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If This Is Right, I Sure Don’t Want To See Wrong
Well, it isn’t the first time but I was wrong. It turns out there was a big miss in the Employment report.
Payrolls rose by only 39,000 employees in November, versus +150,000 that had been expected. There were net upward revisions of 38,000 to prior months, so that the net increase in jobs was 77,000. Moreover, the Unemployment Rate wasn’t steady. It didn’t go up 0.1%. It went up 0.2%, to 9.8%; it was actually 9.817%, so it wasn’t even that it was rounded up…the Rate legitimately rose. The labor force participation rate held at a 24-year-low of 64.5%; note that when the labor force participation rate rises, it tends to increase the Unemployment Rate at first since at first the new people in the labor force are merely looking. Believe it or not, there is a possibility that we haven’t seen the cyclical high in Unemployment yet. The 2009 high was 10.1%. Whether we get there or not, however, the simple fact is that over the last year or two, despite a massively higher stock market, enormous federal expenditures, and a couple of quantitative easings, the Unemployment Rate is roughly unchanged from a year ago and 0.4% higher than eighteen months ago.
One lesson that would-be economists should learn from today’s data, by the way, is that if you want to know whether the job market is doing well, simply asking the guy on the street is a pretty decent way to find out. The guy in the flashy suit and the bow tie, sitting in a fancy office on Wall Street and showing up on CNBC from time to time, may have some neat models, but the employment situation is something that the average Joe is more attuned to (unlike he is with inflation, where as I have pointed out before cognitive biases limit his ability to correctly perceive changes in the aggregate price level). The Consumer Confidence “Jobs Hard To Get” subindex is currently at 46.5, not far away from the cyclical high of 49.4 hit last October (when the cyclical peak in Unemployment was also hit). Until that indicator begins to decline in earnest, it will be hard to be too sanguine about job market opportunities.
Where I was also wrong, more poignantly, is in the market reaction to such a number. Although this was a perfectly awful number, stocks traded as if they hadn’t noticed the data, and finished with a gain, only 1 point from the year’s high close! Volumes were the lightest of the week (instead of being the heaviest, as is more the norm for an Employment Friday). It almost seems as if investors are trying to convince themselves that bad news is actually good news because it implies more quantitative easing (but does it?) and increases the chance of a deal on taxes (but does it?). The buck fell, which makes sense, and commodities rallied as a result. However, inflation markets fell, which is odd given the rally in commodities but at least is the right direction given weak growth data.
This latter point is worth mentioning, incidentally. The sharper-penciled economists have long been basing their forecasts for 2011, and in particular Q1 and Q2, on their assumptions of whether the Bush tax cuts would be extended (and for whom), whether extended unemployment benefits would be granted, whether the AMT fix would be implemented, and a few other matters of less cosmic importance. It seems that the assumptions generally have been that extended unemployment benefits would be extended further/again, that the AMT would be fixed as usual, and that the current tax regime would be extended for at least most taxpayers. To date, none of this has happened, and although there is much smoke about the issue I don’t see any fire.
This really matters, because failing to extend those tax rates would mean a huge fiscal hit to the economy. Now, remember that I am pretty skeptical about the ability of fiscal policy to be stimulative or anti-stimulative in the long run. This is less true when we are dealing with taxation than with spending, but it is still mostly true in my view. If tax rates jump up, this means that consumers will take a huge hit to their earnings. But it will also mean that the federal deficit will improve, which means the government will have to sell fewer bonds, which means that people who would otherwise buy those bonds will have more money than they otherwise would. The short run fiscal effect happens because the extra investable money those investors have only filters back into the economy slowly (for example, when they fund a startup enterprise, or pay a smart inflation guy to consult on what to do with all that extra money when Treasury rates are near zero) while the money the consumers lose is money they would have spent a large proportion of right away.
In other words, it is the opposite of spending money on inefficient and useless “shovel ready” projects that put money in people’s pockets to be spent today but costs the taxpayers decades to pay off. If we could trust the Congress not to spend this “windfall,” then it wouldn’t be a total long-term disaster (although lower spending is better than higher taxes as a deficit palliative, since government spending tends to be inefficient relative to the private sector).
But, in the short-term, it would be a disaster. In an article back in September, Goldman stated that “letting all of these provisions expire would subtract nearly 10 percentage points from annualized disposable income growth in Q1 2011, which could translate into a nearly 2 percentage point decline in final demand and nearly that large a drag on GDP in the first half of 2011.” Frankly, if we got a 10% annualized decline in disposable income growth from the already-stressed levels we are at following the recession, I would expect a larger pass-through than 2% to final demand…but it’s hard to argue with the Goldman economists.
This is now a pretty real-and-present danger. The lame duck Congress really has no reason to act and provide cover for the incoming GOP House. While one would expect the incoming Congressmen to retroactively “fix” the rates, that isn’t entirely clear either since many of them were elected on a platform of fiscal conservatism and having your first vote be one that increases the deficit by $300bln is not exactly an easy call (this, of course, is why the party who is leaving power is more than happy to leave that Hobson’s choice to the incoming party). But even if they did retroactively restore the Bush rates, fix the AMT, and extend unemployment benefits, is there any guarantee that the President would sign all of those bills? And even in the best of cases, the mess it would create (and the additional withholding that would be taken in the early weeks of the year) would itself be disruptive.
QE2 was, in my view, partly implemented because the Fed (whose Chairman is making yet another appearance on “60 Minutes” this weekend. The guy is as overexposed as Jessica Simpson) was aware that such a train wreck was a non-negligible possibility, and needed to “do something” as the only ones who weren’t paralyzed heading into the elections. They deserve some credit for seeing the train wreck, although I’m not sure their actions were very helpful.
There is no economic data due on Monday. We will increasingly be trading, anyway, on political developments over the next few weeks: tax policy here, and machinations in the EU around the Irish bailout (e.g., will the Irish accept the terms?). Also, as we get closer to the end of the year, we will get spastic moves that have nothing to do with anything but illiquidity. I do intend to keep an eye on funding markets heading into year-end. I doubt that there will be any big problems in funding over the turn, and I am sure the Fed will be ready to smooth any rough sailing (after all, as the recent document dump shows they’ll help almost anyone). But this isn’t Monday’s trade.
Over the next week or so my “to-do” list includes breaking out a long-term yield chart to see where we are in the Big Picture and to detail a new inflation model of mine that incorporates housing separately from ex-housing drivers. So stay tuned!
Pending Home Sales Up; Pending Stock Sales Down
The stock market continues to look like a one-decision investment, as investors piled in for a second day and drove prices still higher. The S&P rose 1.3%, reflecting the ebullience and dare I say exuberance in European bond markets. Portuguese 10-year debt rallied 55bps, Ireland improved 36bps, and Greece and Spain both picked up 24bps (poor Ireland rallied a mere 14bps). The occasion for this show of enthusiasm was the meeting of the ECB – actually, more to the point it was that the ECB went into the market to buy bonds right after the meeting.
Clearly banks and investors had been pleading for additional support of the sovereign bond market (which they got) and an extension and even expansion of the special liquidity facilities (they got a one-quarter extension of special loans from the ECB, but no expansion of the program). But the ECB didn’t exactly surprise the market. ECB President Trichet, insisting that recent growth numbers have surprised on the upside … imagine how many banks would have failed already if growth had surprised on the downside!! … admitted that growth risks are currently tilted to the downside although he saw inflation risks as balanced. Yawn.
The equity market rally was aided by a surge in October Pending Home Sales, which leapt 10% month-over-month. Investors overlooked the worse-than-expected Initial Claims (although 436k is still better than we have seen for a while) to focus on this rather unimportant report. To put the jump into context, I think it is worthwhile to look at the year-on-year number. See the chart below (Source: Bloomberg) for that. You see, we also had a surge in Pending Home Sales last fall, so that the monthly spike appears more likely to be the result of poor seasonal adjustment affecting the report in the autumn.
Yeah, the monthly surge in pending home sales doesn't really look impressive on a y/y basis.
U.S. Treasury note yields rose on all of the (scoff!) good news, with the 10y yield rising to a heady 2.99%. The dollar weakened, and the VIX weakened. It would seem that many investors feel the crisis is over. Again. Or perhaps they just hope that it is over for this year.
Before we get too far out in front of this wonderful, powerful, riskless recovery, we probably should pause to look at tomorrow’s Employment report. Recall that last month’s report was a mess, with strong private payrolls yet an Unemployment Rate that barely missed ticking higher and a labor force participation rate that fell to a 24-year low. The market that day initially focused on the Jobs number but was unable to hold early gains. However, looking back on it now, people seem to recall that it was a strong Employment report and they are looking to draw grand conclusions if tomorrow’s report makes it two in a row.
The Consensus forecast is achievable, with expectations for 150k new jobs and a 9.6% Unemployment Rate (unchanged, but this probably implies a small improvement). But while Initial Claims have recently looked positive, there are other indicators that are not so strong. In particular I am mindful of the Jobs-Hard-To-Get element of the Consumer Confidence report. The ADP, which clocked in at a better-than-expected +93k on Wednesday, is consistent with a 101k showing from private payrolls (see chart below).
The 93k ADP figure suggests that +100k is roughly what we should expect from private payrolls.
Accordingly, I am not very sanguine about the number tomorrow although I don’t expect a huge miss; given the recent rally into previous resistance I think that playing stocks from the short side is a defensible trading strategy. It also is not clear to me that, once the ECB stops buying PIIGS bonds, there will be lots of other buyers lined up behind them – so while I wouldn’t short PIIGS bonds for spite (it is usually a bad short-term bet to fade the central bankers), if I were long I would get out.
The Non-Manufacturing ISM (Consensus: 54.8 from 54.3) is also scheduled for a mid-morning release. This isn’t likely to be a market mover.
One final public-service announcement. The Inflation-Indexed Investing Association is soliciting submissions for the inaugural edition of the Journal of Inflation-Indexed Investing. Submissions may be academic/theoretical or practitioner-oriented in nature. We will also consider rhetorical works that are relevant to the topic (these will be clearly indicated as “Opinion” in the Journal). Additionally, we are soliciting research works by undergraduate students on inflation-related topics (which works will also be indicated as such when published). For the full description of the submission process and author guidelines, follow this link. And please feel free to forward that link to anyone you know who may be interested in submitting research.
Lots Of Options
Oh, year-end illiquidity is lots of fun, isn’t it?
After yesterday’s fairly high-volume selloff (the 1.5bln shares was the highest non-witching volume since July 1st), the market launched higher overnight on essentially nothing. The rally was attributed to oblique comments by ECB President Trichet that we should not underestimate Europe’s determination to resolve the current crisis, in an article in the Financial Times entitled “Trichet hints at bond purchase rethink.” The thought is that the ECB might buy more sovereign bonds.
So what? Supposedly, the ECB is sterilizing the purchases, draining the money they use to buy bonds with. So all that they’re doing is elevating sovereign bond prices above market-clearing levels. I can see how that helps the politicians who want to spend more money and not pay higher interest rates (one of the funniest things I have read in the last few days is that the 5.8% aggregate interest rate on Ireland’s package was “punitive.” Really? The market wasn’t willing to fund you at anything close to that level. How is 300bps below market rates “punitive”?), but I don’t see how it helps equity markets. Especially, U.S. equity markets.
But the 2.2% rally in stocks, to the highest level in weeks and above the 1200 level on the S&P, occurred on slightly more than $1bln shares in volume. That’s not horrible, but it’s not exactly a sign that everyone is piling into the boat before it leaves the pier. The VIX fell, but not enough to make you think risk is switched off; the dollar declined, but not so much that it looks like investors are rushing back to the continent. I expect the T-1000 isn’t done yet merely because Trichet murmurs soothing bromides to the newspapers.
The economic picture is improving on this side of the pond, no doubt, but before attributing the rally to that one should be aware that the S&P was essentially over 1200 before ADP even printed. The ADP report was in fact slightly better-than-expected, at 93k (as I noted yesterday, the risks to ADP were to the upside, and the risks to Payrolls are on the downside although less so now). The ISM report was as-expected. Car sales were a bit stronger than expected, but 9.27mm domestic car sales is not going to get anyone thinking that happy days are here again (especially since the Big Three are all still making cars). In general, these are cheerful numbers but not exactly explosive.
Bond yields, though, were explosive! The 10y note yield jumped 17bps to 2.97%, and inflation swaps widened 5-6bps. That 10y yield is the highest since late July, and with the strong autumnal seasonal pattern fully past the bond market looks on fragile ground. Before the ECB ramps up their own purchase program, they should reflect on the fact that the Fed’s unsterilized program has failed to keep yields from rising. The purposes of the two central banks are different, but their chosen weapons – purchases of sovereign bonds, in an effort to keep interest rates from rising or to push them lower – are the same.
If yields continue to rise, eventually duration extension of mortgage portfolios begins to become an issue. Although the mortgage securities market is slightly smaller now than it used to be, and although many mortgage securities are now held by an entity that seems to care little about its duration (the Fed), the hedging needs of mortgage portfolios may still be problematic if they occur in December. Liquidity isn’t very good in December. Moreover, the fact that the Fed doesn’t care about hedging changes in its portfolio duration doesn’t mean that changes in the behavior of its portfolio will not matter. Higher mortgage rates imply smaller prepayments, and smaller prepayments means the Fed’s need to reinvest those prepayments is also smaller. I am not a mortgage quant, so I don’t know exactly where the inflection points are that we have to worry about. But as a former rates trader, I know we should be worrying about them.
While I am mentioning delta-hedging (since that is what a mortgage hedger is doing by buying when the market is rallying and selling when the market is declining: delta-hedging the options embedded in the mortgage security), it is perhaps an opportune time to mention another concern that has been troubling me recently.
Let me first digress for just a moment to introduce quickly a couple of options-related concepts. Those of you who are intimately familiar or at least very comfortable with options concepts can skip this next section.
Quick Option Primer
The delta of an option is the sensitivity of the option’s price to a change in the price of the underlying instrument. For example, if I own a call option with a delta of 0.3 and the underlying bond rises one point, then I expect the option price to rise 0.3 points (all else being equal).
The delta of an option is intimately related to the strike price of the option (that is, the price at which the option owner can elect to buy, if it is a call option, or sell, if it is a put option). If the current price of the underlying security is below the strike price, then a call option’s delta will be less than 0.5. If the current price of the underlying security is above the strike price, then a call option’s delta will generally be above 0.5.[1] So, as the price of the underlying security goes from very far below the call option’s strike (“out of the money”) to very far above the strike (“in the money”), the delta goes from something near zero – it isn’t very sensitive at all to movements in the underlying price – to something near one – it moves in lock-step with the security it is about to become, once the option is exercised.
The way that the delta changes with respect to movements of the underlying security’s price around the strike price is called the gamma of the option. For an option with high gamma, the delta of the option changes very rapidly. The option, in other words, may go from being very insensitive to movements in the underlying security, to extremely sensitive to those movements, all in a short period of time. A crucial point is that the gamma of any vanilla option is at a maximum when the underlying instrument is at the strike price.
If you’re still with me, congratulations! Now for one more concept, and then I’ll explain my concern. An important concept in options theory (and trading) is the notion of a replicating portfolio. That sounds fancy, but all it really means is this: if I have sold you a call option, then when it expires I know that (a) if the option is in-the-money, I will have to deliver to you the underlying instrument because you will exercise the option. So I’d better have the bonds or stocks or whatever on-hand to deliver. And (b) if the option is out-of-the-money, I know you won’t exercise, so I don’t need to have any of the underlying on hand to deliver to you. In the period of time between when I sold you the option, and when you exercise that option, the “replicating portfolio” is (basically) a delta-weighted amount of the underlying instrument. In the example above, of the call with an 0.3 delta, if I sold you contracts on $1,000 worth of bonds then I need to have on hand $300 worth of bonds. If the bonds go up 1 point (1%), then I will have made $300 on my holdings of bonds, and the value of the option will also have gone up by 0.3 * $1,000 * 1% = $300. I am hedged. Under the conditions assumed in Black-Scholes, if price changes are continuous, rebalancing is costless, borrowing costs are the same as lending costs, volatility is constant and equal to the volatility priced into the option…then the fair price of the option is the cost of that hedging strategy. An option is nothing more than a pre-packaged hedging strategy.
And that hedging strategy has a cost, as you can see. If the market rises, then the delta of the option will increase as the option goes in-the-money. That means that to maintain the replicating portfolio, I need to buy more bonds as the market goes up. In reverse, as prices fall then the delta falls and I need to sell more bonds as the market falls. Even if there is no bid/offer spread, this is going to cost money because I am systematically buying high and selling low!
Back To The Story
You can also see implications for markets in this dynamic. While both option-owners and option-sellers can delta-hedge, if the hedging is done mostly by people who are short options then markets will tend to be more volatile since there will be lots of people buying into rallies and selling into selloffs. This is why the mortgage market can have such a big impact on the bond market in illiquid times. Owners of mortgage-backed securities are implicitly short options because the mortgagee (that’s you and me) tend to pay more slowly when rates are going up and pre-pay when rates are falling. Therefore, when rates are falling fairly rapidly and especially when the market is illiquid, sophisticated firms that have a lot of MBS (such as, say, the GSEs) will need to keep buying, and buying, and buying, pushing rates down faster and faster and faster. And the opposite effect occurs when rates are rising.
We haven’t had to worry much in the past about inflation options, because until the last year or so there haven’t been enough outstanding – relative to market liquidity – to worry about. And anyway, if they are randomly spread about then any effects from one hedger’s activities are diluted. But this is no longer the case. Dealers of inflation options are almost always two things: they tend to be short very low-strike options like -2% and -1% floors, which are generated when corporate treasurers issue CPI+2% or CPI+1% notes and then swap them. The corporate ILB market in the US is pretty small, so this isn’t a very large problem, but in 2008 it contributed to the complete collapse of the inflation swap quotes to deeply negative readings for the first several years (see Chart below, source Enduring Investments).
1y US CPI in the aftermath of the oil crash and gamma effects
The other, more dangerous case is that dealers are also almost always short high-strike options like 4%, 5%, and 6% caps on inflation. This is because customers in large majorities tend to be buyers of inflation protection rather than sellers (and you can tell this by the very high prices charged for inflation caps). The demand for this protection is nearly bottomless.
Now, we have never had a situation where inflation expectations rose suddenly, in the same way that they fell so abruptly when oil prices (and Lehman) crashed in late 2008. But if we were to have such an event – and it is certainly not out of the question – I wonder whether there are enough TIPS in the world, or people willing to sell inflation swaps into an obvious dynamic like this, to keep inflation measures from completely coming unglued. And what are the policy implications of this? If the Fed sees forward inflation expectations go from 2% to 3%, 4%, then 5% and 6% in rapid succession, what are they to do?
While I believe the teeth of this dynamic are far away – after all, core inflation is 0.6% – it may not be so far away as we think. Forward inflation between 5y and 10y is already well up and over 3% (see Chart below, source Enduring Investments), and when it comes to an inflation cap you care about each forward “caplet.”
CPI swaps curve
It isn’t something to worry about tomorrow, but it is something to worry about…unless you own caps and want to see forward inflation quotes fly!
Indeed, there is not much to worry about tomorrow…save your worrying for Friday’s Employment Report. On Thursday, the main releases are Initial Claims (Consensus: 424k from 407k), which are expected to show a significant bounce – watch bonds get smacked if they don’t! – and Pending Home Sales (Consensus: -1.0% vs -1.8% last month). I doubt this latter release has any traction the day before Employment. There are also several Fed speakers scheduled.
I expect that today’s prodigious leap higher in equities is not going to be sustained, but hope for solid Payrolls gains and a widening of the ECB bond-buying program might keep prices elevated for a day or two. I would be surprised at further extension, however, and think gravity will probably take over fairly soon.
[1] This is generally the case because the call delta minus the put delta will not sum to 1 but to the present value of 1. So if an option is only slightly in the money, with a long time to maturity, it will actually have a delta slightly less than 0.5. But this is a technical point not critical to the discussion here.
