonds sold off but only a little (10y yield at 2.61%). This is not a robust rally with great internals!
In the afternoon, Philadelphia Fed President Plosser spoke in Zurich on the topic of “Monetary Policy after the Financial Crisis.” Some of his remarks are worth noting. He expressed concern that unless the Fed’s balance sheet is artificially constrained by rule,
“the temptation may be too great to renege on the pre-announced policy and pursue policies that deliver temporary economic benefits that may be inconsistent with longer-run goals…In the context of monetary policy, this time inconsistency typically results in higher-than-desired inflation.”
Of course, placing constraints on the Fed would create the risk that we could have a Lehman-like calamity that the Fed was not allowed to respond to. This would seem to be a bad idea, especially now when the chances of another crisis, while having receded, remain uncomfortably high. Clearly, Plosser fears that the very outcome he is discussing – a further expansion of the Fed’s balance sheet that is unnecessary in his mind – might be a threat that is nearer than we think, and he is suggesting something that perhaps coincidentally will allow him to later say “…but I didn’t want to expand the balance sheet!” Yet, the plea sounds to me a little like the child suggesting that it would be a good idea to have a curfew on the whole family (including, incidentally, his elder brother who just got a drivers license). It isn’t as selfless as it sounds.
In inflation-related news, Barclays Capital this evening announced that TIPS will not be added to the Barclays Aggregate Bond Index, although they will create a new family of combined “Aggregate/Inflation” indices for investors who were unable to do the math themselves from the existing indices. While this news is likely to weaken TIPS, which had been rallying like mad partly because shorts were being flushed ahead of the announcement, it is definitely the right decision (as I argued a couple of days ago here). Folks like me who market inflation expertise as a consultant or asset manager will be in slightly less demand, but Barclays made the right call and for the right reason: a decision to add TIPS to the Agg would take away choices rather than add them. As their statement said:
“Maintaining current rules will enable investors that view inflation-linked debt as a distinct fixed income asset class to continue using their current benchmarks. Those investors that prefer a broader benchmark that does include inflation-linked government debt will soon have a new Barclays Capital benchmark option available to them reflecting this expanded investment choice set.”
Good call!
There is no economic data due on Monday aside from regional Fed indices from the Dallas and Chicago districts. With quarter-end a few days away, it makes sense to expect trends in place to continue especially since the Employment number is on October 8th, not October 1st. So rewind the tape of the last couple of weeks, and play it again!
Get Used To Disappointment
The data recently has had the curious characteristic that it has disappointed both economy bulls and economy bears. The economy bears are disappointed that the numbers haven’t fallen off the cliff yet as Initial Claims several weeks ago seemed to promise was imminent. Yes, Initial Claims rose to 465k, but that’s merely in the middle of the year’s range and a far cry from the 504k high in August.
But economy bulls are disappointed too, because the improvement isn’t happening. While the NBER says we are in an expansion now and no longer in a recession, most of the economic data doesn’t seem to realize that. Existing Home Sales logged their second-worst month ever, at 4.13mm, which was right about on expectations (by the way, the Houses Available For Sale number stayed right around 4mm units. The regression I showed in yesterday’s comment suggests that home price growth over the next 12 months will be around -3% again/still. Economy bulls can’t cheer very loudly for either of these two numbers, and neither did equity investors who watched the S&P shed 0.8% and fall right back through the breakout levels from Tuesday. Even the clean technical breakout has disappointed.
Now, some people will look at today’s 0.3% rise in Leading Economic Indicators (LEI), which was a bit stronger-than-expected, as being good news and auguring further growth. I should first say that I almost never spend as much as five minutes looking at LEI, because it is just an aggregation of individual data releases most of which we have already seen. There is much more information in the individual pieces of data than in the coarse aggregation of them.
For example, for this month the following components added the following amounts to the index:
| Average Workweek | 0.07% |
| Jobless Claims | -0.19% |
| Consumer Goods Orders (*) | -0.01% |
| Pace of Deliveries | -0.12% |
| Orders Nondefense Capital Goods (*) | 0.01% |
| Building Permits | 0.05% |
| Stock Prices | 0.03% |
| M2 Money Supply (*) | 0.11% |
| Interest Rate Spread | 0.27% |
| Consumer Expectations | 0.02% |
(*) indicates the component was estimated by the Conference Board.
So, the biggest contribution to the rise in Leaders was the Interest Rate Spread. In fact, the 0.27% was the lowest contribution from this component in well over a year. This contribution comes from the historical observation that when the curve is very steep, it usually indicates that the Fed is adding lots of liquidity and the market is expecting growth (and rates) to rise in the future.
The problem is that in this circumstance, the extraordinarily steep yield curve is a result of panic and the fact that the Fed lowered rates and did things that led people to expect inflation. But it did little to help growth. This “leading indicator” was adding to LEI in early 2008 (yes, early 2008) and was adding more than 0.1% per month as early as April 2008. By June 2008 it was adding 0.2% per month and by mid-2009 it was 0.3% per month. Now that’s a leading indicator. It’s really leading by a loooong time.
Now, money supply is finally beginning to re-accelerate, slowly. The growth rate over the last 26 weeks, a 4.2% annualized pace, is the fastest pace in over a year although still anemic. But perhaps, finally, the Fed’s actions are starting to gain a little traction, so that the yield-curve-as-leader might be improving. But I am not very confident in that possibility.
We are now being warned that an extension of the Bush tax rates will probably not be passed before the November elections. We are also told that at least some of the rates will be extended post-election, but there is certainly no guarantee that a Republican or partly-Republican Congress will be able to break bread with the Democrat Administration on this issue. I was looking to the Fed meeting right after the election as being the most-likely time for an announcement of some kind indicating that QE2 is beginning. But it may be too uncertain for the Fed to do anything in early November; it may behoove them to wait until December when they may be armed with better information about the likelihood of a fiscal shock and possibly have a lower core CPI to give them cover for such a move. I continue to think that only if there is a threat of a significant fiscal crunch will the Fed pursue a meaningful QE2, but I am less confident than many about the likelihood that Congressmen put in office on a platform of fiscal responsibility will vote to increase the deficit especially if doing so will give the other party cover on that issue. When it comes to politicians, it is usually wise to expect to be disappointed.
.
A reminder/re-announcement for regular readers of this column: I’ve been asked to speak at the New York Investing Meetup scheduled for next Tuesday. My talk will begin at around 7pm. If you’d like to see me wear a tie, and especially if you are interested in my topic “Why I Don’t Worry About Deflation And You Shouldn’t Either,” go to http://investing.meetup.com/21 for details. You don’t have to be a member of the group to attend; attendance is only $10 to cover the group’s expenses.
I’d love to meet you. Please consider coming to the meeting. I will have copies of my book on-hand.
A House In Every Garage! And Some Will Have Two!
Bonds extended the rally slightly (2.55% on the 10y note), while equities took a small breather (-0.5%). Stocks only retraced back to the top of the breakout range, and didn’t sink back into it, so no real technical damage has been done.
There wasn’t much reason to expect any damage, although the FHFA House Price Index was significantly softer-than-expected. This index doesn’t typically move markets, but the miss was not small: -0.5% versus -0.2% expected, month-on-month, and last month revised from -0.3% to -1.2%. That sunk the y/y rate to -3.3% (see Chart). After briefly leveling off late in 2009, home prices have continued to slide as foreclosure properties are finally coming through the pipeline onto the market.
The bounce in home prices may be a dead-cat bounce.
Now, 3.3% declines in home prices will not have the same depressing effect on rents that the 9-10% declines did, but it won’t push rents higher, either. This suggests that core (including housing, which relies on rents and the rental equivalence of ownership) may well rise more sluggishly than it otherwise would, although I believe that core inflation overall is nevertheless in the process of bottoming over the next two months.
The fact that core inflation has a chance of hitting 0.8% or even 0.7% in the next two months (although probably not until after the November meeting), even if that is going to be the low and even if core inflation ex-housing begins rising more briskly, helps set the table further for QE2. I still think that further aggressive Fed action will only be likely to happen if the fiscal tsunami due to wash over this country early next year is not diverted by Congress in the next month or so, but it is plain that continued low inflation (and especially further deterioration) is helpful to the case. I have to share here (without permission) a great limerick that a lyrically-gifted friend (Andy F) posted in reply to my column yesterday:
The Fed said inflation not growth
Is the critical part of our oath
If it weakens anew
Then here comes QE2
Unemployment? We can’t handle both
With the weak housing data, you wouldn’t think it would make sense that TIPS would rally hard but TIPS have been on fire recently. I noted a week or two ago that European inflation markets had been suddenly perky, and that the US was showing signs as well; however, in recent days it has been very much a real rate phenomenon and not an inflation-swap phenomenon so much. The chart below shows Bloomberg’s on-the-run 10-year TIPS yield series, which is plumbing all-time lows (I have the 10y real yield more like 0.69% than 0.65%, but the point of the chart doesn’t change).
I guess since real yields can be negative...there is no theoretical bottom to this hole.
As I previously pointed out, some of this is likely due to speculation that Barclays might add TIPS to the Aggregate index, an idea which makes very little sense but it enough to scare bears in the product out of their positions. And rightly so, because if Barclays does make such a change it would mean a massive one-time flow into the asset class as indexers get on their marks (more than likely, Barclays would phase in the change over time so that the Treasury would have time to meet the greater demand with further supply…but there is, after all, no guarantee that the Treasury will choose to do so). I don’t know when the formal announcement would come, but it shouldn’t be long.
Tomorrow’s data includes both the suddenly-vibrant Claims number (Consensus: 450k, unchanged from last week and back near the lows of the 2010 range) at 8:30ET, followed by the suddenly-catatonic Existing Home Sales figures (Consensus: 4.10mm, which would have been an all-time record low if last month’s 3.83mm hadn’t printed). More important than the rate of Existing Home Sales, which has been really jumpy and so one month probably doesn’t mean a lot, will be the count of Homes Available For Sale in the same report. The inventory of existing homes is around 4mm, below the all-time highs of 2007 and 2008 but near the highs of 2009 and 2010. As long as the inventory number remains high, the Home Price Index is going to remain under pressure. The chart below makes this clear. It relates the count of Homes Available For Sale (in millions) with the rate of home price appreciate or depreciation over the immediately-subsequent 12 months (data since 1999). The R2 is probably exaggerated due to the wide range covered by the data, but to me it is still a pretty compelling chart.
More supply? Lower prices.
Empty Words Are Words Enough
The Fed today, as I had expected, gave no indication that QE2 is on the near-term horizon. While indicating that the Committee felt inflation to be somewhat lower than they would like, and pledging to “continue to monitor the economic outlook and financial developments,” the Fed also declared that it is “prepared to provide additional accommodation if needed to support the economic recovery.”
That’s a relief. It would have been really ugly if they had said something like “the Committee is not prepared to provide any additional accommodation, even if it is needed.” The market, however, reacted to this empty gesture in very curious fashion. Going into the meeting, there was definitely some expectations in many quarters that the Fed would at least signal QE2, even if they probably wouldn’t start it today. When there was only the vaguest wave of the hand in the direction of such a move – in my mind, reducing slightly the chance of QE2 at the November meeting – one would have thought that bond and stock holders would have been disappointed.
Not by half! Both bonds and stocks rallied significantly, raising the question of what in the world the Fed could have said that would have caused a bearish reaction! Gold rallied. Inflation swaps rallied. What were people worried about, a rate hike?
As I have said several times, there was simply no reason to begin QE2 today; while data has been weaker than expectations, it hasn’t been dreadful, and the main argument for QE2 is and has been forward-looking based on the likelihood that tax rates will rise sharply in 2011, leading to a sharp contraction in growth. But Congress still might prevent that from happening, which would obviate the near-term need for QE2. Ergo, the FOMC didn’t have enough information to confidently declare that QE2 is needed, and so they made the merest nudge towards the possibility.
QE2 is the last bullet in the gun. The Fed will use it if necessary, and I think they will use it before the absolute last resort, but it is no surprise that they aren’t anxious to do so. It seems the market believes that they have itchy trigger fingers, although by the end of trading the equity indices had retraced most of their gains. Bonds, however, had not, and the 10y note closed at 2.59% with the 2y note at another all-time low of 0.425%. Gold also closed at an all-time record. The dollar was hammered. What news service are all of these investors getting? I must be reading the wrong Fed statement.
Earlier in the day, Ireland sold lots of debt (1.5bln€) at yields (above 6% for 8y money) that will be terrific for investors if the bonds eventually redeem in full and there’s not much inflation. The same statement can be made about almost any fixed-rate bond on a rotten credit, I suppose! But in this case, my question is: what are the odds of a slow-growth environment, which would be the one that would be most likely to result in low inflation, being coincident with a non-default of a country that has an overwhelming burden of debt and deficit? If inflation is high, the odds of repayment of a fixed-notional bond increase but you won’t like the real return very much. If inflation is low, the real return is very good but the chances of default are much higher. It seems to me you need two bets to work out in order to like your investment, and the odds don’t look right to me.
Housing Starts came out above expectations, at 598k, but still around the middle of the last year’s range. Pretty weak, but not so weak as to suggest that quantitative easing is imminently necessary.
Banks perhaps could use a little more help padding their bottom lines with cheap Fed money. According to Bloomberg as cited by Financial Advisor Magazine, Bank of America is firing as many as 400 employees; Barclays and Credit Suisse are also laying off people. This move comes following the predictable decline in bank profits. An article in the Sunday New York Times declared that “business has taken a surprising turn – downward.” I have been commenting on the trading volumes, which fell off a cliff as the Volcker Rule neared passage and the SEC began questioning liquidity providers after the “flash crash.” The downshift has been surprisingly abrupt, even for someone (me) who said it would happen.
But the arrow of bank profits should come as a surprise to no one. We knew that return on equity was almost a slam-dunk to decline since two of the three components of ROE – asset turnover (volumes) and financial leverage – were destined to be under severe pressure after the financial crisis, and the third component (net profit margin) came under pressure as a result of the regulatory diktat to start moving over-the-counter product to exchanges. Add up three negatives and it is hard to get a positive result. According to the article, stock IPOs worldwide are down 15% from a year ago; bond issuance is down 25%; and August NYSE volume was 30% below year-ago levels. Meredith Whitney sees bank earnings down from $56bln last year to $42bln this year. If that’s right, then next year ought to be worse since proprietary trading revenues will also be missing. And once interest rates rise and remove the yield curve benefit…well, I’m just not sure why people are so interested in bank stocks. They look like mostly downside to me.
.
The only data out on Wednesday is the Home Price Index (Consensus: -0.2%), although Geithner is testifying before the House Financial Services Committee on the state of the international financial system. That testimony is due to start around 2:00ET. I don’t see any big catalyst for volume, but perhaps after digesting the Fed’s words overnight some investors will realize they don’t seem to be as supportive as initially believed. In the meantime, I remain flummoxed.
.
A quick announcement for regular readers of this column: I’ve been asked to speak at the New York Investing Meetup scheduled for next Tuesday. My talk will begin at around 7pm. If you’d like to see me wear a tie, and especially if you are interested in my topic “Why I Don’t Worry About Deflation And You Shouldn’t Either,” go to http://investing.meetup.com/21 for details. You don’t have to be a member of the group to attend; attendance is only $10 to cover the group’s expenses. My honorarium is…well, hopefully some people will buy copies of my book, which I will have on hand.
I’d love to meet you. Please consider coming to the meeting.
Why Does Expansion Feel So Much Like Recession?
The technicians will be happy with today’s price action in equity markets. The movement of the S&P clearly above the summertime highs will clearly signal to some that the “inverted head and shoulders” on the daily chart – which projects to new equity market highs – has been completed and we are about to take a massive run to the upside.
I am less convinced, although the technical damage done to the bearish case by the 1.5% rally is undeniable and I would no longer lean short on a tactical basis. But volumes remained weak (912mm shares, still under 1bln even with a breakout), bonds rallied, and the VIX refused to move to new lows. By the way, the scale of the “inverted head and shoulders” is out of proportion with the length of the move into the formation, so technically it isn’t a reversal pattern at all. However, because the pattern is recognizable by all investors as well as dogs and some species of fish, there will be much ado about this move…especially this near to quarter-end.
The impetus for the rally? It probably was not the sharp widening of credit spreads for Ireland and Portugal. Greek Prime Minister Papandreou said that for Greece to default on its bonds would be a “tragedy” and he promised it would not happen. Didn’t we already move on from that? I hate it when someone promises something that we already took for granted. It makes it seem like we were prematurely taking it for granted, because otherwise he wouldn’t need to promise, right? (Of course, this is tongue-in-cheek. It would be a grievous error to assume that Greece will not default, or that all of the dealers who own piles of Greek bonds and are telling us it’s time to buy them are necessarily giving arm’s-length advice.)
A better candidate for goosing the rally, although it was already well under way at the time, was the announcement by NBER that the recession is over…actually, that it was over in June of last year. That is a curious decision in cycle dating. The Unemployment Rate rose another half-point after last June, and is only back down to 9.6% because of the decennial Census. The U-6 measure, which adds discouraged and marginally attached workers, is still 0.2% higher than in June of 2009 (see Chart).
Sure, unemployment definitely looks like it's improving. Really?
Initial Claims has come down from the 550k-600k level seen in mid-June, but as I have written previously that merely indicates that the Lehman bankruptcy did not actually end the world. It was almost impossible for Claims to continue at that level; the spike was related to the crisis but the recession is distinct from the crisis. And Initial Claims remain at levels comparable to those seen at the worst points of the prior two recessions (see Chart below).
Initial Claims...is this why this expansion seems so much like a recession?
Capacity Utilization clearly bottomed in June 2009 (see Chart below), thanks to huge government spending, but fewer Americans toil in manufacturing than used to so surely this is less important than it once was.
Capacity Use definitely bottomed. I guess that's all that matters?
I guess the real question here is, what’s the hurry? With total output still not up to the level it was in 2008, declaring an end to the primary recession mainly creates the possibility (which will become a probability unless the Bush-era tax rates are extended) that the single recession will shortly be declared to be two recessions. I submit that the only reason to do this now, the day before the FOMC meets and less than two months before the elections, is political. It isn’t like most of us were sitting around waiting for the NBER’s pronouncement, but I would expect the political advertisements of the incumbents are already being re-written to incorporate the declaration that “Senator so-and-so helped end the recession…”
It will certainly make it a little bit harder for the FOMC, when it meets tomorrow, to make any overt move towards QE2. I didn’t really expect any overt move this month, since it makes so much more sense at the next meeting (the day after the election), but it will be extra-difficult to be dovish when the NBER has just said that we are in an expansion that is already 15 months old.
Housing Starts tomorrow (Consensus: 550k from 546k) will help remind them, and other observers, that the economy isn’t exactly booming. The NAHB Housing Market Index, out today, remained mired at 13 despite expectations for a small pickup. That is lower than it was in June 2009, so this expansion has led somehow to worse housing market conditions (even with tax incentives!). The all-time low in January 2009 of 8 is not likely to be exceeded any time soon, but neither is the high of 2005 (at 72). Nor is the 2006 high of 57, or the 2007 high of 39. I think you get my point. If this isn’t a recession, then it is a pretty sorry excuse for an expansion.
.
In inflation-related news, the Barclays Index Advisory Council is having its annual meeting tomorrow. According to the Wall Street Journal, among the topics is whether to include TIPS in the Barclays (neé Lehman) Aggregate Bond Index. This is apparently partly what has been behind the recent bump higher in inflation-linked bonds, although it doesn’t explain the bump in European inflation swaps!
It makes very little sense to include TIPS in the Agg. It makes exactly as much sense to include inflation swaps, which have only inflation duration, as it does TIPS, which have only real duration, in an index of nominal bonds. Let me explain.
Irving Fisher’s equation says that
(1+nominal rates)=(1+real rates)(1+expected inflation)(1+risk premium).
For brevity, we usually combine the risk premium with expected inflation and say:
(1+n)=(1+r)(1+i)
which reminds us that nominal rates are a function of real rates and expected inflation. Now, recall that duration describes the change in a bond’s price caused by a change in its yield to maturity. We can go further (and Waring and Siegel did, in their landmark 2004 article “TIPS, the Dual Duration, and the Pension Plan”), and observe that TIPS have only real duration – meaning that changes in their value today depends only on changes in their real yield to maturity – and inflation swaps have only inflation duration – their value depends only on changes in expected inflation. Nominal bonds are an equally unique case in which the inflation duration is approximately equal to the real duration. That is, a 1 basis point change in real yields will cause roughly a 1bp change in nominal rates; a 1 basis point change in expected inflation will cause roughly a 1bp change in nominal rates as well. Nominal bonds have both inflation duration and real duration, in (more or less) equal helpings.
By adding TIPS to the Aggregate Index, it will no longer be possible to calculate the Aggregate’s nominal duration. It will be a meaningless number. TIPS have an indeterminate nominal duration! By that, I mean that if you tell me that nominal interest rates changed by 1bp, I can not tell you anything about what happened to the price of TIPS. It depends whether that 1bp change in nominal rates came from a change in real rates (in which case TIPS will move), a change in expected inflation (in which case TIPS will not move), or a combination of these two in which case TIPS might move more, or less, or in the opposite direction.
For example: suppose that inflation expectations rise 2bps and real rates fall 1bp. This means:
- The nominal interest rate, which is approximately their sum, will rise by about 1bp.
- TIPS will appear in this case to have a negative nominal duration, because their prices will rise since real yields fell.
By adding TIPS, the Agg will become a confusing mishmash of unlike instruments. So I really hope the committee decides not to do it.
Two groups, however, would find such a change in the index very good news indeed. The first is the U.S. Treasury, which would find a sudden increase in demand for TIPS from bond fund managers who are trying to track the Barclays Agg. The second group is the community (fairly small!) of inflation experts, who will have a much larger audience for our services. Perhaps this is a good time to point out that I do consulting…
Tired And Shivering Is No Way To Invest
When the murky waters of the loch appear to swirl and boil up in an unusual manner, the statistical reality is that it is much more likely to be a trick of the light, or a manatee-like creature, or something similarly non-threatening. But as a swimmer, doesn’t it warrant being more careful? If the chances of coming face-to-fangs with a sea monster are remote, the penalty is also extremely large. Viscerally, most of us shiver involuntarily when we swim over deep water and imagine what might be looking up at us…there is a reason for this primeval response; perhaps we ought to listen more.
I am starting to feel just such a shiver as I read headlines such as the ones today from Ireland (for example, this one). Cursed with a deficit that is 25% of current-year GDP and a recent crisis at a major bank (Anglo Irish Bank), credit spreads on this one of the PIIGS countries have been widening again and not, I might add, without reason.
The shiver looks as if it hasn’t yet made it into the stock market, which responded to the Irish news with decided indifference. Indeed, apparently bulls and bears called a truce today with stocks, bonds, the VIX and the dollar all closing nearly unchanged. Equity volume was good, but that was solely due to the fact that it was triple-witching Friday.
When both sides have battled to exhaustion and have retired from the fight temporarily, the military strategist looks to see who has the longer supply line; whose front is overextended and more-difficult to sustain. Sometimes, the answer is that no one is – the pugilists have traded punches toe-to-toe in the center of the ring. But that isn’t the case here. Clearly, the equity bulls and fixed-income bears have been the ones advancing over the last couple of weeks. The enthusiasm for pressing the advantage has apparently ebbed, and at an inopportune moment. The position is extended, and I don’t see the equity bulls having the gumption to overrun the Maginot Line at 1131 on the S&P (see Chart). I expect a pullback in short order, and a rally in bonds. As these are the usual seasonal tendencies, those are positions I would actually entertain. However, it does bear repeating that the level of uncertainty right now is quite high and positions should be smaller than normal. I view this as a tactical decision only.
With both sides exhausted take the one with shorter supply lines.
The economic data this week didn’t help much. While the Michigan Confidence number today was surprisingly weak, down to 66.6 versus expectations for a rise to 70.0, that is a second-tier number a best. Interestingly, the respondents’ expectations for inflation 1 year ahead fell 0.5% to 2.2%, the lowest number in a year. This sounds like it ought to be a big concern, but it’s not. If you look at the Chart below, which shows the Michigan 1-year-ahead inflation expectations against year-on-year CPI, it looks like Michigan does an awesome job.
Gee, Michican Survey isn't bad!
But alas, all this shows is that respondents are giving as their answer to the survey question the number they heard on TV today. The Chart below shows the Michigan results shifted forward a year (so the point that respondents are supposedly forecasting matches up with what happened). You can see that the responses are close to random. In 2008, the year-ahead forecast of the Michigan Survey missed by 7% what actually happened. Several months later, they missed 1% the other way. All the Michigan Survey tells you about inflation expectations is how closely people are following the current financial news.
On second thought, why do I care for a survey of bad forecasters?
So let’s look at the real CPI. The headline change was +0.254%, barely rounding up to 0.3%; the core change was +.046%, barely rounding down to 0.0%.[1] The modest downward-surprise on the core CPI was apparently due to aggressive seasonal adjustment factors that were unexpected. The year-on-year core CPI remained at 0.9% (actually 0.890%) and is actually at some risk of squeezing out another tenth decline over the next month or two before it begins to rise.
The question we all want answered, of course, is whether this is good for stocks and bonds both since it makes deflation appear closer and hence enhances the chances of QE2? Alas, probably not. The downtick was by the slimmest of margins, and it certainly sounds as if the Federal Reserve is looking more at indicators of activity (and omens of activity to come, in particular the actions of Congress), and as long as CPI doesn’t look to be plunging or soaring immediately it probably isn’t relevant to near-term policy deliberations.
On the topic of Congress: while I try to keep raw political observations out of this commentary, this will sound like one. I have begun to notice that politicians on the left side of the aisle who have joined the push to extend the Bush tax cuts are calling the action of extending them “the Obama tax cuts” rather than “the extension of the Bush tax cuts.” (see for example here) I would think that it is naked cynicism except that it is the same approach as the Administration has taken with the “jobs created (or saved)” metric. The Administration, and now the Congress, are basically taking one of the worst practices of the asset management industry and applying it to politics. In the last couple of decades, so much attention has been paid to the performance of asset managers relative to a pre-selected benchmark that most compensation is awarded based on relative performance. If the stock market is down 35% and you were down 34%, you’re a hero because you added 1% of value to what was assumed to be the baseline. The Congress here is saying that because the rise in taxes would happen as a result of existing law, if Obama acts to keep rates unchanged it is effectively a tax cut over what would have happened otherwise.
But to me, the taxpayer, it rings as false as when the fund manager tells me he did great by shaving a point off my loss. If the bill were to pass, my tax rates would stay the same. How is that a tax cut to me? If the bill fails, then my tax rates will rise. That sure sounds like a tax increase, but according to the spinmeisters, it isn’t.
Do these bozos have any idea how sickening it makes us all feel to realize they don’t even care enough about our opinion to come up with a clever dissimilation?
Well, I apologize. I hope that reads more as a harangue against the dolts in power (who at the moment happen to be predominantly Democrats) than against one political party. I am sure the Republicans mostly wish they’d thought of it first.
[1] It embarrasses me to admit an error in yesterday’s comment. I stated that an 0.3% change month-on-month should be associated with 1.3% year-on-year; red-faced, I confess that I was looking at the wrong cell on my spreadsheet. The 0.254% change seasonally-adjusted came from a non-seasonally-adjusted change of 0.14%, which drops the year-on-year figure to 1.148%. I apologize for that goof, which is ostensibly in my area of expertise and so doubly embarrassing.
Accumulating Incongruities
It seems that every day these days I am befuddled by something new. Today’s unusual experience was that professional economists actually did a great job at forecasting that the sharp improvement in Initial Claims, which happened to be coincident with the failure by eight states to timely file their reports last week. This week, rather than a bounce and a hefty revision higher as the actual data came in, Initial Claims actually improved further with only a 2k revision to the prior week. That means that the estimates the Department of Labor and the various states made last week in lieu of actual data were actually more accurate than the estimates of professional economists. This week, only 2 states still had to estimate claims because of a backlog, and those two states (Nebraska and Virginia) aren’t big enough to imply too much of an error.
So, while it is hard for me to believe, apparently the big improvement in claims happened at exactly the same time that California and some other states had to be estimated, and those estimates happened to be exactly right. The DOL didn’t think it was important to mention this week how much the estimates used last week deviated from the actual reports, but they must have been remarkably close.
While the employment situation is clearly doing better than I thought and doesn’t appear to be falling apart, let me tell you why I am suspicious that this may not presage a dramatic improvement in the labor market. The Department of Labor indicates that the job market is improving markedly. But when surveyed about their own prospects, consumers reply that jobs remain very hard to get (see Chart of the “Jobs Hard To Get” response in the Consumer Confidence survey, below). Historically, this survey tends to do a good job of measuring actual conditions in the job market, because it is something that consumers are well-positioned to judge accurately (unlike, say, the purchase-dollar-weighted-average price change in their market baskets). When firing stops and hiring starts, it will be normal people who are talking to other normal people that will first detect this fact.
Labor market is probably not really improving, very much anyway, or people would feelit.
What could be happening, although it strikes me as remarkable that no Street economist I am aware of suggested this possibility previously, is that the big Census layoffs have played havoc with the normal seasonal pattern. I can understand why such a phenomenon could lead to a big rise in August claims, but am at a loss to figure out why it would lead to a sharp improvement in September claims.
In any event, while there are now enormous error bars around the estimate of the true pace of Initial Claims, it seems we can reject the hypothesis that the labor market is growing markedly worse. This point, combined with the possibility that some or all of the Bush tax rates could be extended – although that seems an electoral loser to me – decreases the chances of QE2 this year. If the outlook isn’t markedly worsening yet, then Bernanke’s precondition hasn’t been fulfilled. Now, if the Bush tax rates aren’t extended so that the fiscal drag in Q1-Q2 is going to be predictably large, then QE2 is still pretty likely, but it would be much cleaner if we were already seeing weakness even before tax hikes and municipal spending cuts went into effect.
I hate to say it, but I have a certain level of sympathy for Chairman Bernanke and the crew at the Federal Reserve. They haven’t done a very good job since Bernanke’s term began, but he was put at a disadvantage early as a result of inheriting the mess contributed to by the prior occupant of his office. Basically, Chairman Greenspan cut the steering column in half and then handed the wheel to Bernanke and said “Here, you drive.” The steering isn’t working like it is supposed to be working, but that’s partly because the former driver trashed the car.
.
Tomorrow’s data is the cream of the crop for the week. CPI (Consensus: +0.3%/+0.1% ex-food-and-energy) is out at 8:30ET. The mere 0.1% rise in core inflation will pull the year-on-year rise in core CPI back up to 1.0%. This may mark the bottom of the cycle although it is more likely to be set in October. The consensus for headline is odd, because a seasonally-adjusted month-over-month rise of 0.3% should, on my calculations, cause the year-on-year increase in headline prices to rise to +1.3%; Bloomberg has the consensus for the year-on-year figure at +1.1%. In principle, this is a fairly easy calculation. It actually looks like Bloomberg has 76 responses to the month-on-month figure but only 40 responses to the year-on-year figure, and I imagine this explains the discrepancy. A print of 0.2% is roughly consistent with a year-on-year of 1.2% (although it depends if it is a “high” or a “low” 0.2%).
Although CPI is the crucial data for the week, however, the major conundrums these days are all market-related. I think I have some idea why stocks and bonds are moving in the same direction more often now (because both are likely to respond similarly to an increase in the chance of QE), especially when strength in these markets is combined with dollar weakness and commodity strength. And I have a sneaky suspicion that the very low exchange volumes and stubbornly-high VIX are related to the diminishment of liquidity associated with the Volcker Rule and other assaults on market-makers. But these are only guesses, and while they make sense there is very little supporting data right now.
I wrote earlier this summer (here) about the implication of uncertainty for bet size (referring to the Kelly Criterion to illustrate). Back then, I was writing in the context of a VIX that was in the process of rising from 23 to over 35, but the thought process applies similarly when the number of unanswered questions is rising. Odd market behavior sometimes precedes bad market behavior (funny, this sounds a lot like the explanation in the movie The Matrix about the cause of déjà vu), but in any case it lowers one’s confidence in the edge one has an investor. The tricky part is noticing when these incongruities are accumulating, and that’s where writing a commentary helps. I feel I can’t explain a lot of what is happening. That makes me nervous.
Some traders are very systematic. I tend to rely on models myself a great deal of the time. But as I have gained experience, I have learned to listen to my nervousness more. I almost never increase a bet based on gut feel, but I will often decrease a bet if I am nervous. I always want to live to fight another day! Accordingly, I will almost assuredly never have a +100% year. On the other hand, I will also almost assuredly never have a -100% year, and that is much more important to my long-run return.
