Archive for November, 2010

The Terminator Re-Forms

November 30, 2010 Leave a comment

Blam! Blam! The EU fires and the T-1000 Terminator is blown to bits. Or…is it? There was the ECB’s liquidity provisions of 2009, but Greece happened anyway. The EU responded to the Greek crisis with a “shock and awe” package, but in only a few months the T-1000 pulled itself together and kept coming. Now the Union is trying to build a firebreak after Ireland, a line in the sand, and finish off the crisis for good.

It doesn’t look hopeful at this point. Although the bleeding among periphery bond markets slowed today, with Portugal and Ireland rallying 16 and 6bps, respectively, and Greece, Italy, and Spain selling off a mere 3-4bps, the Euro itself continued to take a beating and is now back at mid-September levels, down from $1.42 less than a month ago to $1.30 now. And there have been some tentative signs of pressures in the funding markets: front Eurodollar contracts were down 2-4bps while red and green packs were up around 6bps today. Front March is down 15bps over the last week. Since it seems very unlikely that the Fed is going to be tightening any time soon – and indeed, the Fed Funds strip hasn’t moved – this seems to be a miniature version of what we saw at times during the 2008-2009 financial crisis. The state of interbank lending needs to be carefully monitored, and surely the ECB and Federal Reserve will be more proactive this time around. But it is a still a sign that all is not well.

The concern all along was that the next financial blow would come before the global economy was fully healed and it appears this concern may be validated by events. Output isn’t in the sorry state it was in the middle of the Lehman debacle, but it can hardly be described as robust and healthy. The Case-Shiller Home Price Index has flattened out, and underperformed expectations today. This is not necessarily a bad thing, if properties that were formerly stranded (because their owners wanted to wait for higher prices) are trickling onto the market, but it is a reminder that we are still unwinding the last bubble. The Chicago Purchasing Managers’ Report (62.5 vs expectations for 59.9) and Consumer Confidence (54.1 vs expectations for 53.0) were both incrementally stronger-than-expected, but neither has left the range of the last year. Moreover, the Jobs Hard To Get subindex of the Consumer Confidence survey actually rose slightly to 46.5.

None of this spells a collapsing economy (we might also say that it doesn’t describe an economy that, on that evidence, needs a central bank to print money), but it also doesn’t give the impression of obdurate Schwartzeneggerian implacability. So who’s going to face the T-1000? Ben Bernanke? Jean-Claude Trichet? Jean-Claude Van Damme, maybe. Perhaps we’re going about this crisis thing all wrong. Muscles from Brussels, indeed.

In the absence of Van Damme, investors are seeking protection in dollars, to a lesser extent in commodities – note that in the chart below, the dollar and the SP-GSCI over the last week have both been gaining although they typically mirror each other – and in options.

Commodities and the dollar - recently moving together, though this is hardly without precedent.

Interestingly, and perhaps because the threat is to sovereign issuers, U.S. Treasuries haven’t been doing decidedly well. 10-year yields remain 40bps off the lows set at 2.40% in October. Inflation-linked bonds have also been going nowhere fast, although weakening a smidge at the margin. We know the story about equities: somehow treading water and bouncing again today off the 1174-75 level in the S&P. But the VIX is back to levels last seen in early October, although a far cry from the crisis spikes of 2001, 2002, 2007, 2008, and 2010 (May).

Between the VIX and the whiff of LIBOR funding pressures, I suspect that equities might be vulnerable since the momentum of last month has now firmly evaporated. It is courageous to sell stocks into year-end these days, but if the S&P breaks below that 1174ish level there is a good deal of space on the downside before useful support.

Bulls will cross their fingers for the few days leading up to Employment. Tomorrow, the ADP (Consensus: +70k vs +43k last) provides an early snapshot. The ADP report isn’t a great look at Employment, especially when the government is taking a very heavy role in hiring, but it is the best indicator we have. And yet, over the last year the Payrolls number has run 876k higher in aggregate than the ADP figure. Coming into 2010, the 5-year average of rolling 12-month periods was about 96k per year, so a very large gap has opened up between Payrolls and ADP. Except for periods when Census firings were dampening Payrolls, ADP hasn’t been above Payrolls for a year. Consensus estimates are institutionalizing this expectation, with economists looking for +70k on ADP versus +145 for Payrolls.

I think it is reasonable to suppose that either ADP needs to start catching up to Payrolls, or Payrolls needs to start sagging towards ADP. I suppose I think the latter is slightly more likely since the surveys of consumer attitudes suggests a weaker Employment picture rather than a stronger one, but from a trading standpoint the more relevant observation is that ADP has upside risk and Payrolls downside risk as long as economists forecast – reflexively, it seems to me – the wide spread to continue.

December 1st also brings the final revisions to Q3 Productivity and Unit Labor Costs data, and (more importantly) the ISM Manufacturing report (Consensus: 56.5 from 56.9). The Beige Book is also due out tomorrow afternoon, and car sales throughout the day.

Categories: Economy, Employment

Justifiably Concerned

November 29, 2010 Leave a comment

Back in July, when the EU bank stress test results were announced, I noted (in the commentary linked here) that the €3.5bln in capital the EU said was required of the banks which failed the test was “a fraction of the lowest arm’s-length estimates.” Moreover, it bears noting that of the seven banks that failed the test, none was in Ireland (only one was in Greece; one in Germany; five in Spain). In the bailout announced yesterday for Ireland, €35bln is earmarked for the Irish banks (€10bln immediately, and €25bln later) which had previously passed the test.

I think this means that if you own one of the seven banks who were considered to be worse than the Irish banks, you are justified in being concerned about your investment.

You are also justified in being concerned if you own Spanish sovereign debt, because after all five Spanish banks were among those seven which failed (to be sure, they were small banks – ones that apparently didn’t get the memo about how to represent their assets so as to pass like the bigger banks did: see the Wall Street Journal article mentioned in my September 7th missive “Hard to Flunk When You Have The Answer Key”). Spanish 10y note yields rose 23bps today (Italy: +21bps, Portugal: +14bps, Belgium: +20bps, Hungary +22bps). As many other observers have noted, Spain is a much bigger pill to swallow than Greece and Ireland (and Portugal, if it comes to that).

If you are an Irish worker, you might be justifiably concerned. The bailout includes €17.5bln from the Irish government, some of which is actually coming out of the National Pension Reserve Fund (and we thought that Americans were mad about the banks being bailed out!).

The EU also courageously committed U.S. taxpayers to the rescue, as the IMF is pitching in €22.5bln. The U.S. quota is currently around $56bln of the IMF’s $360bln in total quotas, so around €3.5bln of the Irish bailout comes from U.S. taxpayers. By the way, the Executive Board of the IMF earlier this month approved a general doubling of quotas, although the U.S. share will not quite double.

Apparently, though, if you own U.S. shares you needn’t be concerned. Although stocks opened up sharply lower, by the end of the day the indices had recouped their losses. For the fourth time in the last week and a half, the 1175 level on the S&P provoked solid buying. On what basis, I haven’t a clue, unless it is that we’re not Ireland. Late last week saw an awful Durables number, even including revisions, a very weak Home Price Index, and continued weak home sales. Initial Claims was much better than expected last week, indeed the best since 2008, and lower Claims figures are a necessary (although not sufficient) condition to an improvement in the Unemployment Rate.

Sure, the Fed is printing money, and somehow managing that trick while strengthening the currency besides. And perhaps that is the short-term legerdemain: as long as you can print unlimited quantities of scrip, each of which has as much (or more) value in exchange for foreign goods as that already in existence, then you really can create wealth by printing money. Methinks this is not a successful long-term strategy, however.

Also not a good long-term strategy: to tell everyone what you really think of them (or so my daddy always told me). The Wikileaks scandal, in which hundreds of thousands of supposedly-secure documents were stolen from the U.S. State Department and given to a handful of large media organizations to do with as they wished, will damage even further the current Administration’s standing on the world stage and therefore at home. There is just no way to put a positive spin on your Secretary of State directing employees to gather credit card numbers of foreign diplomats, as it appears ours did. To be sure, just as with the exposure of the documents that weakened the main thrust of the global warming movement, those who are made to look the most foolish will do their best to redirect outrage towards the (assuredly criminal, immoral, and wholly vile) act of stealing state secrets and distributing them willy-nilly. However, as with Climategate this effort will not change the content of the documents, and these will weaken the Administration just as the Climategate documents weakened the global warming cabal.

However, unlike with the Climategate documents, this scandal has market implications. A weaker Administration tips the balance of power further towards the minority party in Congress, which already has considerable positive momentum. It increases the urgency of some positive showing from the lame duck Congress, which so far has done little to pass an AMT correction and even less to roll back the tax hikes scheduled for January. I don’t think it is necessarily over-simplistic to say that the weaker the Administration, the better it is for the stock market and the worse it is for the dollar.

Now, the dollar is clearly in the grips of a bigger effect right now, and that is the European disaster. And stocks have significant problems (see above!) that are probably not solved by a marginal change in the power of the backbenchers. At the margin, however, those investors who are already marginally bullish on stocks have a small additional reason to be positive.

Tuesday brings the release of the Case-Shiller Home Price Index (Consensus: -0.4% month/month) – not to be confused with the FHFA Home Price Index, which was released last week. More importantly, the Chicago Purchasing Managers’ Report (Consensus: 59.9 from 60.6) has been chopping between 56.7 and 63.8 for the entire year, and unless there is a move outside of that range (note that the consensus estimate is pretty close to the middle of that range) it is not likely to have much significance. Consumer Confidence (Consensus: 53.0 from 50.2) is nearer to the bottom of the annual range than to the top, and following the election results should see an improvement. As always, however, I remind readers to focus on the “Jobs Hard To Get” subindex, which tends to lead or at least be coincident with actual improvements in the Unemployment Rate (see Chart, source Bloomberg).

The Man on the Street doesn't yet see employment improvement.

After all of the numbers are out, be aware that Minnesota Fed President Kocherlakota is scheduled to speak about monetary policy at 12:30ET. Kocherlakota occasionally has, er, interesting ideas, such as the one in August when he argued that the Fed may have to raise rates in order to increase inflation expectations. (I “discuss” this idea in this post). Partly because of those ideas, I don’t think he is viewed as particularly influential, but one should keep an eye on the tape when someone with the potential for crazy talk – and about that, we may be justifiably concerned – stands at the podium.

Categories: Economy, Politics

Making A Bad Policy Even Worse

November 23, 2010 5 comments

The markets continue to respond relatively calmly to the news floating about, almost all of which is bad. Although I have not written about it before, because it seemed to involve only one or two bad actors who had previously worked at SAC Capital (one of the ‘blue chip’ hedge fund names), the SEC has been widening its probe into insider trading. Today, document requests were sent to SAC Capital, Wellington Management Company, and Janus Capital. This is a bit of an escalation in significance from the raids yesterday of Level Global Investors LP, Loch Capital Management, and Diamondback Capital Management LP – the funds that were founded by the former SAC traders. The SEC is casting a wide net, and it hardly needs to be said post-Madoff that they need some wins, badly.

Meanwhile, looking to Asia, North Korea shelled an island populated by South Korea. Now, lobbing shells at South Korea isn’t completely unusual activity for North Korea, and had happened several times over the past decade – it was only this past March when the North Koreans sunk a South Korean warship. There are three differences this time which make this instance slightly more dangerous. One is that North Korea this time has targeted civilians; the second is that North Korean dictator Kim Jong Il is ill; the third is that the North Koreans just revealed the existence of a uranium enrichment plant that a U.S. scientist toured and called “stunning” (presumably, not merely for its beauty alone).

And, lest we forget, Ireland is in the throes of collapse with some observers wondering who the EU will negotiate a bailout package with if there is no government in power. Irish 10y rates rose 37bps; Portuguese rates jumped 21bps and Spanish yields rose 16bps among the periphery countries.

With all of this geopolitical unrest, it wasn’t surprising to see the dollar rally to its highest level since September, which triggered some mild weakness in commodities. It wasn’t a shock to see bonds rally, with the 10y yield falling to 2.76%. It can’t be considered unusual that the VIX rose from 18.4 to 20.7. And a 1.4% drop in equities isn’t anything to write home about. The only thing surprising was how pedestrian the moves were and how lethargic the intra-day action. I wonder if this isn’t going to be one of those times when we all are looking around wondering why the market isn’t reacting very significantly to significant news…and then it suddenly wakes up.


Today the FOMC released the minutes from its early November meeting. They were almost comical, as I suppose we should have expected them to be when the actual decision about QE2 had clearly been already made prior to the meeting. The discussion seemed to accurately assess conditions, but those conditions didn’t match with the decision about what to do with monetary policy. Here are a few excerpts:

The Desk judged that if it continued reinvesting principal payments from the Federal Reserve System’s holdings of agency debt and agency MBS in longer-term Treasury securities, then it could purchase additional longer-term Treasury securities at a pace of about $75 billion per month while avoiding disruptions in market functioning.

I have mentioned this before – whether you think the Fed wants to add $1 trillion or $2 trillion or “only” $600bln to the money base, the decision to add $600bln by June was essentially a pedal-to-the-metal decision. The manager of SOMA (the “System Open Market Account”, aka “The Desk” at the NY Fed where they buy and sell securities for the account of the Fed) told them he could only handle $75bln per month, and that’s what they got.

Participants again discussed the extent to which employment was being held down, and the unemployment rate boosted, by structural factors such as mismatches between the skills of the workers who had lost their jobs and the skills needed in the sectors of the economy with vacancies, the inability of the unemployed to relocate because their homes were worth less than the principal they owed on their mortgages, and the effects of extended unemployment benefits on the duration of unemployed workers’ search for a new job. Participants agreed that such factors were contributing to continued high unemployment but differed in their assessments of the magnitude of such effects.

In other words, we don’t really know exactly what is driving the Unemployment Rate. Doesn’t this suggest we ought to be careful with monetary policy?

While underlying inflation remained subdued, meeting participants generally saw only small odds of deflation, given the stability of longer-term inflation expectations and the anticipated recovery in economic activity.

Hmmm, and there’s also no real risk of deflation. Doesn’t that suggest we can be more careful with monetary policy?

Participants generally agreed that the most likely economic outcome would be a gradual pickup in growth with slow progress toward maximum employment. They also generally expected that inflation would remain, for some time, below levels the Committee considers most consistent, over the longer run, with maximum employment and price stability. However, participants held a range of views about the risks to that outlook. Most saw the risks to growth as broadly balanced, but many saw the risks as tilted to the downside. Similarly, a majority saw the risks to inflation as balanced; some, however, saw downside risks predominating while a couple saw inflation risks as tilted to the upside.

There seems to be a fair amount of disagreement, and fairly balanced risks in the eyes of the average Committee member. Is this a prescription for a pedal-to-the-metal easing? Moreover, the thing that the Committee is most worried about, Unemployment, is also the thing that monetary policy is less efficacious in dealing with. So the Fed is going to gun for small gains while taking big risks?

Some participants, however, anticipated that additional purchases of longer-term securities would have only a limited effect on the pace of the recovery; they judged that the economy’s slow growth largely reflected the effects of factors that were not likely to respond to additional monetary policy stimulus and thought that additional action would be warranted only if the outlook worsened and the odds of deflation increased materially. Some participants noted concerns that additional expansion of the Federal Reserve’s balance sheet could put unwanted downward pressure on the dollar’s value in foreign exchange markets. Several participants saw a risk that a further increase in the size of the Federal Reserve’s asset portfolio, with an accompanying increase in the supply of excess reserves and in the monetary base, could cause an undesirably large increase in inflation. However, it was noted that the Committee had in place tools that would enable it to remove policy accommodation quickly if necessary to avoid an undesirable increase in inflation.

So “some participants,” not just Hoenig, were pretty worried – and the Minutes spends a surprising amount of space cataloguing a very reasonable set of views. Were they really swayed away from these legitimate concerns by the perception that the Fed can “remove policy accommodation quickly if necessary?”

What policy tools are these, anyway? It is generally believed that actions by the central bank take about 6-18 months (depending on who you talk to) to affect the economy. Direct injections and/or drainings of liquidity are probably quicker, but presumably the Desk can’t sell bonds any faster than they can buy them so how quickly can they really remove policy accommodation? Increasing IOER may be what they have in mind, but IOER is an uncalibrated instrument that we have almost no experience in using.

So, with all of this discussion, the Committee decides almost unanimously “in for a penny, in for a pound” and starts flushing liquidity into the system as quickly as they can.

But that’s not the worsening of policy that the title of this column refers to. In the FOMC minutes was also a notation about a videoconference meeting that occurred on October 15th. Among the topics considered at this meeting:

Participants discussed whether it might be useful for the Chairman to hold occasional press briefings to provide more detailed information to the public regarding the Committee’s assessment of the outlook and its policy decisionmaking than is included in Committee’s short post-meeting statements.

Seriously? The single biggest failure of Federal Reserve policy over the last two decades, in my view, is that over-communicating their goals and expectations creates a false sense of safety for investors (false, because the Fed has nowhere near the control that investors think they do, as they have proven repeatedly) while creating the conditions for a sudden loss in confidence in the central bank. If no one knows what you were trying to do, (a) they need to be careful in case you’re not doing what they thought you were doing, and (b) they can’t as easily lose confidence in you for making a big mistake – because they don’t know what you were expecting. So, really? The Greenspan Cult of Personality wasn’t enough? We need Bernanke Briefings? This ain’t Princeton, and this ain’t a classroom. We don’t need a lecture; we need you to figure out what to do with monetary policy. And if the right answer depends on what the press-conference-viewer thinks about what you have to say, then you’ve already lost.


On Wednesday, a flood of economic data sends us into the Thanksgiving holiday with an exclamation point. Durable Goods (Consensus: +0.1%, +0.6% ex-Transportation) is expected to bounce back smartly from last month’s decline. Personal Income (Consensus: +0.4%) and Personal Spending (Consensus: +0.5%), the Core PCE Deflator (Consensus: +0.0% month/month; +1.0% year/year), and Initial Claims (Consensus: 435k) are all released at 8:30ET. Good luck making lunch out of that soup. The revision of the Michigan Confidence figure, the September Home Price Index (Consensus: 0.0%), and New Home Sales (Consensus: 312k from 307k) are all out on or around 10:00ET.

So, while you’re enjoying your Thanksgiving feast, remember all of the poor economists, who will probably still be writing up their analyses.

None of this is, however, as important as the geopolitical developments. And, it being the Wednesday before Thanksgiving, none of it is probably likely to excite the market very much. But you never know when investors will wake up and realize that the biggest issue they have to confront is not the question of Black Friday sales at the mall. I suspect that day is coming.

Categories: Economy, Federal Reserve

Inevitable But Still Alarming

November 22, 2010 Leave a comment

Well, just like that, Ireland’s ruling coalition sinks beneath the waves. After having promised that the country had enough funds to make it through until mid-summer 2011 (if you ignore the needs of the banking system, which apparently investors were not willing to do), and then folding and asking for help, the Prime Minister (Brian Cowen) announced today that the country will hold new elections after passage of the new budget in early 2011. Cowen faced defections from relatively minor (but crucial) coalition parties after seeking aid less than two weeks after claiming Ireland didn’t need any money. The amount of money it now appears they do need, according to Goldman Sachs as cited in this Bloomberg story, is a mere $130 bln (€95bln). That’s a lot of soda bread…and it happens to be something like 60% of Irish GDP. So Mr. Cowen was a wee bit off. It isn’t a ‘done deal,’ either, since Germany intends to attach pretty stringent measures to the bailout and other EU countries (those who haven’t failed and don’t plan to) will also have a voice.

While Irish bond yields actually declined a few basis points today, since the aid package is presumed to be aimed at eviscerating the bond and equity holders of the banks (which ought to be interesting, since many of them are other banks elsewhere in Europe), Greek 10y bonds sold off 33bps. Spain and Portuguese rates were roughly unchanged, which is encouraging if you’re hoping to arrest contagion before it gets started…but I wouldn’t think we’re done with this test yet.

U.S. and Continental equities were smacked, although U.S. markets managed to rally back to nearly unchanged on the day. But the FTSE was off 1.9%, the Spanish IBEX fell 2.7%, and the French bourse -1.1%. U.S. 10y real yields ended at 0.65% and 10y nominal rates at 2.81%, both improved on the day. The reactions are still surprisingly tepid, and the VIX today actually fell back to near recent lows. Some of that is due to a calendar that is rotten with holidays, but one certainly gets the impression that investors don’t get it. Ireland was never supposed to happen. Greece was supposed to be the last domino. Does that worry anyone?


Looking back at last week, it seems odd to me that the markets responded positively to any rumor of an Irish bailout, while reacting negatively to news that China was tightening lending. For the record, during the last 12 months the United States has $275bln in exports to Europe and only $85.5bln with China (Source: US Census, e.g. here), so in terms of our domestic growth Europe is about three times as important as is China. True, imports of $370bln from Europe are only somewhat higher than the $348bln from China, but if China contracts 5% and Europe contracts 5%, the latter is a much bigger deal. Not only that, our banking system is much more intertwined with the European banking system than with the Chinese banking system.

Now, the fact that China is tightening is also a problem, but it is certainly less immediate. The problem there is that tighter monetary policy in China, coupled with looser monetary policy in the U.S., should make the yuan much stronger relative to the dollar. This is what we want, but China doesn’t. A stronger yuan would slow the Chinese economy (which they seem to want), lower inflation (which they seem to want), but it would seem to be a concession to the West (which they don’t seem to want). The Chinese government seems reticent to let the yuan accelerate its appreciation, but if it tightens policy and does not loosen the reins on the FX market, the pressure will build for a future less-gentle adjustment. I just don’t think that’s something we need to worry about in the next few months, while the collapse of the EU periphery on the other hand is something we need to worry about. And, as odd as it sounds, it doesn’t seem to me as if anyone is worried about it.


Tomorrow’s main event is the release of the FOMC minutes from the November 2-3 meeting. While just about every Fed official has spoken either in the days leading up to the meeting or in the days immediately following the meeting, so that it seems unlikely the minutes hold anything we are not already aware of, the market will lean on the nuance of the discussion (or what it perceives to be the nuance). Was it a close call, or is there pressure for a bigger or longer-lasting program? Among the unsurprising things we could learn that the market might still react to would be some admission that QE2 is progressing about as rapidly as the Fed can operationally handle; this could be read – depending how it is phrased – as a recognition that the current state of monetary policy is “we’re pedaling as fast as we can” and that quantitative easing over a longer time horizon is entirely possible. This would be presumably good for TIPS and commodities and perhaps good for equities (although by now investors may realize that QE is not a license to buy stocks without risk).

The earlier data releases are less exciting. There will be a revision of Q3 GDP, and Existing Home Sales (Consensus: 4.48mm from 4.53mm) will also be released. Pay attention, as usual, to the inventory of existing homes, last at 3.38mm. A significant decline in inventory is a sine qua non for a recovery in broad pricing pressures and likely also crucial to broad economic activity as well. Finally, the Fed will buy TIPS while the Treasury sells 5y notes. I will say this much for the government, at least they avoid having the Fed buy exactly what the Treasury is selling…perhaps that will confuse some people.

Categories: Economy, Government

Reading The T-Leaves

November 18, 2010 4 comments

Some bounce for the equity market is certainly understandable, from a psychological perspective. The market had rallied, basically uninterrupted, for two months and 18% or so without a setback of more than a percent or two. Is it really surprising, then, that the first time there is a mild pullback, some performance-chasers are trying to plunge in? This is fairly routine behavior: “I have a second chance! I missed the rally, but now I don’t have to endure the taunting of my friends at cocktail parties.” This doesn’t necessarily end well, since after all someone is selling securities to these buyers and it may well be the guy who wanted to get out a week and a half ago and then felt “trapped” by the Ireland news. I am also impressed by the chart in Barron’s that shows the very high ratio of insider sales to buys. Why would insiders be selling just when aggregate demand is beginning to swell?

To be sure, there was decent economic news today and one can use that to justify the higher prices (and weaker bonds). The Philly Fed index had exactly the opposite message as the Empire Manufacturing index a couple of days ago. Empire went to 18-month lows; Philly Fed matched the highs of the last couple of years. The Employment subindex rose to 13.3 from 2.4; New Orders rose to 10.4 from -5.0. These subindices support the headline, which in the Philly Fed survey is a separate question about general business activity, rather than a composite of the subindices. Maybe this has something to do with the fact that the Philadelphia Eagles scored 59 points this weekend while the Giants were beaten by the Cowboys. (Just kidding, maybe).

Delinquencies and foreclosures both declined to early-2009 levels, and have likely seen their peaks. The declines, though, are not exactly rapid. Some improvement is rates of delinquency and foreclosure is natural, simply because the lowest-hanging fruit goes delinquent and then defaults first. You want to see a rapid improvement, not a slow improvement, in these figures before breaking out the bubbly.

Initial Claims was approximately as-expected, which is to say that it is at the low end of the year’s range. It still has not broken decisively lower, but at least it is threatening to.

Now, the problem with all of this as an excuse for the market rally is that the rally happened predominantly overnight. Once the market opened, stocks went sideways and were mostly unaffected by the data. So this looks more like dip-buyers in Asian and European centers and perhaps a second round of excitement about the fact that Ireland is going to get some kind of bailout.

I said yesterday that I was going to be more focused, today and in future weeks, on development in the money supply (which the Fed reports at 4:30ET on Thursday afternoon). You can see why in the chart below, which shows M1. No special prizes if you are able to identify QE1 and QE2 on the chart.

In this edition of "Where's Waldo," you need to find QE1 and QE2.

Of course, M1 is not where the inflationary rubber meets the road. That is in the broader aggregates, which as has been repeatedly documented have not responded as sharply. With IOER in place they may not, but this week’s data moves the 13-week annualized rate of change up to 7.66% (see Chart). It will take a few weeks to see any real impact here – the recent rise in the aggregate is actually the slow seepage from QE1.

M2 starting to look perky again.

Inflation-linked bonds have stabilized a bit after having been beaten badly for about a week. What happened to cause the selloff, which was largely complete before the low CPI printed yesterday?

The story of the bond market since May, seen through the lens allowed us when we separate the nominal interest rate into its constituent parts of a real rate and inflation compensation, is fairly interesting and the actually quite clearly told. Refer to the chart below, and follow along carefully as the chart is pretty busy. The yellow line is the 10y nominal Treasury rate, which dropped 140bps between April and August, flatlined for a couple of months, and then has risen in November. The white line is the 10y TIPS yield; the reddish line is the 10y breakeven (the difference between real yields and nominal yields, which is predominantly inflation expectations). Each has its own scale, which can be seen to the right. Because the scales cover different ranges, two parallel lines on the chart are not quite parallel in reality, but close enough that you can get the gist of what has happened.

Confusing chart. Read the text closely.

From May until August, the decline in nominal rates was substantially about a decline in inflation expectations. You can see this by the fact that the yellow and red lines trace closely while real rates decline only slowly. From April 30th to August 27th, nominal 10-year yields declined from 3.66% to 2.65%, while 10-year breakevens dropped from 2.40% to 1.63% and10-year real yields fell from 1.26% to 1.02%. So, of the 101bp decline in nominal yields, 77bps came from the 10y breakeven (inflation expectations) and 24bps came from a decline in real yields.

As I have written elsewhere (link), from August 27th until QE2 on November 3rd, nominal rates didn’t move much (2.65% to 2.57%, -8bps), but this masked a large decline in real yields (1.02% to 0.42%, -60bps) and a significant rise in inflation expectations (1.63% to 2.16%, +53bps). Clearly, this is what the Fed was trying to do: lower real yields by holding nominal rates down and increasing inflation expectations. They even said that was what they were trying to do.

Since November 3rd, what has happened? Nominal yields have risen 33bps from 2.57% to 2.90%. That is entirely accounted for by a rise in real yields from 0.42% to 0.75%, with inflation expectations unchanged. Put another way, just slightly more than 2 weeks out from the announcement of QE2, half of the decline in real yields that the Fed engineered has evaporated.

Now, if real yields have risen because investors expect growth to re-accelerate, then this isn’t an indictment of the Fed. But I think the evidence is more consistent with the notion that investors are expecting the cost of money – which is what real rates are – to rise when inflation rises. Inflation-linked bonds were simply too rich when they were at 0.42% and nominal yields were at 2.57%. The Fed is buying right now, but everyone knows that eventually they will be competing with real borrowers to sell bonds back into the market. This isn’t really the Fed’s fault, but the consequence of having large fiscal deficits. Investors aren’t willing to keep lending money to the G-men at 40bps real yield when the federal appetite seems insatiable.

The fact that nominal rates are rising despite the Fed’s pledge to buy $600bln in Treasuries (plus rolling maturing bonds) is amazing. But perhaps it shouldn’t be – while direct manipulation of government bond markets is fairly unusual, we have a lot of experience with FX market intervention. What FX traders will tell you is that when the central bank steps in to purchase the currency and stem its decline, or to sell the currency to arrest a rise, it only works if the market was already exhausted and looking for an excuse to pause or reverse. Otherwise, whatever pause the bank is able to create tends to be temporary and the dominant trend soon resumes.

I think the same thing is true with interest rates. Fed buying can hold interest rates down, or push them lower, only if the market was willing to go there anyway. The market is larger even than the Fed, and if the underlying trends call for higher rates, then higher rates we will eventually get – Fed or no Fed.

There is no economic data on Friday, and trading is likely to thin out early as some people will take the Thanksgiving week in its entirety as a holiday. I don’t know what that means for market direction, though. On the one hand, trimming risk before the holiday season officially begins would argue for lower equity prices; on the other hand, I would think the EU will want to make a loud, generous announcement about Ireland sometime before markets open on Monday, so I wouldn’t want to go home short either. Tough call.

Have a nice weekend. This comment will not be produced on Friday, as I am taking a partial day off myself. I will be writing on Monday, Tuesday, and possibly Wednesday next week, however. Thanks for reading.


A Bridge To…Another Bridge

November 17, 2010 2 comments

One day on, one day off – the risk shuffle continues. Irish bonds rallied 17bps today, simply because the EU and the IMF have said they are working with Ireland on a rescue plan. Was there a doubt that they would work on a plan? Less comprehensible was the rally in Portuguese bonds. To the extent that Ireland, or Irish banks, or anyone else for that matter, actually gets bailed out, doesn’t that mean that there is less money for Portugal? I suppose the fear was that the mechanism might completely break down; this would explain the correlation between these bonds when Ireland-specific news somehow lifts the other PIIGS boats.

Either way, Ireland for a day drifted to the background. This was fine for me, since it also happens to be CPI day. It was also Housing Starts day, and Housing Starts fell to the lowest level since April 2009 (519k); however, as I said yesterday the wiggles here hardly mean anything with the overall level so low.

The October CPI should be the trough print in the year-on-year numbers, as I have been saying for a while. The index certainly made the most of that trough, surprising on the downside for the second month in a row. Headline inflation clocked in at only +0.2% despite the rise in gasoline, but this miss was due to the (more important) fact that core CPI came in at -0.007%. CPI was pulled down by vehicles (-0.4%, echoing the weakness in PPI that I pooh-poohed yesterday) and apparel (-0.3%), which jointly constitute about 10% of the index and more like 12-13% of the core index. But there was broad softness outside of those categories as well. The year-on-year core CPI fell to only +0.6%, the lowest ever.

Yes, that core CPI number is exaggeratedly low because the Housing component of the index has fallen -0.2% over the last year, and Housing is around half of core CPI. But that still means that Core CPI-ex-Shelter dropped to 1.29%, the lowest level since late 2007 (see Chart). By itself, this would suggest the Fed is right to think inflation is a trifle low – although being at 1.3% when the target is 2.0% doesn’t really warrant, to me, a $600bln injection of liquidity – except for the small detail that this is almost certainly also the cyclical low.

Core ex-Shelter is at recent lows, but this is also likely the cyclical low. Source: Enduring Investments

Not only is this index, and y/y core CPI itself, likely to rise because of base effects (that is, the comparisons for the next couple of months will be against the very low prints of late 2009 and early 2010 rather than from the relatively high-and-declining prints of early 2009), but QE2 just kicked into gear and these effects may eventually be felt. Actually, I am reasonably confident that they will eventually be felt; the question is whether IOER slows the effect to a crawl or whether the effect of IOER in a non-crisis situation is different from IOER in a crisis situation. Do take the time to review my math about “what might happen” from last week (

Because we are at the inflection point, QE2 has begun and yet the CPI reflects the “old, pre-QE2 regime.” In a very real way, today’s CPI report is old news, and I am more interested in the near-term with…can you imagine?…the money supply figures that come out every Thursday afternoon. The 13-week and 26-week rates of change were already rising (at 7.3% and 6.2% annualized, respectively) prior to the implementation of quantitative easing. Of course, those rates jump around a lot, but I will be watching especially attentively over the next few weeks to see whether there is any sign of lift-off in the growth rates.

On Thursday, in addition to the post-close M2 figures, Initial Jobless Claims (Consensus: 441k from 435k) will be released in the morning. Recent economic data have been weak: Empire and Housing, PPI and CPI. Claims, on the other hand, has shown a modest strengthening although it seems too early to call it a trend. At 10:00ET, the Philly Fed index for November (Consensus +5.0 from +1.0) ought to be scrutinized carefully given the reading from the Empire survey. Also at that time, the Mortgage Bankers Association will release the Q3 statistics on delinquencies and foreclosures. In Q2, the rates were 9.85% and 4.57%, respectively. For all the talk about the improving credit picture, the evidence has yet to show up in a meaningful decline in either delinquencies or foreclosures. Flat is nice, but we must remember this is flat at depression-like levels (see Chart). Any meaningful economic recovery will be accompanied by a significant decline in these ratios, and such a decline is also a sine qua non for getting housing inventory under control and giving home prices a chance to rise in the future.

Delinquencies haven't fallen despite the 'return to growth.'

A sideways move in stocks does not impress me. While I think it is fairly likely that “a rescue” gets announced for Ireland soon, it will be interesting to see what sort of credibility the market gives to such a package. After all, the Greek “rescue” package didn’t work, and the “backstop” did not prevent a run on Ireland. It is an almost-certainty that a rescue will be announced at some point, with lots of smiling and cheerful predictions that the market can now calm down. The last such rescue calmed the market for about four months. How long will this one last? Or will the market go ahead and fast-forward to the next calamity, to save the four months?

I remember during all of the anthrax scares, the initial market reaction to a report of anthrax being found or suspected was dramatic. After several such reports, the market reaction grew markedly less, until after a while the market would immediately move in the opposite direction on the announcement, since everyone knew that if you bought on the rumor, you probably wouldn’t be able to sell on the news in time. So investors skipped the whole “buy on the rumor” thing. It was remarkable to watch the market “learn,” and I am curious to see how the market reacts to this “rescue” that we all know is just a temporary bridge to the next rescue.

Categories: CPI, Politics

Turbulent Flows

November 16, 2010 1 comment

With the holidays rapidly approaching, it seems the market is striving to get the volatility out of the way as soon as possible. Tuesday was one of those days when the under-the-water turbulence (that I recently referred to in these terms) comes boiling to the top.

At low rates, a fluid’s flow may be laminar; at some point, as the fluid’s rate of flow increases, it turns turbulent. The flow rate today managed to exceed the critical point, and suddenly things appeared to be growing less predictable.

Ireland was one obvious source of concern. Today, a subtle change took place as Irish 10-year yields rose 29bps. Until now, although there were clearly behind-the-scenes discussions about market conditions, Ireland staunchly denied that it had any need for additional funds before the middle of next year. Today, the Irish government conceded that these discussions were taking place, but Irish Prime Minister Cowen attributed these discussions to circumstances outside of Ireland:

“The turbulence in the markets over recent weeks has been about issues of wider concern than Ireland’s situation. It is appropriate therefore that we discuss with our partners, as we are, how these issues should be addressed.”

See, it isn’t about Ireland but rather about the general turbulence in the markets…which just happens to come knocking at Ireland’s door. EU Economic Minister Olli Rehn said the problem was in Ireland, but attributable (of course!) to those darn bankers. He said:

“The (European) Commission, together with the ECB, the IMF and the Irish authorities, are working in order to resolve the serious problems in the Irish banking sector.”

Now, the fact that Ireland is running massive deficits and undertaking austerity measures that will probably make things worse in the short run is conveniently overlooked. After all, despite all of those problems, Ireland was funded through the middle of next year until it had to bail out its banks. The Irish government had painted itself into a corner and made it almost impossible to accept help without admitting defeat; this nuance change allows it to save face by pointing out that it would have been okay but for the problems with Irish banks.

The same basic process happened with Greece earlier this year: there is no problem. There is a problem but it isn’t a bad one. There is a problem but it is not about us. There is a problem but we can solve it. Okay, we will accept some help just so that markets can calm down. Well, maybe we do have a little problem. Actually, the problem is somewhat worse than we said. Help. Now.

And speaking of Greece, that saga is not yet finished either. Greek bond yields rose 21bps (for the 10y) as Austria threatened to withhold payment of its next tranche payment (due in December). This is one reason that the “shock and awe” deal back in the early summer never seemed very credible to me even though the market loved it for a few months. Each country in the EU – and there are a couple of dozen – needs to write a check every time Greece needs another tranche. In this case, it is easy for Austria to put up a fight, because Greece is not meeting the targets they needed to with respect to cutting the deficit. Austrian Finance Minister Josef Proell said that the current progress “doesn’t give us any reason to approve the December tranche.”

So why didn’t the EU just collect all of the money up-front when they passed the hat for Greece? The answer is obvious: if they had demanded that governments write checks back then, they couldn’t have gotten the unanimous vote they required. Some governments went along, assuming that it would be politically more palatable to write checks later “once things calmed down.” But what were the odds that all of the EU members would be able to write the checks later? Nearly nil, I would say, and now we are starting to see how rotten that deal was.

Pressure will be brought to bear on Austria. EU President Van Rompuy pulled out the superlatives today when he said “We are in a survival crisis. If we don’t survive with the euro zone we will not survive with the European Union.” This seems accurate, and scary considering that two or three weeks ago no one was worrying much about this.

Turbulent flows are inherently chaotic. They will form unpredictable vortices that impede and redirect the flow. In a laminar flow, the transit time of a given molecule of the fluid is highly predictable and distributed normally; in a turbulent flow, the transit time of a given molecule is highly unpredictable. We anthropomorphize such flow: we call the rapids “angry” waters. Right now, the waters are angry.

The dollar loves the EU turmoil, and strengthened again today. Stocks, not so much: the S&P dropped 1.6%. The decline of the indices from the highs is not yet very dramatic, but now all of the oscillators have turned and it will be much harder to rally back through the April highs now that momentum has flagged.

Bonds sold off, and then rallied to end modestly higher into the close. There were dueling Fed speakers today, with one (Bullard) implying that there was no guarantee the Fed would use the full $600bln they have allotted and another (Rosengren) that he “fully anticipate(s)” the Fed will use the full charge. In fact, they both said almost the same thing: if the economy booms, they won’t need to spend all the money. They merely accented the statement differently.

But the bigger news Fed-wise was that there is a strengthening move afoot to change the Fed’s mandate. A group of former Fed and Congressional officials, plus the brilliant Cliff Asness of AQR, wrote a letter to Chairman Bernanke imploring him to stop QE2 before it blows up into serious inflation. The story is here.

At the same time, Congressmen Corker and Pence introduced a bill that would replace the Fed’s “dual mandate” with one that focused only on inflation. Helping the bill is the fact that Rep. Barney Frank, who routinely is on the dumb side of history despite being generally perceived as one of the smartest Congressmen in terms of raw IQ, said “The notion that the Fed should be indifferent to unemployment is a terrible idea, damaging to the economy.” Since Mr. Frank is usually wrong, this is good for the bill.

Of course, saying the Fed shouldn’t be indifferent to unemployment is like saying the Fed shouldn’t be indifferent to the plight of the Giant Panda. Sure, but the Fed can’t do anything about either. (Okay, so perhaps because of money illusion the Fed can do something about unemployment as a side-effect of monetary policy. But managing to the side-effect seems absurd).

This seems as good a time as any to state that I completely support the notion of narrowing the Fed’s mandate to one it actually can do something about. In fact, in my book (by the way, have you considered buying an autographed copy as a holiday gift?) I devote the entirety of Chapter 4 to “Fed Problem 3: An Impossible Mandate.”

“The multiple prongs of the Fed’s mission are, unfortunately, significantly in conflict. No, that’s not strong enough: as practiced, they’re inherently inconsistent.”

And, later in the chapter, I edit the first bullet point of the Fed’s mandate statement this way:

Conducting the nation’s monetary policy by influencing the money and credit conditions in the economy in pursuit of full employment and stable prices. [Insert] Supervising the credit conditions in the economy and conducting monetary policy in pursuit of a stable monetary environment in which the natural economic cycle can play out.

So, needless to say, I am in support of the Corker/Pence efforts, although I cannot speak to the actual bill since I have not seen it.

I haven’t yet commented about the PPI release today. That is partly because there are other important things happening today, but in truth almost anything is more important than PPI to an inflation trader. The index surprised on the low side, with core PPI coming in at a breathtaking -0.6%, worse than during any month during the crisis. However, this is a great illustration of why we mostly ignore PPI. The decline was due entirely to a -3% fall in new cars and a -4.3% decline in new trucks. Yes, this is almost certainly due to faulty seasonal adjustment around the model-year changeover…without those two components, core PPI was up.

Now, inflation bonds significantly underperformed nominal bonds again, with CPI swaps ending the day down by 4-8bps. Some of that might be a reaction to PPI, but I think it is more likely that it is a reaction to the recent sharp selloff that is driving some investors who loved ‘em at 0.41% to hate ‘em at 0.75%.

Now, tomorrow’s data is a different story. CPI matters, although with the Fed just beginning QE2 it probably doesn’t matter all that much. The consensus is for +0.3% and +0.1% ex-food-and-energy. The short TIPS are expecting slightly lower numbers than that for the headline index, but the odds are for something a smidge higher. If we get the expected core print of +0.1% then year-on-year core CPI will hit 0.7%. I think there is a small risk of 0.2% on core, but either way this month’s figure ought to mark the trough in the year/year numbers as core prices were completely flat from October through January last year, and rose at only an 0.3% annualized pace between October 2009 and April 2010. Even if core inflation is only running at 0.8% between now and April, the year/year number will rise back to around 1% by the time the April number arrives…and I think that core has a good chance of moving somewhat faster, soon.

Also tomorrow, but of lesser import, are the Housing Starts data (Consensus: 598k from 610k). These numbers are at such a low ebb that even a significant percentage miss will barely show up as a wiggle on the chart. The inventory of new houses is quite low, which sets up Housing Starts for a move higher eventually; unfortunately, the inventory of existing homes is still far too great, and since existing homes are a substitute for new homes this means that whatever homebuilders build, they’ll have trouble selling.


The Bang Has Been Bucked!

November 15, 2010 Leave a comment

A real yield of 0.82% for ten years isn’t exactly plush, but on the other hand it is nearly double the real yield that prevailed on the day that the Fed announced QE2 (see Chart).

Real yields are abruptly climbing

Ironic, isn’t it, that between August 27th, when Chairman Bernanke first talked openly about QE2, and November 3rd, when QE2 was effected, 10-year real yields declined from 1.01% to 0.41%. Subsequent to the actual announcement of QE2…when the Fed actually started adding money to the system…real yields rose back to 0.82%. I wrote on October 28th, rather presciently if I do say myself, a comment entitled “The Bang We Have Already; The Bucks Are Yet To Come.” My point was that the decline in real yields we had already seen was probably most of what we were likely to see even once the Fed actually followed through. I did not, however, suggest that we would see a sharp rebound higher in real yields and a decline in inflation expectations.

Obviously, this is a classic buy-the-rumor, sell-the-news outcome. Real yields of 0.4% for a decade didn’t make any sense economically; yields were there because buyers expected that the combination of quantitative easing and the resulting Fed buying would make TIPS rally and make them relatively invulnerable to a selloff (the Fed is, after all, buying virtually all of the marginal TIPS supply through next summer). Ten-year real yields back to 1% wouldn’t be terrific, but it would make this asset class at least competitive again with some of the other (expensive) asset classes available.

Inflation-linked bonds were not the only instruments struck by a selloff today, to be sure! The nominal 10y note rose to 2.95%, the highest yield since early August. Keep in mind, this was with Retail Sales data that was as-expected at +0.4% ex-auto, but an extremely severe miss from the Empire Manufacturing survey. That survey printed -11.14, the worst figure since early 2009, compared to expectations for +14.0. There were sharp declines in the subcomponents of New Orders (-24.38 vs. +12.90), Shipments (-6.13 vs +19.39), Number of Employees (+9.09 vs +21.67), and Average Workweek (-12.99 vs +3.33). The 25-point miss was the worst in at least 9 years (that’s all the data that Bloomberg had), although there was a 22-point miss in 2005 so it isn’t entirely unprecedented. The index is now at levels that are much more consistent with recession than with recovery (see Chart).

Empire Manufacturing. Maybe we're not out of the woods yet!

Empire Manufacturing is merely a single number, which ordinarily wouldn’t raise eyebrows even with a modest miss. But a miss of this size does raise the possibility that something more serious is going on and raises the stakes for forthcoming economic releases.

It didn’t, though, support fixed-income.

The bond selloff could perhaps be seen partly through the lens of re-risking, although that seems to me a stretch. It is true, though, that the only bond markets to rally in Europe were in Italy, Spain, Portugal, and Ireland. But a re-risking seems premature, to put it mildly, when to my eyes nothing about the looming catastrophe in Ireland (or for that matter Portugal) has changed. And the re-risking didn’t extend to equities, which had a minor rally going but couldn’t sustain it into the close.

Sometimes, the zigs and zags don’t need to make sense. Sometimes, after all, they are just zigs and zags. Especially as we get further into November, and even more into December, the analyst needs to remember that sometimes markets move because liquidity is diminishing and some big account needed to get something done today.

In the bigger picture, though, I don’t have any problem with the notion that real yields can rise appreciably further while nominal yields rise further still. It is hard to imagine how all of this can happen when the Fed is buying hundreds of billions of dollars’ worth of bonds, but I am gifted/cursed with a creative imagination. Here’s one way: if the foreign central banks – the ones who have expressed dismay at the Fed’s explicit QE when they were being more discreet themselves in their own QE – decided to meet the Fed’s bids with their own offers, then the Fed’s buying would be easily overwhelmed. I don’t really sit around worrying about that, because even if they did so those dollars either need to be recycled into US goods or recycled into US assets. It could pressure the dollar, but some dollar devaluation is what the Fed is seeking anyway.

The arrow of future inflation seems to point upwards. This indicates that higher yields are (eventually) in the offing. I just don’t know that the recent selloff is the beginning of this process, or just some more zigs and zags.

Data tomorrow include PPI (Consensus: +0.8%, +0.1% ex-food-and-energy) and Industrial Production/Capacity Utilization (+0.3%/74.9%). The PPI isn’t very useful as a gauge of inflation, but there is one somewhat interesting implication of PPI that I will discuss tomorrow. And Industrial Production doesn’t usually draw much attention when Cap U is in the 70s. Given the Empire number today, though, a surprisingly weak IP/CU release may raise more eyebrows than did the Empire number alone.

Categories: Economy, Federal Reserve, TIPS

I Don’t Know Why They Swallowed The Fly

November 14, 2010 1 comment

I waited to write my “Friday” comment until Sunday for a couple of reasons, the most important of which was that I wanted to see how the European drama played out over the weekend.

On Friday, the rumblings from the Continent were not the main cause of the stock market’s 1.2% drop, or the reason that bonds fell and the 10y note yield rose to 2.79% (the highest in 2 months). Bloomberg said that these things happened because China might raise interest rates. Talk about the tail wagging the dog! The Chinese central bank gets more respect in U.S. markets than our own central bank!

Commodities set back hard on the fear that slower Chinese growth lowers the future demand for every sort of good. Oil fell below $85 from what had been 6-month highs near $89. Sugar fell 11.6%, and Corn, Beans, Silver, Nickel, and Zinc were all down more than 5%. Every commodity included in the S&P GSCI declined. That index had a bigger fall back in August when the weak skein of economic data showed up, but since QE2 had been proposed it hadn’t seen a meaningful weekly setback (see Chart). This drop occurred just after the index reached a 50% retracement of the collapse seen in the financial crisis, and it should be noted that it happened with the dollar unchanged on the day!

The commodity drop isn't that much in the grand scheme. Hard to believe we're only halfway back!

The recent pressure on Irish and Portuguese debt, in particular, started to percolate into something more on Friday, but it took until 6pm on Friday to erupt into a rolling boil. Earlier on Friday, European bonds rallied after the finance ministers of France, Germany, Italy, Spain, and Britain issued a joint press release. The market recently had become concerned because recent debate about the “future permanent crisis resolution mechanism” had suggested there ought to be some “sharing” of the risks by the private sector. Of course, when the government starts to talk about the private sector “sharing” the costs, the first reaction is to grab for one’s wallet and make sure it is still there; the second reaction is to make sure you are not part of the “private sector” in the market being eyed.

All of this may be confusing to the reader who doesn’t follow the European soap opera on a regular basis…like me. I thought the crisis was resolved six months ago, with the establishment of the European Financial Stability Facility (EFSF) backed by €750bln in guarantees by the member states and the IMF? Remember, the size of the facility was designed to be so large that its mere announcement would “shock and awe” the crisis into receding, and it seemed to work, for the extended period of six months (€750bln doesn’t buy what it used to!). What has happened to that money that we now need private sector involvement? Could it be that member states are feeling a little bit queasy about the size of the commitment, since it looks like the facility may actually have to start disbursing more funds?

But, not to worry. The joint press release by these finance ministers declared:

Whatever the debate within the euro area about the future permanent crisis resolution mechanism, and the potential for private-sector involvement in that mechanism, we are clear that this does not apply to any outstanding debt and any program under current instruments. Any new mechanism would only come into effect after mid-2013 with no impact whatsoever on the current arrangements. The EFSF is already established and its activation does not require private sector involvement. We note that the role of the private sector in the future mechanism could include a range of different possibilities, such as a voluntary commitment of institutional investors to maintain exposures, a commitment of private lenders to roll-over existing debt or the inclusion of collective action clauses in future bond emissions of euro area member states.

You can see why bondholders might get the shivers. What exactly does it mean to have backing from the EU, if the holders of those bonds might someday be required to “share” the cost of a bailout? That sounds an awful like a default. The press release seeks to calm these concerns by reassuring investors that they are in fact protected by the EU crisis resolution mechanism…at least, until mid-2013. (You can see more about this story here.) It had its intended effect; Irish and Portuguese bonds rallied as some holders decided (I suppose) to wait until early 2013 to get out of their positions. Good luck, I say. If this whole debate doesn’t make a bondholder wonder about the shifting definition of the “crisis resolution mechanism” and the quality of the support from the EU, then that bondholder is acting more like an equity holder and focusing on return, rather than focusing on the question of the return of principal.

This was the state of play on Friday afternoon, with stocks and bonds down, the dollar stable, commodities taking a licking, and periphery Eurozone bonds rallying.

Then, at 6pm on Friday, this headline crawled across the Bloomberg ticker: “Ireland said to be pressed by European officials to take aid.”

Now, Ireland has said quite loudly that it doesn’t need aid since it is funded through mid-2011. It appears, though, that those calculations do not incorporate the potential need to recapitalize the two large Irish banks that the government has now assumed responsibility for; Ireland may be hoping that those entities can raise money in their own names with the sovereign guarantee behind it, but realistically the sovereign guarantee isn’t carrying much weight – so if those banks need money, it will have to come from the Irish government.

And if the Irish government therefore needs money, it will have to come from the EFSF.

And if the EFSF needs to disburse money it will need to come from the EU nations.

And I don’t know why they swallowed the fly…perhaps they’ll die. (And now, through the magic of YouTube, Mister Burl Ives: link)

The weekend has brought many headlines about what is going on behind the scenes at the moment. With the curtain still down, all of these reports are just speculation but everybody seems interested in getting ahead of this crisis before it simply melts down. On Sunday morning, the latest headline is that Germany is pushing Ireland to seek aid, while Ireland continues to declare it doesn’t need aid (it should be recalled that the Greek crisis followed roughly this same script). Of course, Portugal asked just the other day about a clarification about the crisis mechanism, but seems to be second in line this weekend.

Pressure on the European Union continues to increase. It flabbergasted me back in May that investors were willing to take the EU’s statement that “all is calm” as sufficient evidence that all was calm, but I wonder how much longer investors can be assumed to be gullible. The old maxim is that one’s reputation doesn’t behave like a boomerang: once thrown away, it doesn’t come back. The bond markets have always acted like this rule didn’t quite apply (see, for example, emerging markets née LDC debt, high yield née junk bonds, JM Advisors née JWM Partners née Long-Term Capital), but it seems to me dangerous to ignore. We will see, perhaps as early as Monday.

Also on Monday, Retail Sales for October (Consensus: +0.7%, +0.4% ex-auto) is supposed to put in another respectable showing, and the Empire Manufacturing report (Consensus: 14.00 vs 15.73 last month) is supposed to retain most of its surprising jump last month. None of this is important if Europe curdles.

In inflation-related news, I know that I will get questions regarding this story about how a “secret Wal-Mart survey” shows that inflation is already here so let me address it. I have noted for a very long time that ex-housing, prices of many classes of goods are already rising. I have also illustrated (see for example my paper here) why inflation feels higher even than that. So it isn’t terribly surprising to me that if one takes a selection of small, frequently-purchased goods that one will find there is some inflation! It supports my main thesis. At the same time, it bears noting that the consumption basket in this study wasn’t designed to look like the entire consumption basket (which would have to include other big things like housing, medical care, tuition, cars which are not available at WalMart…so far). So the survey is helpful in highlighting inflation in one part of the consumption basket but shouldn’t be taken as having any more weight than the BLS measure. In fact, I suspect that if one took the item-level indices from the BLS and combined them in the same proportions as this researcher did, you would get a similar answer.

And this, I suppose, is the point I want to make. Careful observers will agree that in a broad sense inflation is already growing in a meaningful way if you take out shelter. But that doesn’t mean the BLS is cooking the books and making up numbers as some people will claim. It should be noted that even this study, focusing on things that are commodity-sensitive and that we all agree have been inflating, computes much less inflation than the ShadowStats conspiracy theorists do. The main thing I want is to have the conversation about inflation while working from common, agreed-upon premises, and in this sense the Wal-Mart survey contributes to the discussion while the ShadowStats guys don’t.

Categories: Economy

Volatility Lurks In One Hundred Caves

November 10, 2010 Leave a comment

With some markets closed tomorrow – pit trading of interest rates closed, electronic markets open, equity markets open, cash bond markets closed – the ones that are left open will be thin. Frankly, to me this seems to be part and parcel of building more tension. The 10y note has been in a range since early August, despite the fact that September and October are historically very strong months seasonally. The dollar has been in a range, although volatile within that range, since early October. Stocks haven’t been in any kind of range for a while, but after clambering to resistance and achieving technical projections haven’t really done very much to blast off to new frontiers.

There is no tension evinced by the VIX. With the election, QE2, and Employment in the rear-view mirror and a sparse event calendar given all of the holidays coming up, implied volatilities are soft and will stay that way until we have a meaningful move. But beneath the calm and unruffled surface of the duck, there is quite a bit of frenetic paddling going on if you peak beneath the surface. European bond markets continue to weaken; yesterday the Portuguese Finance Minister asked the EU for clarification on how the crisis mechanism would work in practice (link to the story is here), his comments helping to send the 10y Portuguese bond rate up 33bps to 6.91%. I can remember when 7% was a fairly generous rate, but it is now almost considered distressed! Greek bonds sold off 23bps (to 11.45%), Irish bonds declined for the 12th day in a row with the 10y yield at 8.48%.

And while the big events in the U.S. have passed, the effects of those events are all still in the future! Congress – that is, the lame-duck Congress – needs to pass legislation to fix the AMT and prevent the big January tax increases, and soon or it will be a real mess. The Fed has just started printing and at the same time, there are signs of a pulse (albeit a weak one) in some parts of the economy. Today Initial Claims improved to 435k; while it is hard to say definitively that the labor market is improving markedly the recent dribble lower in ‘Claims does raise the question of whether the Fed is opening the sails too full to a following wind. (Still, it is difficult to say that Initial Claims are about to improve to the 325k level associated with even modest expansions – see the Chart below).

Claims better, but hardly great. Still, perhaps dipping below pre-Lehman levels finally?

And on the other hand, Cisco today guided revenues and earnings forecasts sharply lower after the close today. Cisco followed the usual fin-de-bubble practice of reporting better-than-expected earnings while guiding sharply lower for forward earnings and revenues. But this was pretty serious downward guidance: revenue this quarter of $10.1-10.3bln versus expectations for $11.1, and earnings of $0.35/sh compared to analyst dreams of $0.42. Ouch. That has smacked Cisco 15% lower in after-hours trading so far. I don’t read it as a bellwether or anything like that. I just take it as a reminder that there is volatility lurking out there in one hundred caves, and we should be careful to avoid becoming careless just because it is sunny where we are. I am still waiting for a meaningful break one way or the other from these levels in equities before I make a decision on changing my allocation, but I must say I think the odds of a break lower in price – given these 100 dark caves full of potential baddies and the widespread bullishness seen in investor surveys – are greater than the odds of a break higher. However, I don’t have to make an investing decision today; I can wait until things become a bit clearer. And so I will.


I enjoy anecdotes. Of course, we must be careful not to treat anecdotes as definitive evidence, in the sense that because A happened it implies that B must have happened. However, I think that anecdotes are useful in helping shape one’s thinking. How does this event fit into my mental model of the world? A model that explains a large number of anecdotes is more likely to be useful than one which is perhaps purer in theory, but doesn’t fit what we actually see.

That preliminary is meant as a justification for a short anecdote about government spending. Of course, most of us believe that the government spends far more of our money than we would like it to, but some people don’t mind as much because they believe that most of the money is, at least, being directed by wise people in government who share our values (I am not claiming this as my own view, but I think it’s a reasonable summary of how advocates of big government feel). If this is so, then it is difficult to explain the following anecdote as anything other than an odd exception.

Last week, I went with my wife to a Jazz at Lincoln Center Orchestra (JLCO) concert. I was thumbing through the inevitable program. I enjoy looking at the list of contributors at the back (it always amazes me how rich the Anonymous family must be). On this occasion, I noticed that the top tier of contributors to the JLCO (“Leaders”) included the usual names: the Mellon Foundation, the Rockefeller Foundation, etc., but also included the United States Department of Education and the United States Department of State.

I can make a reasonable argument for why the Department of Education could plausibly give some support for the arts, although it is a mild stretch. But the State Department? Really? And doesn’t the existence of contributions from two separate departments imply that no one really understands whose mandate it might fall under to make a contribution to Wynton Marsalis and his excellent orchestra? (Oh, by the way, the National Endowment for the Arts also made a contribution, which is to be expected. So make that three departments.)

One or two pages further, I note that contributors to Lincoln Center (generally) includes Lehman Brothers, who is a “Bravo Sustainer” at a contribution level of $1mm and above, and the Federal Highway Administration and Federal Transit Administration, at “Bravo Champion” level of $20mm and above. I don’t see what Lincoln Center has to do with either highways or transit. There is a subway stop at Lincoln Center, but it has been there for many years and I am not sure why its presence would occasion a gift to Lincoln Center.

None of this has anything to do, in microcosm, with the markets. The question of whether the massive deficits we are running and the massive debt we are accumulating represents efficient spending which thereby contributes to long-term growth, however, is a reasonable question that gets to the heart of whether Keynesian stimulus should have a net positive effect in the long run. Of course, this is just an anecdote and we must be wary of mistaking it for evidence. I can’t think of any other corroborating examples. Except for the U.S. Postal Service. Well, perhaps there are one or two more.

If government deficit spending is more productive than the alternate uses of the capital to which private industry would dedicate that money, then Keynesian stimulus is good in the short run because it stimulates demand, and pays for itself in the long run. If it is unproductive (or simply less productive than private spending), then whatever short-term stimulus it produces will be paid back in the future from an economy that produces less than it otherwise would…that is, it is a long-term negative. Nine stitches instead of the one in time. (This is not strictly true; if Keynesian stimulus is borrowed and the money is spent on projects that return at least the cost of interest, and it never needs to be paid back so that the aggregate leverage of the economy is permanently increased with no private spending being crowded out, then it may be the case that Keynesian stimulus is productive in the long run. We have seen, though, that most of these assumptions are provably false).


While I will be working tomorrow, the fact that many markets are closed implies that readership will likely be down considerably. I expect therefore to take the day off from writing; I will post something on Friday, however.

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