Archive for December, 2010

Portfolio Projections For The New Year

December 18, 2010 4 comments

Bonds lifted off today, with the 10y rate all the way back to 3.33%, but this time with TIPS underperforming. We really have seen it all recently, with TIPS sometimes outperforming in rallies, sometimes outperforming in selloffs, sometimes underperforming in rallies, sometimes underperforming in selloffs, and sometimes outperforming when nothing else was happening. Nominal rates have been up and down with considerable ranges on no news at all (for example, today) and other times have been quiescent despite important data. Even the one constant these last few months, a rallying stock market, hasn’t been constant. On the week, it rallied just a little bit but not exactly in a straight line!

This is all noise, rather than the prelude to a larger move imminently, if the vol markets are any indication. Sure, implied volatilities tend to sag a little bit in December, but not as much as you would think they would – the thin trading conditions make it harder to hedge short-vol positions and the wide ranges make it more costly to do so. But today, the VIX approached three-and-a-half-year lows in the 15 range.

The fact that no one is currently winning the tug-of-war does not necessarily imply that there are no forces pulling on the rope. In my opinion, strong conflicting forces – the possibility that there is some budding economic growth, the significant Fed liquidity provision, tax cuts and associated increased near-term deficits, pressures on the EU periphery (Moody’s finally downgraded Ireland today, 5 notches), oil at levels that would have been all-time highs except for the melt-up two years ago…I don’t know who wins that tug of war, but my suspicion is that the most-likely outcome isn’t “a tie,” and that’s what is being priced into vols.

But let’s take a step back, in what is probably my last comment for the year, and forget about the one-week and one-month swings. The end of the year is a great time for a top-down portfolio allocation exercise.

To do such an exercise right, you need several things. You need to know what your stream of “liabilities” looks like (are your future expenditures fixed in nominal terms, or are they real? How do they grow over time?). You need to specify the asset classes you want to include in the investing universe and the allowable maximum and minimum weights in each asset class. These are all important decisions, and we all would think about these problems in similar ways. But equally important are the assumptions about the expected returns, expected risks, and the correlations between asset classes. And here, we would all come up with different answers. For many years, asset allocation exercises were fond of using historical numbers for asset class returns. This produced recommendations of a very high weighting in equities, because the period of 1930-2000 (for example) produced an exaggerated historical return: from deep in the Depression to the top of the bubble.

Asset allocation specialists, many of whom either worked for Wall Street firms or were effectively in thrall to them, loved an answer that included lots of equities, because the fees for management of equity funds are a lot higher than the fees for management of bond funds.

And then, the 2000-2010 period hit. Asset allocations began to emphasize estimates of future returns, rather than historical inputs. I am not saying that this necessarily had anything to do with the fact that the other method would have implied very low allocations to equities, but whatever the reason the industry seemed to arrive at the right answer. Ironically, while we know very little about what the returns next week will be, we have much greater confidence that we can say something intelligent about the central tendency and the likely range of possible outcomes over the next decade. This is because we have at least a basic idea of what the drivers of long-term returns are, even though we are clueless about the drivers of short-term returns. As the saying goes, in the short-run the market is a voting mechanism; in the long-run it is a weighing mechanism. The vicissitudes of politics versus the confident predictions of physics – and this is why we use long term average returns to drive asset allocation exercises.

I know that some readers at this point will protest “but this is crazy. Surely no one could have seen the equity returns of the 2000s coming! But this is not so.

At the end of December, 1999, the S&P stood at 1469.25. The 10-year “Shiller P/E” stood at 44.20 (the Shiller spreadsheet is here) compared to a long-run average of 15 or 16. If we assume that equity multiples return half-way to the mean, our calculation of expected 10-year return on December 31, 1999 would have looked something like this:

Long-term real growth in earnings: 2.25%/yr (Note: see this commentary for discussion on why this is a solid long-term assumption)

Long-term inflation: 2.11% /yr (difference between 10y nominal bonds and 10y TIPS at the time)

Dividends: 1.15%/yr

Valuation Reversion: = -3.75%/yr

…for a back-of-the-envelope, somewhat-optimistic (for it assumes that only some of the overvaluation is unwound) estimate of 2.25% + 2.11% + 1.15% – 3.75% = 1.76%/year. A full return to average valuations implied more like a -4%/year return (n.b. I’m not being super precise here about compounding; this is just for illustration). So the actual total return of the S&P from 1999-2009 of -0.95%/year was actually right about where we would have expected.

Actually, it’s even better than that. The actual Shiller P/E at the end of 2009 was 20.24 and compound inflation was 2.52%. If we had correctly forecast those two numbers, then our overall forecast would have been: 2.25% + 2.52% + 1.15% – 7.51% = -1.59%/year. Not bad!

None of this math is particularly challenging, and none of the numbers hard to come by. And folks like Jeremy Grantham were right out front in telling folks that that was about what we could expect from equities.

So there is some reason to think that we can make some reasonable guesses at long-run return numbers. The better our estimates, the more appropriate our asset allocation will be (even if the estimates don’t turn out to be exactly right, our asset allocation will still be a more efficient allocation of risk and reward if our description of the distribution is approximately correct).

With that lengthy preliminary, then, here are my asset-class estimates that I am plugging into my own asset allocation exercise for year-end 2010 (along with a brief explanation). All numbers are annually compounded real returns, except for inflation which is obviously not in real terms!

Inflation 2.63% Current 10y CPI Swaps
TIPS 1.00% Current 10y TIPS. This is not at equilibrium, but it is what we can lock in today.
Treasuries 0.70% Nominal bonds and inflation-linked bonds ought to have the same a priori expectation, but Treasuries trade rich to TIPS because of their value as repo collateral. Current 10y nominal rate is 3.33%, implying 0.70% real.
T-Bills 0.50% Approximate historical long-term real return. Is less than for longer Treasuries because of liquidity preference.
Corporate Bonds 1.00% Shouldn’t I earn a spread for owning corporate bonds? Yes, you should earn a spread that compensates you for expected credit losses. Unless you are getting more spread than you should for the default rate that is expected, you shouldn’t expect unusual rents. Chart 1, below, suggests that Moody’s “A”-Rated Corporate yield right now is just about at where you’d expect them to be, given where Treasuries are.
Stocks 2.58% Analogous reasoning to above, except that since these are real returns I’m not including inflation: 2.25% long-term real growth + 1.89% dividend yield – valuation convergence halfway from 22.5 Shiller P/E to the long-run mean. Note that I am using long-run growth at equilibrium, not what TIPS are implying we’re gonna get.
Commodities 4.30% Various researchers have found that commodity futures indices have a long-run return from rebalancing of about 3.5%. To this we add 1-month LIBOR to represent the return on the collateral behind the futures.
Real Estate (Residential) 0.50% This is the long-run real return of residential real estate. Current metrics (see Chart 2) suggest the housing market may be back to near fair value, so I have not deducted from this long-run return. Note that commercial properties produce cash flow but also may still be somewhat overvalued.

Chart 1: Moody's A Corporates vs Treasuries - looks about right.

Chart 2: Home prices getting close to fair (these data through Q3).

There are lots of other flavors of assets, of course: I haven’t included global equities, emerging market instruments, or hedge funds (just to name several). Coming up with a determination whether Brazilian stocks are overvalued relative to U.S. stocks or vice-versa is very difficult, and also a very important part of the expected return. I have left them out here (partly because this table will provoke enough arguments as it is!)

The chart below shows the expected returns I have explained above, together with the historical volatilities over the last decade – which is what I use as inputs, in most cases. Volatility is generally considered to be strongly mean-reverting (look at the VIX!), so unless you have a good reason to think a market over the long run…and we are talking about 10 years here…is going to have different risk characteristics for some reason, using historical volatilities is a reasonable approach.

Chart 3: Projected 10y Real Returns and Risks

We can take those real returns and risks and, when we incorporate a correlation matrix, produce an “efficient frontier” that shows the best combinations of risks and returns that are available, without leverage, in a portfolio which includes those assets.

Chart 4: Estimated efficient frontier from the points above.

Notice that, like good little Markowitzian portfolio optimizers, we recognize that we can achieve points in a portfolio that are superior to any of the individual points, because the variance of the sum of two assets is less than the sum of the variances due to the covariance between them.


We can also look at the composition of the minimum-variance portfolio for a given target return. Chart 5, below, illustrates this. Notice that even though real yields for TIPS are rotten, they still show up as a crucial element in lower-risk portfolios.

Chart 5: Even with puny real yields, TIPS are an important part of many portfolios.

Indeed, notice that the way you build an efficient portfolio in real space tends to be a barbell of the lowest-risk asset (TIPS) and a higher-risk asset (in this case, commodity indices or stocks). This is contrary to the usual practice of “buying some of everything.” That turns out to be inefficient because you are wasting part of your risk budget on assets that are too expensive, in terms of the return for the risk you’re taking. Better to spend your risk on the things that give you the best return per unit of risk, and put everything else in something as close to riskless as you can get. (If you expand this exercise to include hedge funds and private equity, allocations to public equities all but disappear!)

Something else you can probably not help but notice is that even the riskiest portfolios have pretty poor expected real returns over the next ten years. That isn’t because I am pessimistic; it is because that’s what the numbers are. We live in a low-return world. This probably doesn’t mean you should take on extra risk to reach your return targets, but it does mean that it is more important than ever to watch fees and expenses on investment products you own, and to try very diligently to stay as close to the efficient frontier as possible. There isn’t enough return out there to go wasting it on inefficiency.

So, what does this mean for your asset allocation? Unfortunately, I can’t tell you that because I don’t know your risk tolerance. And, even more importantly, this analysis is very one-sided. I looked only at the asset side of the balance sheet. I didn’t consider what your liabilities might be. Remember how I alluded to that early on in this exercise? You see, if most of your expenses are exposed to inflation (and this is true for most of us), then your optimal portfolio is probably heavier-still in inflation-linked bonds. This is because the real goal of investing for retirement isn’t to maximize your return on assets subject to a given level of risk on the assets; it is to maximize your retirement surplus (or minimize the shortfall) while constraining the risk of that surplus. To put it another way, if you have fixed-dollar expenses and invest in fixed-rate bonds, then you are well-hedged. But the same portfolio of fixed-rate bonds will be a total disaster if your expenses rise with inflation, and there is an inflation surprise. It is important to consider your entire life situation not just in the master plan, but in the asset-allocation exercise itself.

And with that thought, I will leave you for 2010. Happy holidays, everyone! See you on the flip side: this comment will return on January 4th.

The Market Grows Thinner; I Do Not

December 16, 2010 5 comments

As the year grows older, it gets more and more difficult to attribute market moves to particular motive forces. In thin conditions, a particularly motivated buyer or seller can mean a lot more than flows from investors who care about, say, the economic data…but who don’t have the desire to increase risk at this point of the year.

So I resist the inclination to read too much into the fact that Housing Starts, Initial Claims, and the Philly Fed index were all stronger-than-expected today but the bond market and stock market both rallied. To be sure, Housing Starts and Claims were insignificantly stronger-than-expected, but I really thought when Philly Fed printed 24.3 – a new 5.5-year high – the bond market was going to be toast. The Employment subindex declined to 5.1 from 13.3, but this is too subtle for mid-December. Bonds dribbled lower, but then rallied for the balance of the day.

There was news today that the ECB is planning to roughly double its capital by adding €5bln over the next three years, at least in part as a buffer against losses on government bonds it has been buying. This isn’t to cover potential mark-to-market losses on money-good bonds, because the ECB (like the Fed) isn’t required to mark to market. The only way these bonds would become losses is (a) if they were sold at even lower prices than where they were bought, in which case there would a realized loss, but in that case then the program didn’t do a very good job, did it? or (b) if those bonds default. Either way, this is hardly a vote of confidence about the solidity of the system!

There were a number of earnings announcements today. RIM, Oracle, and Accenture (disclosure: I own none of the stocks mentioned in today’s commentary) all beat the expectations for their earnings, but FedEx missed. Quick quiz? From a macroeconomic standpoint, which do you think is a more important bellwether: the tech companies or FedEx? This is a surprising miss if the economy actually is improving as it appears to be.

Yes, it’s true: the fact that the news these days is occasionally good, rather than being entirely bad, is a qualitative change that is worth noting. But to me, it appears as if this qualitative change is already discounted in the stock market (and stocks rallied 0.6% today). It may happen that the market now decides to discount a further qualitative improvement, but it may also happen that the market declines because bonds also discount such a qualitative improvement and yields rise!

That didn’t happen today, though. 10-year Treasury yields declined to 3.44%, but 10y TIPS outpaced them again. The rally in fixed-income, despite this improving news, may indicate that the bond sellers are finally exhausted and bonds are ready to bounce. In September, I might bet that way. In December, I’m more cautious about that view and since buying bonds at 3.44% for me is at best a short-term trade, it isn’t one I wish to make at this time.

And that is the effective end of data for this week. Friday sees Leading Indicators, but that isn’t a significant report.

As we approach the solstice, the days and the commentaries get shorter and shorter. What is more, a dozen years or so of writing this sort of comment has convinced me that also ebbing is the number of people who have the time and the desire to read remarks about markets that are twisting randomly (and mostly, gently) like a wind chime in a summer breeze. Too, the pundit needs a mental break, and this is a good time to take one.

Accordingly, this is my next-to-last planned commentary of the year. Tomorrow’s comment will present the 10-year expected returns for various asset classes that I am using in my own portfolio modeling, and make some general wrap-up observations; after that, the next scheduled commentary will be on January 4th (the Tuesday after New Year’s Day, since I am traveling January 3rd). It is unlikely, but possible, that if market conditions warrant I may post something in the intervening two weeks, but I don’t plan on it!

Thanks to everyone who has taken time to read these comments this year. On the various places this column is “syndicated,” it has collected something on the order of 600,000 comment-views this year. That’s not John Mauldin territory, but it makes a guy like me feel useful! Thank you, and thank you for continuing to refer the material to your friends.

Categories: Uncategorized

The Inflation Lows Are In

December 15, 2010 Leave a comment

Stocks didn’t need this. Nominal bonds didn’t need this. But TIPS apparently needed this!

The CPI index today was fairly close to expectations, with two relatively small exceptions. One is that the actual index number for November – which had great salience for owners of the TII Jan-11s, whose payment at maturity is now fully defined and no longer exposed to inflation – was a tenth or two higher-than-expected. This also helps TIPS generally because it improves the month-to-month carry, and many institutional investors buy and sell TIPS with far too much focus on the carry.[1]

The other small exception is that for reasons that no one seems to be able to fathom, there was a large change in seasonal factors for November (which implies there will probably be an opposite change in December) that caused the seasonally-adjusted month-on-month change to be lower than it would have been with the old seasonals. (Before anyone gets all up-in-arms about the government conspiracy, note that inflation-linked contracts pay on the index numbers and have nothing to do with the seasonally-adjusted numbers). So, core CPI came in at +0.098%. Under the seasonal adjustment factor that most of us were assuming, this would have led to a year-on-year rise in core CPI of +0.65%, and hard to tell if it would have been slightly higher or lower and therefore rounded to 0.6% or 0.7%. But year-on-year was actually 0.768%, implying that the underling core CPI rose about twice as much as people expected. Or, in other words, using the old seasonal adjustment factors we would have seen more like +0.2% rather than +0.1%. A similar effect was seen in the headline CPI.

Now, higher inflation (which this was, although it appeared to be on-target!) ought to be bad for equities. Equity valuations tend to be maximized with inflation between 1% and 2%, though, so one could argue this is bullish since it gets us closer to that range…if, that is, one could argue with a straight face that inflation is likely to abruptly stop when it get there. The indices actually retreated somewhat today (-0.5%).

And of course, higher inflation is bad for nominal bonds. The 10y note yield rose to a new high at 3.525%. For those of you keeping score at home, that puts the overall rise in yields during this rout to 47.8%, tying it for second place on the list of worst 90-day “logarithmic” routs (see yesterday’s comment).

Higher inflation, however, is a boon to TIPS relative to nominal Treasuries. TIPS, as has been documented here, have been shellacked recently, but today TIPS outperformed nominals by 10bps or so – they rallied while nominal bonds declined. At 1.16%, I still wouldn’t back up the truck to shovel 10y TIPS into it, but it certainly is an improvement and I can certainly think of investments I like less.

The low for year-on-year core inflation is almost certainly in. For the next six months, we will be dropping very low year-ago prints from the rolling-12-month figure: from Dec 2009-May 2010, seasonally-adjusted core CPI rose at an 0.44% annualized pace. It will take very little to keep the year-on-year rate rising, and it should be back at or above 1% in two months. The risk, I think, is on the upside.

There is a caveat. The core-ex-housing number dipped this month slightly, to 1.17%. While this continues to signal no deflation threat outside of housing, it has come down a very long way in just a few months. This is probably also troughing, but it also means that fears of imminent inflation can also be put on hold for a few months at least.

In other news, the Empire Manufacturing number was even stronger at +10.57 than the forecasts, which I already found optimistic. The extreme volatility of Empire over the last year, unfortunately, means that we need to put huge error bars on any print, but at least the return to mild strength makes it harmonious with the other manufacturing surveys.

Tomorrow, the release calendar includes Housing Starts (Consensus: 550k from 519k), Initial Claims (Consensus: 425k vs 421k), and Philly Fed (Consensus: 15.0 vs 22.5). Remember that the Housing Starts number last month was very disappointing (the consensus forecast had been 598k and the low forecast had been 550k), but no matter what is reported tomorrow it will still be a very long way from any level of housing activity that could be considered normal. Remember, in the recessions of the early 1980s and the early 1990s, the worst month for ‘Starts was never below 798k.

Initial Claims is of more interest, although since we are in December we need to apply more than the usual amount of skepticism since the December and January seasonal adjustments are humongous. Tread gingerly, however, since lower-than-expected prints will still be greeted with bond selling, to be sure. Similarly, although the Philly Fed index is expected to decline, any increase…which arguably wouldn’t be too surprising since the manufacturing surveys are doing okay…would put the index at new post-2005 highs and would pressure bonds (do note, however, that the Philly index is a diffusion index, meaning that it measures the relative proportion of respondents reporting improving conditions and not necessarily the speed of expansion!).

And the further that bond yields rise, the harder it will be for equities to ignore it. While a rise in yields would, if it were caused by fundamental factors, indicate that growth expectations in the bond market were converging upwards to the generous expectations embedded in equity prices – rather than the latter converging downward, as many of us have expected – the higher yields serve as competition for equities. Admittedly, 10-year interest rates at 3.5% are feeble competition for nearly anything, except perhaps for the feeble dividend yields of the stock market as a whole. The chart below (Source for historical price and dividend data: Robert Shiller at shows a very simple ratio of S&P dividend yields to the 10y Treasury yield. While by this view stocks could arguably still be cheap in some sense, the change in the relative value over the last month or two is what I am pointing out.

At the margin, higher yields make stocks look less attractive.

I want to discourage readers from drawing a very strong conclusion on the relative value of stocks and bonds from this chart. I show the relationship because some analysts do place a lot of emphasis on this relationship, but I think that emphasis is misplaced. One of these two yields is backward-looking and (since dividends move slowly) essentially says that stocks get more expensive when prices go up and vice-versa. Well, duh. And I’d say that buying bonds because they offer a nice premium to stock yields…when bond yields are at 3.5%…is clearly pretty simplistic. We need to know the levels as well as the relationship between these yields, and a bunch of other things. So don’t use this chart to trade!

But my point is…some people will use this relationship to trade, and so if bond yields continue to rise it will be harder and harder for stocks to ignore that. Money at the margin is eventually going to shift from stocks to bonds.

[1] Unless the market is inefficient, excess positive carry over any given month should be countered by an expected capital loss. Finance theory says that we shouldn’t be able to make risk-adjusted profits simply by playing for carry. There isn’t any compelling proof that this is false, although I suspect it is when securities are fairly complex. But in this case, it would be really remarkable if you could make money simply by owning TIPS in high carry months and selling them in low-carry months!


Categories: CPI, Investing, Stock Market, TIPS

Bond Vigilantes Are Alive And Well

December 14, 2010 4 comments

The Federal Reserve, as was widely expected, announced nothing notable following its meeting today. I had thought there was a remote chance the Chairman would try to get one more dovish heave done before the new slate of Fed officials come in, but it was always a long shot. There is an old maxim that there is only one real vote on the FOMC, and that is the one that belongs to the Chairman. No Chairman has even been outvoted, or even vaguely challenged, in a recorded vote; this detail of Realpolitik means that whether Bernanke feels threatened by the onslaught of Ron Paul he is about to endure, he most likely feels no threat from the hawkish Fed Presidents that are about to acquire an official vote. At the end of the day, those votes are mostly pro forma.

The bond market really needed some kind of a dovish hint from the Fed, and perhaps for that reason it appears that some traders expected some indication of sympathy for the bondholders. Once the more-or-less unchanged statement was released, bonds took another hit on top of the shellacking they had already endured after Retail Sales this morning bested estimates comfortably (+1.2% on core retail sales, along with an upward revision to last month of +0.4%). The 10y note yield ended at 3.471% and the 10y TIPS yield all the way up to a plump 1.17% (well, compared to a month ago). The 30y TIPS got above 2% real yield for a little bit, down more than 2.5 points on the day.

I noted in the long-term chart I ran last week that the current bond market selloff was comparable in logarithmic magnitude to the one of 1987. That was 20bps ago. The current selloff is now the fourth-largest selloff of 90 calendar days or less since 1980. A mere 68 calendar days ago, on October 7th, 10y yields sat at 2.385%. They are now 45.5% higher at 3.471%. The table below (computed with Bloomberg 10-year yield closes) records the five largest routs in ratio terms of the last three decades (really, only four routs since the two separate legs of the 2009 selloff appear). Incredibly, Ben Bernanke has presided over three (two) of them, and those routs have occurred during the most aggressively easy monetary policy in history. Hint?

Red indicates a rout currently in progress.

Heck, this current rout even has another three weeks before it reaches the 90-day mark. Another 25bps and it will be the worst proportional selloff in history (over 90 days, anyway). By the way, if you need any reminder that we had a multi-decade bull market, notice that to get #5 on our list I had to go all the way back to Jimmy Carter near the blowoff conclusion of the 1970s bear market!

We will shortly find out how much of this is selling the rumor. Tomorrow’s key economic release is CPI (Consensus: +0.2%/+0.1% ex-food-and-energy). The consensus forecast is actually for something  a bit lower than 0.1%, since a print of exactly that number would raise the year/year core CPI to +0.7% on rounding but the consensus call is for 0.6% year/year. It would take an outright negative print on Core to induce a downtick to 0.5% year/year.

While I don’t focus on forecasting month-to-month numbers, my model suggests we should have seen the low in core CPI. In other words, I think the bond market has the general idea right but has taken things too far. Remember, however, that in December the gamma-hedging effects will tend to make these trends persist longer than they would otherwise. To put it another way: I wouldn’t fade the selloff, even though I think it’s overdone. It is a flow-driven overreaction within the context of a market that is turning from secular bull to secular bear. That’s not even worth a punt from the long side, especially given the fact that Empire Manufacturing (Consensus: +5.0 from -11.14) and Industrial Production/Capacity Utilization (Consensus: +0.3%/75.0%) among tomorrow’s releases will both probably show some signs of firming. Empire was shockingly weak last month, but also an outlier, so improvement is probable (although a bounce all the way to +5 seems ambitious to me).

Neither the rise in rates nor the very modest signs of a halting recovery is likely to encourage the Fed to tighten or even to slow its easing campaign, unless it is accompanied by a meaningful rise in actual inflation out-turns. And I don’t see that happening yet (it will be too late, once it does!). Employment is weak, and that’s a political hot potato; moreover, there will be plenty of pressure from Congressman Paul’s camp to stop the printing presses next year. The Fed is going to keep buying bonds for a while…but that doesn’t mean we should.

Categories: CPI

Inflation Targeting – Bronco Ben Rides Again?

December 13, 2010 4 comments

Stocks ended flat on the day, but bonds ended higher for a change. The catalyst, interestingly, was a court decision.

Bonds had been lower overnight, and stocks higher as has become the norm over the last couple of weeks. Around 11:00ET, however, a District judge ruled that part of Obamacare is unconstitutional. Specifically, according to the judge (who is of course not the last word, but it’s getting closer) the federal government cannot compel citizens to maintain minimum health coverage.

This is a big blow to Obamacare, because the large costs of the plan are only as small as they are because the law forces healthy people to buy insurance that is overpriced for them. This is a frequent problem with insurance. Why should a good driver pay $1,000 per year for insurance? Because that good driver is subsidizing the legally-capped rates on the really bad drivers. Insurance companies would lose money hand over fist if they were forced to insure bad drivers at rates limited by the insurance board, unless they also have a bunch of good drivers overpaying for the same coverage. If this part of Obamacare is thrown out, then a re-assessment of the program’s costs should find a dramatically higher price tag. The implication is that the law is much more likely to be repealed now, and this implies smaller future deficits. So bonds rally, for at least an hour or two!

Tomorrow, the data deluge for this week begins. Of some interest will be the November Retail Sales (Consensus: +0.6%, +0.6% ex-auto). Of somewhat less interest is the PPI (Consensus: +0.6%, +0.2% ex-food-and-energy). Of least interest…probably…is the outcome from the FOMC meeting.

I have to couch that as “probably” because the rotation of FOMC membership in 2011 will change the composition of the Board significantly. Gone will be hawkish gadfly Hoenig, but also moderate Pianalto and doves Bullard and Rosengren; in will come Chicago Fed President Evans (hawk), Philadelphia Fed President Plosser (generally a hawk), Dallas Fed President Fisher (hawk, but also relies a lot on the signals from gold), and Minneapolis Fed President Kocherlakota (confused dove; earlier this year he advocated raising rates to cause inflation expectations to rise. It is hard to imagine what we’ll get out of an FOMC member who is that squishy on economic fundamentals). This chart makes the balance of power move pretty obvious, although of course the positions of the particular officials on the scale can be debated.

This means that if the Chairman has any desire to extend the QE2 program, his opposition will be lighter if he does it this month. One might even speculate that it would be more tactically adroit to be extra-dovish this month so that next month, when the new Congress and new Fed Overseer Ron Paul take their seats, the Committee has room to appear more hawkish. In some sense, this will be the last time it will be easy to be easy.

I don’t really expect any major changes to come out of the FOMC meeting when the results are announced tomorrow. However, the Committee could extend the duration of QE2. I doubt that will happen, because it would set up expectations (which would be easy to dash, but the Fed hates to dash expectations rather than to set the up correctly in the first place) that the end of QE2 will be signaled no less than 4-5 months in advance, when at some point the Fed decides not to extend the maturity date of the bond buying. To reiterate, I do not expect this change, but it is possible. On the other hand, it is very unlikely that they would foreshorten the plan already, especially since there will be pressure to do just that in 2011.

I suspect that the most likely outcome is a fairly innocuous statement with no significant change in policy. Employers certainly “remain reluctant to add to payrolls,” and Housing starts “continue to be depressed.”

However, one topic that will be getting increasing attention in 2011, I expect, is the question of whether the central bank should adopt a price level target, even informally, rather than the informal inflation target it currently has (1.5%-2.0% on core PCE, 1.75%-2.25% on core CPI is how it’s usually perceived). Under a price-level target, the central bank declares that if the price level today is 100, then it seeks to establish the price level in (for example) 10 years as 121.9 (that is, 2% compounded inflation). The difference is simple: under an inflation target, past misses are forgotten while under a price-level target the bank attempts to make up for past misses – lower-than-optimal inflation is made up for by a later period of higher-than-optimal inflation.

Chairman Bernanke broached the subject in his August speech at Jackson Hole, saying:

“A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability. I see no support for this option on the FOMC. Conceivably, such a step might make sense in a situation in which a prolonged period of deflation had greatly weakened the confidence of the public in the ability of the central bank to achieve price stability, so that drastic measures were required to shift expectations. Also, in such a situation, higher inflation for a time, by compensating for the prior period of deflation, could help return the price level to what was expected by people who signed long-term contracts, such as debt contracts, before the deflation began.”

He then downplayed the value of this strategy:

“However, such a strategy is inappropriate for the United States in current circumstances. Inflation expectations appear reasonably well-anchored, and both inflation expectations and actual inflation remain within a range consistent with price stability. In this context, raising the inflation objective would likely entail much greater costs than benefits. Inflation would be higher and probably more volatile under such a policy, undermining confidence and the ability of firms and households to make longer-term plans, while squandering the Fed’s hard-won inflation credibility. Inflation expectations would also likely become significantly less stable, and risk premiums in asset markets–including inflation risk premiums–would rise. The combination of increased uncertainty for households and businesses, higher risk premiums in financial markets, and the potential for destabilizing movements in commodity and currency markets would likely overwhelm any benefits arising from this strategy.”

But it is worth reflecting on that dismissal, because the arguments he gives against are pretty poor – they’re not even the best arguments against, as I’ll show in a moment. “Inflation would be higher and probably more volatile under such a policy,” he says, but this is presumably the point. In the short run, inflation would be more volatile because it would no longer be a crucial policy variable. Over the target horizon, though, the volatility would diminish as the time to the target reduced. Ideally, the volatility of the price index 10 years in the future would be zero. If that is the case, then the fact that the 1-year volatility is higher is not terribly important. The Fed would be trying to make inflation considerations irrelevant for long-term investments and contracts. Indeed, if the market believed that such a policy was credible, then we would see a big change in the implied volatility curve in inflation options. Short-dated vols may rise, but longer-term vols around the target tenor would decline; beyond the target date, vols would increase again.

Think of volatility being the scatter of bullets being fired by a cowboy on a bucking bronco at a stationary target. If the cowboy is a decent shot, then the bullets might leave the pistol from anywhere – way up there, way down here, way off to one side – but will all go through the target. On the other side of the target, they’ll spread out again. The vol curve in short would be “squished” in the middle.

If the Fed were able to achieve this feat, why would it be squandering its hard-won inflation credibility? It would seem to me to enhance it if Bronco Ben were able to hit the target. He sure is missing the target at the moment.

I think the Chairman was setting up a straw man on purpose, so that as the debate continues he can look like the sage wise man who carefully considered both sides of the story. But the available evidence is that he has made up his own mind on the subject. For example, see the book he wrote in 2001 with Laubach, Mishkin, and Posen.

I expect that it will be difficult for the Fed to adopt such a policy. Kansas City Fed economist George A. Kahn pointed out some of the reasons why the Federal Reserve is unlikely to pursue it in a good, readable paper published in 2009. He writes:

“While price-level targeting offers a number of potential benefits relative to inflation targeting, the benefits may be relatively small and uncertain. In addition, price-level targeting is untested in practice…and would present challenges for policymakers in communicating with the public regarding the objectives and direction of policy over the medium run. As a result, price-level targeting will not likely be adopted by central bankers without considerable further research or a dramatic deterioration in economic performance that leads policymakers to fundamentally reconsider how they conduct monetary policy.”

But I think the best argument against the Fed taking such a step is this from Kahn:

“Another reason central banks may not be willing to embrace price-level targeting is that they have no modern practical experience with such targets. All of the arguments supporting price-level targets come from economic theory and past empirical relationships. The economic theory is a highly stylized representation of the actual economy that abstracts from many real world considerations…while some policymakers may find price-level targets appealing, no central bank may be willing to be the first to implement them. Every central bank may be waiting to learn from the experience of another central bank.”

Now, I am not really a fan of price-level targeting, because I don’t think the central bank has anything like the amount of control that is necessary to plausibly zero in on such a goal. It does make a lot more sense than pursuing a one-year target, which is essentially what they are doing now, but in general I think the Fed ought to focus on simply avoiding big policy errors, something it hasn’t been able to do in the last couple of decades.

I think Kahn makes very good arguments against implementing a price-level target any time reasonably soon. But we have not factored in the fact that Chairman Bernanke, while often wrong, is rarely in doubt. I fear his overconfidence in these models. They remind me of the time my employer was a bank stuffed with quants. I had been there a few weeks when my boss thrust a paper in front of me that had pages and pages of mathematics asserting an abstruse phenomenon about inflation derivatives. “What about this?” he challenged, apparently assuming I had been unaware of this theory. “What I know,” I said, “is that the effect is small, it is in our favor, and the market values it at zero.” He stomped off and set our quants to work on it. After three months of work, we had math to prove that the effect was small, and in our favor, and it was a simple matter then to prove the market valued it at zero. So I was right, but the important thing was that now we had a mathematical model. That bank, more than any one I have ever been at, was willing to take ridiculous risks as long as there was some mathematical model that supported the pricing. Bernanke seems to me to be cut from the same cloth. “Let’s do it,” I can hear him saying authoritatively. “The math works.”

Now, again – I don’t know if this is on the agenda for tomorrow, and even if it is I rather doubt that it would be implemented at the meeting. But looking into 2011 I expect we will hear an increasing number of speeches on this topic.

Categories: Federal Reserve

Do Deficits Matter?

December 10, 2010 4 comments

According to Bloomberg, Treasuries on Friday fell and stocks rose “as U.S. Economic Data Top Forecasts.” Stocks added 0.6%, while 10y note yields perked up to 3.32%.

The economic data that beat forecasts was the trade deficit, which was mildly better-than-expected, and the Michigan Confidence figure, which at 74.2 managed to beat the 72.5 expectations, but didn’t even reach a new high for the year. It should be noted that the low for the Michigan number in the last recession was 77.6!

Oh, and by the way the Budget Deficit for November was 150.4bln, more than $12bln worse-than-expected and the biggest November deficit ever. To the extent that these second-tier numbers are better-than-expected, do you think that Federal largesse has anything to do with it? I’d be more impressed if the deficit was improving as well!

Moreover, China overnight increased bank reserve requirements for the third time in the last few months. After the prior two hikes, markets sold off. This time, there was nary a ripple – perhaps because investors figure growth is so robust we no longer need to rely on China as an engine of growth?

Overlooked too, it seemed to me, was the fact that the leaders of Germany (Chancellor Merkel) and France (President Sarkozy) met today and jointly announced that they reject the notion of the European Union issuing bonds – which of course would mainly have value because of the economic power of Germany and France – and are opposed to expanding the €440bln rescue fund that was set up in May – and which costs fall predominantly on Germany and France. To be clear, Merkel and Sarkozy reiterated that they completely support the common currency, but they also made clear with their actions that they are more willing to let periphery nations flounder alone than to let the problems of the PIIGS besmirch the good names of Germany and France.

So stocks rallied, according to the soothsayers, because economic data topped forecasts. Given the actual distribution of news today, though, this seems to me to be a hopeful justification. Stocks look to me like they are rising now because they are at new post-Lehman highs, and some investors are afraid of missing the boat. And bonds are falling because it is December, and they already have fallen quite a ways, and in the bond world you generally don’t want to fade moves made in December no matter what the cause because of the size of the short-gamma hedging need compared to the available liquidity.

If the news is so good, then let’s see how the stock market holds up next week when it gets real data. Retail Sales is on Tuesday along with PPI and a Fed meeting; CPI, Empire Manufacturing, and Industrial Production are on Wednesday; and Housing Starts, Initial Claims, and the Philly Fed report on Thursday. I don’t think that we know anything more today about the economy, with Michigan and Trade in-hand (especially given China and the budget), than we knew yesterday. But by next Friday, we will actually have some real information.

I will leave you this week with one more fun chart. Today’s Deficit figures put the running 12-month total at a mere $1.288 trillion. Assuming we have roughly 2% growth this quarter, this means the deficit is around 8.7% of GDP.

Now, we all know that big deficits should lead to higher real interest rates, right? Well, take a look at the following chart, which shows the 10-year TIPS yield against the rolling 12-month deficit as a proportion of GDP. What we see is rather the opposite – real interest rates have instead declined as the deficit has increased.

Note: last 2 points of Surplus/Deficit line are estimated based on 2% growth rate in current quarter.

Let this be a lesson against the careless use of statistical inference! What is happening here is that both deficits and interest rates respond to a common factor, and that is economic growth. The first period of deficit deterioration, which largely overlaps the first big decline in real yields, is associated with the recession of the early 2000s. Deficits improved and bond yields rose during the tepid expansion of the middle part of the decade, and then the second recession of the decade sent both deficit and yields lower. So real yields are not responding to the deficit, nor the deficit to real yields; they are both responding to rotten economic conditions (and where we are on the chart should give you some pause about expecting robust growth ahead).

However, look instead at a scatter plot of TIPS yields as a function of the deficit. The relationship is pretty good, but interestingly it is not linear. I’ve plotted two regression lines here: one is linear and the other is polynomial of order 2. The polynomial curve fits better (notice the higher R2), which confirms what our eyes seem to tell us when we look at it.

Same data as above, but arranged in scatterplot form.

In other words, the indirect relationship (through growth) isn’t clean. Real yields are not as low as they should be given growth that is bad enough to lead to a deficit as large as it is. This either means that (a) we are getting bad mileage out of our deficit spending, and running one too large given the underlying economic growth, or (b) real yields are higher than you would think they should be given how punk growth is. I suspect both of these are true, but the implication of the latter is more worrisome because we can always improve the profile of what we’re wasting money on. Higher real yields suggests that the government is having to pay a bit more to fund its deficit (in real terms), even though the Fed is buying scads of the debt. Now, if we want to be generous we can suppose this is because private borrowers are competing for the capital more than they were, but look again at the first chart and see where the inflection really happened. This is a phenomenon associated with the huge deficits resulting from the latest recession.

Indeed, my regression lines are probably too generous. The clump of dots on the right appears to be roughly linear, but then the clump of dots on the left represents total outliers. If the linear-vs-nonlinear approach is “right,” then real yields are about 75bps higher than we would expect them to be otherwise but that’s just the point estimate and you can plausibly argue the effect isn’t large. But if the dots from the most-recent period are best viewed as outliers relative to the “normal” relationship from the last recession and the expansion periods around it (basically, one full cycle since TIPS were first issued), then real yields are a couple of hundred basis points too high, or the deficit is over 5% larger than it should be given the underlying growth dynamic, or some combination of the two. Any way you slice it, I think the first chart (the “happy” one) is misleading, and the scatterplot (the “unhappy” chart) is more illuminating. So, do deficits matter? You tell me.

On Monday, I plan to discuss what will no doubt be a hot topic at the Fed meeting on Tuesday: inflation targeting.

Categories: Economy, Government, TIPS

Chart-A-Palooza! It’s Z.1 Time!

December 9, 2010 Leave a comment

Initial Claims did not administer the coup de grace to the bond market. While TIPS continued to struggle, bonds were roughly unchanged on the day as Claims came out quite near to expectations (421k). It does appear that ‘Claims have begun a new slide to a lower level, but I would caution here against relying too much on one’s eyes. The spike in late summer makes the slide appear larger than it really is, and moreover at this time of year (and, frankly, through most of January) the volatility of the Claims numbers is much higher. Ergo, we need more data to be sure that we’re really seeing what we’re seeing. I would say that I “suspect” it is so, but I don’t have enough evidence yet to reject the null.

Absent such a mercy-strike, the market was reasonably quiet today. However, one of my favorite data releases – come to think of it, the fact that I have a favorite data release is pretty sad – was out today: the Federal Reserve’s quarterly Z1 Flow of Funds report, updated through Q3. I like this report because it allows me to update charts like these:

This chart shows that Federal, State, and Local debt (including Fannie Mae and Freddie Mac debt) as a proportion of total debt. This matters because the higher this ratio goes, the bigger the incentive for the government to simply monetize the debt. It isn’t outlandishly high yet, but the trend is kinda bad.

This chart makes a neat point. The private sector is deleveraging, slightly. But the overall economy is not, because the government has thoughtfully taken up the slack and borrowed whatever we weren’t borrowing. This is not unrelated to the fact that the economy didn’t collapse after 2008Q3. Some of you may applaud the Administration(s) for this since it helped avert an imminent collapse. Some of you may throw brickbats at the Administration(s), since if leverage was what was causing the collapse to threaten, we clearly have the same Sword of Damocles hanging over our heads. I tend towards the latter camp, but either way I think we can agree it’s a smashing chart.

So where has the private deleveraging come from? Well, there is a myth that the consumer is deleveraging. A little bit, yes, but most of the deleveraging is coming from domestic financial institutions (banks, dealers, etc). And yes, you might combine these last two charts and say “so, the financial system basically foisted a bunch of debt onto the federal ledger, aka taxpayers?” Yep, that was the deal the Administration(s) made with the devil. Again, some of you will applaud this for the short-term results and others will hurl rotten tomatoes. But probably none of you will pat Bank of America on the back these days. (I’m just sayin’.)

Tobin's Q / Average Q

And, yes, the Z.1 allows us to calculate a variation of Tobin’s Q. If you don’t know what Tobin’s Q is, you can read my comparatively-succinct explanation here, but in a nutshell it is a way of comparing the market value of equities to the replacement value of their assets. Higher means a frothier market. Here I’ve divided the calculated Q by the average Q since 1952 to get a normalized Q. If this makes you think the stock market may still be overvalued, then you can thank Q. You’re welcome!

Panic, But Take Your Time

December 8, 2010 10 comments

Another day of selloff in the bond market, and I wonder how much fingernail-chewing is happening at the Fed? 10-year Treasury yields rose to 3.27% for the first time since mid-June (see Chart). Forget QE2 at the beginning of November, or the discussion about it at the end of August; in June we had just watched volatility spike and the S&P was undecided about whether to go above 1100 or below 1050 (it eventually did both). Inflation expectations were in retreat.

This is starting to get ugly.

The sharp selloff in bonds is, at some level, not terribly surprising because of the time of year. Illiquidity in December is hardly a news flash, and I always take care to remind people that illiquidity doesn’t mix well with all of the mortgage paper out there that represents “short gamma” positions. More succinctly put, if you start a stone rolling at this time of year, it is often more likely to gather speed than come to rest.

For all of the beating that nominal yields have taken, though, real yields today got it worse. The 10-year real yield surpassed 1% for the first time since September, on a 19bp selloff. 10-year TIPS yields have risen from 0.40% to 1.04% since the Fed started QE2 (see Chart). Keep in mind that this happened on a day in which the Federal Reserve was buying TIPS in the market.

The movement is largely in real yields...the Fed appears to be winning!

Consider the implication that most of the rise in nominal yields has come from the annihilation of inflation-indexed bonds. Observers will want to say that the bond market vigilantes are punishing a profligate Fed, but that is not at all the case. Yields are jumping because growth expectations are soaring. Bernkanke has them snowed, in other words. He has saved the world, and now we’re going to get strong growth and low inflation. Or so the bond market is telling us. No wonder stocks are doing so well!

It’s probably a good idea to put this big rise in yields in perspective. While I think the convincing rejection of any attempt at new lows below the Dec-2008 lows is confirmation that the secular decline in interest rates is indeed history (as I said in early 2009), that doesn’t mean that a secular rise in rates is necessarily imminent. The chart below plots 10-year Treasury yields back to 1980 (I used to do this on Excel because the axis needs to be logarithmic, but now Bloomberg makes the pictures so much prettier).

In the long sweep of time, we're only half-swept.

The big selloff is in context here, in two opposite senses. On the one hand, even though the selloff is “only” 90bps or so, in relative magnitude that is comparable to the roughly 3% selloff from 7.20% in March 1987 to around 10% in October 1987 (I don’t remember what happened next). So 90bps is a big move, in the context of ultra-low rates (and concomitantly long durations).

On the other hand, in the grand scheme of things the selloff only puts yields back in the middle of the secular downtrend. In order to get seriously concerned that a movement significantly higher in rates is about to occur, you’d need to break above 4% or so I think, and confirmation that the secular downtrend is in fact over won’t happen until we have a monthly settle above the upper channel line at around 4.40%.

So panic, but take your time.

I wonder, though, what will happen if Initial Claims tomorrow (Consensus: 425k from 436k) continues the recent trend of improvement. Let’s be clear: the best information that we have on the jobs market, in the form of Employment, the ADP report, and the Consumer Confidence Jobs Hard to Get number, are clearly indicating that the jobs market is still comatose. The Initial Claims data has been stronger recently, and this may be an early sign of improvement elsewhere since employers need to stop firing so many people before they start hiring. But if that was really happening, I would expect to see something upbeat from the answers of the man-on-the-street. We need to keep in mind that Claims in December and even more in January are difficult to seasonally adjust because lots of people are coming and going from the retail establishments. This is especially true at a time when the gross size of payrolls has already shrunk so dramatically. With all that said, if we do get a below-consensus number tomorrow then I’ll take it as reasonable evidence that we can reject the null hypothesis that the underlying run rate of Claims is 445-480k.

So far, though, I think economists are looking too much at the improvement from the 500k print from August (see Chart). Sure, 425k from 500k looks like a trend, but the 500k number wasn’t any more real than the 427k dip from early July. The “trend,” if you want to call it that, is from an average around 455k, so I think people are getting enthusiastic about false optics.

The improvement from the previous range is still pretty feeble. The improvement from the local peak is what has economist (too) excited.

That being said – if the Labor Department were to toss out, say, a 410k figure then the bond market doesn’t have many people waiting around to catch that knife. Initial Claims isn’t something I ordinarily get very excited about, but these days it’s worth keeping an eye on.

Categories: Economy

A Welcome Retreat, But Is It Enough?

December 7, 2010 3 comments

The highest 10-year yields since mid-June were the reward for the news that President Obama had executed a remarkable pirouette and agreed to extend the duration of the Bush-era tax rates. 3.17% is not exactly an asphyxiating rate of nominal interest, but compared to the 2.39% rate that prevailed in early October or the ~2.55% rate that was the standard when Bernanke first broached the subject of QE2 back in August, this seems almost dizzying.

Stocks initially rallied on the notion that the deal will help stimulate the economy, although equities hadn’t exactly been selling off on the alternative – other investors seem to have noticed that, and the market ended flat. Volume was much heavier than it had been over the last few days, actually more than double Monday’s tepid volume, at 1.57bln shares. An unchanged market isn’t awe-inspiring, but the internals were encouraging (at least for technical types). I personally think that the growth estimate baked into current index levels is very generous, but there is no question that such an estimate is more plausible today than yesterday – at least, in the short run.

The about-face from Obama is interesting. Whereas the Administration previously had been insisting that some Americans get higher tax rates and that the tax code get even more progressive, it finally agreed to allow tax cuts for all on the condition that there be … even more tax cuts. In addition to the two-year extension in the marginal tax rates, there were increases in various credits such as the earned-income tax credit and a small reduction in payroll taxes.

Assuming that the President still has the charisma to get his own party to agree to passage, and assuming that the Republicans don’t also do an about-face now and insist on higher taxes, the agreement effectively removes the possibility that gridlock will cause a large rise in taxes and crush consumption. It is a clear positive for near-term growth. And, to the extent that the Federal Reserve was taking the oars in order to pull the economy through that potential Q1 swamp, it makes QE2 less necessary (since it was mostly political cover anyway, and a risky form of it at that). So this is all good news. We may as well enjoy it, because after Friday’s Employment report good news seems to be at a premium. The chart below shows the S&P index against the Citigroup Economic Surprise Index for the USD. You can see that the improvement in the indices from September occurred in concert with a gradual improvement in the tenor of the data, but the report on Friday really damaged the underlying sense of consistent positive surprises in the data.

Friday's economic surprise removed one underlying support to the rally.

As I noted yesterday, there is really not much in the way of significant data this week, so the Citi Surprise index isn’t going to improve very much for a little while. I don’t know whether this will be significant: I am just pointing it out.


I have previously on this site presented the output from my model(s) of core inflation, which indicated a trough in year-on-year core inflation in September. (I have two marginally different models which I usually run with two marginally different sets of parameters in order to get a sense of the sensitivity of the model and a range of potential estimates.) The actual trough, because of base effects, was probably October’s figure; we will find out next week. However, for more than a year now I have always presented the models’ forecasts with great big, flashing-letter warnings because the models treat “core inflation” as a homogeneous slurry and do not differentiate between the various subcomponents of core inflation.

Ordinarily, that is not a fatal assumption because to the extent that there are “special effects” that perturb one part of core inflation, they tend to be random (and mean-reverting) and typically not large. But over the last couple of years, as I have noted repeatedly, core inflation has really been composed of two heterogeneous parts: housing, which is descending from a bubble and can be expected to exhibit depressed price pressures regardless of the underlying dynamics of the economy, and core-ex-housing. These are roughly equal parts, and so a model that predicts the sum of two basically different variables should rightly be used with caution.

I finally got around to bifurcating my model and re-estimating the coefficients with respect to forecasting ex-housing core inflation. That is, using essentially one of the same models as I was using before I can now produce a forecast of ex-housing inflation. I can combine that with a very simple model of housing inflation (such as one based on the inventory of existing homes, which I illustrated here) and solve the problem that the model was trying to predict something that is inherently not “normal” right now.

The encouraging outcome is that the resulting forecast series is very similar to the forecasts made with the naïve model that ignores the dynamics in the housing market. The chart below shows a whole riot of lines: The thin solid (green and orange) lines are the old models; the purple dashed line is the “new” model using the same explanatory variables but predicting housing and ex-housing separately and then combining the results. The thick red dashed line shows the average of the three models, and the heavy black line shows the actual results.

The new model (purple line) suggests that the biggest drag from housing is mostly past.

One quick technical observation: don’t read too much into the little spike running up into January followed by a setback. That spike occurs because I am using set lags rather than distributed lags, and it just happens that some important lags all lined up with interesting moves in the variables at different times. The true forecast path is better thought of as a smoother line connecting the last solid-black point and the last dashed-red point. Someday I may refine the methodology but this serves my purposes for now. The point estimate right now stands at 1.5% core CPI for calendar 2011. The risks lie predominantly on the upside; the main risk is that a sudden shift in the monetary dynamic abruptly flushes a large quantity of bank reserves into M2 where it can do real damage (see my comment here to get a sense of how big a shift that would be).

The inflation market currently is pricing 1.4%-1.5% inflation for 2011 (it depends a little on how you look at the seasonal pattern in December 2011 versus 2010), so it seems to be approximately fairly priced for a change. Inflation for 2012 is priced at 1.7%, however. That not only seems a little low to me, but monetary policy errors would probably have a much larger effect on 2012 inflation than on 2011 inflation (at least some of which is already “baked into the cake”). This makes Jul-13 TIPS, at -0.5% real yield, appear to be an attractive alternative to nominal Treasuries at 0.685% for the same maturity. Neither one is going to rock your world performance-wise, but if I were an institutional money manager I would be optimistic that inflation will exceed 1.3% per year for the next couple of years.

Categories: CPI

Oh, Ye Of Little Faith

December 6, 2010 2 comments

The December doldrums may have officially set in, with equity market volume today essentially matching the lowest readings of the year (with the singular exception of the day after Thanksgiving). And this, mind you, is on the day after Chairman Bernanke’s appearance on “60 Minutes” to defend (again) the Federal Reserve’s approach and reputation.

Some regular readers of this column might expect me to launch into the Chairman for this appearance and some of the things he said. But far be it from me to criticize a Princeton economics professor and his explanation of the Federal Reserve’s mission and powers and the efficacy of monetary policy in bringing about economic Nirvana.

Indeed, there can certainly be no benefit in my commentary on remarks such as this:

Bernanke: Well, this fear of inflation, I think is way overstated. We’ve looked at it very, very carefully. We’ve analyzed it every which way…We’ve been very, very clear that we will not allow inflation to rise above 2% or less…We could raise interest rates in 15 minutes if we have to. So, there really is no problem with raising rates, tightening monetary policy, slowing the economy, reducing inflation, at the appropriate time.

Clearly, the Chairman is so much beyond my poor ability to comprehend that the apparent insensibility of this statement is mere illusion. I know what you’re thinking. You’re probably saying “but surely, if Professor Bernanke’s students were to assert this, they would flunk the ‘Money and Banking’ course, since whether or not the Fed can practically raise rates instantly has no bearing on the fact that the (uncertain) effect of that policy action would only be felt six-to-eighteen months later.”

Poor, poor benighted readers! Bernanke is playing the meta-game – the game behind the game. Mere mortals like us cannot begin to grasp his plan. This much must be obvious, even though you and I are sorely tempted to wonder why the interviewer doesn’t ask something like “if you really have that kind of power, why don’t you simply turn the dials and get growth and inflation to where you want it in the 15 minutes after we’re done with this interview?” That would be very cruel: to imply that the Chairman either doesn’t have the sort of power he asserts, or doesn’t have compassion for all of those people who would really like him use this power for the personal benefit of the millions of out-of-work Americans and tens or hundreds of millions of underutilized workers around the world. For shame!

I do not speak for our great Chairman, but I can assure you that there is a greater good at play here. It obviously suits his purpose to let some people – for example, the self-righteous pundits who spill virtual ink on the internet but cannot comprehend the mind of Ben – believe that he doesn’t have such power, that he is simply saying such things because he doesn’t want bondholders to riot and stop him from getting away with monetizing their debt for a much longer period. What a great man he is, and must be, for saying things that would tend to make lesser people think he is actually a damn fool who believes in his own infallibility far more than is healthy for himself and for the economy. He accepts these slings and barbs, knowing that he is the right man, in the right place, at the right time, and ultimately He will triumph and smite the wicked.

Most of us, cursed with less certainty about our ability to predict with perfect foresight, would proceed far too tentatively. We would tend to be cautious, knowing that there is a natural cognitive bias towards overconfidence. But for one like Dr. Bernanke, gifted with superior prognosticative abilities (not to mention a devastating handsomeness), such plebeian concerns are almost amusing.

Pelley: You have what degree of confidence in your ability to control this?

Bernanke: One hundred percent.

So I hope that it is clear. We are in good hands. It is pointless to resist. You will be assimilated.


This seems as good a time as any for me to go have a nice, stiff glass of Diet Coke while reminiscing about other great feats of prognosticative certainty. “Peace for our time!” exulted Chamberlain.

It isn’t that Bernanke is wrong, although I think he is. It is that he is preternaturally certain about things which, rationally, he should be not only less certain but, dad-blame-it, uncertain. This is extraordinarily dangerous.

Unless, of course, there is indeed a meta-game here that I am missing. I have said before in this space that I would find it incredible if the Fed actually believes that QE2 will have dramatic effects on growth (especially while they continue to restrain the passage of quantitative easing into the money supply by continuing to pay Interest on Excess Reserves). But I think they were in a situation – especially with some elements in Congress that would like to slap the Friedmanian shackles on them and constrain them to a very narrow mandate – where they needed to appear to be doing something. And, perhaps, Bernanke’s appearance on “60 Minutes” is meant to burnish the Fed’s reputation and buttress its defenses against Congressional incursions on its powers. But either way, it strikes me as ill-advised. By appearing certain, he may rally his support among the in-cognoscenti, but people who really do understand that monetary policy is an art (at best) rather than a science are just scared, scared. And those people are the ones who own trillions of dollars worth of bonds.

We can spend another day or two dwelling on the significance of the Chairman’s appearance – there is no meaningful economic data until Thursday, and that is only if you define “significant” to include weekly Initial Claims during the holiday season.

Categories: Federal Reserve
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