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This Ain’t Pismo Beach!

Stocks edged back -0.8% today, on (do we even need to say it?) light volume. Some observers feel the pullback evinces concern about the earnings season, which semi-officially gets underway Thursday when Alcoa reports, but if there is concern it isn’t a deep and abiding concern: the market bounced off the June and August range highs and the breakout…although it is a pretty weak breakout so far…remains inviolate.

It isn’t that surprising to see investors taking some gains when the market has rallied into earnings season and the Employment report also looms. The pullback isn’t much to be concerned about, yet; the 10y note at 2.48% is also near its 2010 highs (low yields) and remains in a gentle but unmistakable uptrend. I am more likely to be bearish on equities than to fade bonds at this point in the year, but I need some catalyst to take action in either case.

NY Fed Markets Group boss Brian Sack didn’t give any reason to be bearish on assets in the near-term during his talk today. Of course, Mr. Sack is not going to be the mouthpiece that signals quantitative easing, but he did convey the message that the Fed views the recovery as “relatively tepid” and believes that “further expansion [of the securities portfolio] would likely provide additional accommodation” for the economy. This is far from assured, and anyway the bang for the first $1.7 trillion bucks was, if I may say so, “relatively tepid.” I think adding more liquidity by buying bonds makes little sense if the Fed doesn’t also lower the interest on excess reserves, but more and more this seems to be beating a dead horse (which may be fun, but is not effective – gosh, maybe it’s the Fed who is getting ready to beat a dead horse with QE2?).

Wall Street observers are gradually coming to the view that QE2 will be announced at the November meeting. I still don’t think so, but so far the Fed has done little to discourage that view. In the context of the “new” openness at the Fed, the failure to guide the market away from the wrong idea may be considered tacit approval of that idea. The Fed isn’t meeting today, and doesn’t need to decide today, but within a couple of weeks if QE2 isn’t on the way they’ll probably want to signal that.

Whether they will need to will, of course, depend on the data. If the Employment report and other data bespeak a rosy-cheeked recovery, the Street will change its mind without help. But if the reports come in as-expected (that is, weak) then the expectations of QE2 will continue to gain currency – ironically, since it can be expected to hurt our currency. Tomorrow’s release of the September Non-Manufacturing ISM (Consensus: 52.0 from 51.5), though, is not a big mover of policymaker opinion, and thus is unlikely to be a big mover of markets.


I mentioned last week that I attended an inflation conference and I planned to give some impressions and thoughts that the conference provoked.

The first thing I will observe is that I have been going to these conferences for a while. The first ones tended to be all about TIPS: who is buying them, how they work, why the Treasury should keep selling them, how they work, why other countries should follow suit, how they work, etcetera. To be honest, it grew fairly monotonous, which is one reason that the flow of inflation conferences has been reduced to a trickle in the last year or two.

By the same token, less-frequent conferences allow us to see the market change in sharper relief. I can observe that market participants on the dealer side seem to have much more of a clue than they did just a few years ago. Dealers are still making a few mistakes, but the bad mistakes seem to be fewer in number and there are many more dealers who are capable. The difference between the top dealer and the bottom dealer, in short, has shrunk.

Clients, too, have generally gotten more sophisticated. No one needs to be told how TIPS work these days. And in some cases they have passed their dealers, or at least can see through the hype. At one presentation, the (dealer) presenter was arguing that TIPS these days don’t offer as much diversification as they used to; that investors in TIPS have gotten more volatility than they would have by being invested in Treasuries, but not significantly more return, and with a high correlation to nominal rates. Someone in the audience nailed him by asking “what is your risk-free investment? Cash?” When the presenter said yes, the questioner observed that investors don’t care about maximizing (nominal) return subject to (nominal) risk, but  rather real return subject to real risk. This is something that few people understood as recently as five years ago. Institutional investors, furthermore, care about the increase in the real surplus (assets minus liabilities) subject to the variance in the surplus. This is much more sophisticated than the questions of 2005.

One other observation, though, that follows. There is an increasing stratification of comprehension of these markets. That is, the folks who have been doing this a while are pushing the boundaries further along and are more sophisticated, but the people who merely dabble in inflation markets are further behind as a result. (This is one reason that I have been offering consulting on inflation markets). These latter investors are much more likely to lose when they face a sophisticated counterparty than they would have been five years ago, when both sides of the trade were almost equally-likely to be missing something.

There was a very entertaining keynote speech from Dennis Gartman, of the famous Gartman Letter. Mr. Gartman gave a very long-wave view of price pressures in developed versus developing economies. He made one little error, which is the type of error that is often made by people dabbling in inflation. He said that in coming decades wages will deflate in the U.S. and inflate in China and in India. I believe that is very likely to be incorrect. Relative wages will converge, to be sure, but wages in the U.S. are quite unlikely to fall outright. Far more likely is that wages in the U.S. will inflate at a slower pace

But the whole question of international wage convergence is by its very nature a complex subject. If a Chinese worker makes 1/20th what an American worker does, but the same basket of goods costs 1/40th as much, then in real terms he is making twice what the domestic worker is. Of course, this isn’t the case at the moment, but my point is that the wages of the workforce need to be looked at in real terms in the local markets, not in converted-to-dollars-at-the-official-exchange-rate terms. And to do that, we need consistent inflation baskets. But is the relevant basket the basket of goods consumed in China, or the basket of goods consumed in the U.S.? They will be very different, even if the standards of living converge. Still, I think we all know that the GDP/worker will continue to grow faster in emerging economies than in the developed ones, and if the proportion of GDP allocated to wages is constant and the size of the workforce is constant this implies real wages should be rising faster in emerging markets. Note, however, that the second “if” is a bigger if. The size of the workforce in truly developing countries also tends to grow as improving living standards tends to allow more women to enter the workforce.

This all gives me a headache, whereupon I move to an unrelated observation.

There was talk in several of the presentations about the notion of inflation targeting. David Greenlaw of Morgan Stanley made a good point that Chairman Bernanke literally wrote the book on inflation targeting (see the book here) and the recent retirement of Donald Kohn as Fed Vice-Chairman may free Dr. Bernanke to pursue more aggressively an explicit inflation target.

Personally, I think that setting an inflation target, or a price level target that some have proposed as a superior alternative, is a great idea if you can hit the target. There is, unfortunately, much greater confidence among academics of the ability of the Fed to hit the target than there is evidence to suggest they can get anywhere near it. The forecasting record of the Federal Reserve is abysmal, even worse than that of private economists (who aren’t very good themselves). If we don’t know where they are going, they can always plausibly claim to have arrived; however, if they claim to be going to Pismo Beach but show up in a cave instead then we will know they have turned left instead of right at Albuquerque. I suspect that we are not right now, economically speaking, where they wanted to be…but I can only suspect that they missed the mark.

Now, the very announcement of an inflation target will probably hurt TIPS, even if the targeted level is above the current level of breakeven inflation. This is because the breakeven incorporates more than the mere expectation of the inflation level; it incorporates what is essentially an option value since the higher inflation goes, the more TIPS are worth (relative to their nominal cousins) but in a deflation they are worth essentially the same (since they both pay off par in that case). Consequently, if the Fed makes explicit that they intend to truncate the tail of this implicit option, the fair value of the breakeven will decline and this will probably be reflected in a rise in TIPS yields.

There are lots of reasons at the moment to be wary of TIPS yields, to be sure, with real yields negative out to 5 years. I would say, though, that there is no reason to be more wary of them than of nominal Treasuries. While I wouldn’t necessarily allocate from, say, commodity indices into TIPS, to the extent that I plan to hold Treasury paper anyway I would prefer to own TIPS. This is unlikely to change until nominal yields go substantially higher…that is, no time soon!

Categories: Federal Reserve
  1. Andy
    October 5, 2010 at 6:08 am

    Two things, first the picayune, his name is Donald Kohn; and second, I would contend that it has become the mainstream view that the Fed will embark on QE2 starting at the November meeting, rather than merely tending toward that. The idea that so many of the governors/presidents have been discussing it, and the Brian Sack comments, and the Bernanke history, and the addition of Janet Yellen, uber-dove, as Vice Chair, indicate that the Fed is going to continue to be pre-emptive on any concerns that the economy is not going to pick up. And alas, it is not going to pick up any time soon.

  2. October 5, 2010 at 6:16 am

    Ouch, good point on the David/Donald goof. I’ve corrected that above.

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