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Ripples Of Inflation Concern
Another quiet, weather-dampened day as a minor ice/slush storm trickled across the Northeast. Traders easing back from the holidays defaulted to the recent, easy trade of buying stocks and selling bonds, which moved in their usual directions today.
Ostensibly, part of the reason for the rally was that “Euro-area finance ministers vowed to strengthen the safety net for debt-strapped countries yesterday, examining ways to give the 750 billion-euro ($1 trillion) rescue fund more flexibility without ruling out boosting its size…” (link to story).
It is very convenient that in this country we didn’t have to look to any other European headlines to know whether to be long equities (heck, it isn’t clear whether we need to look at news or data of any kind these days! Just buy, buy buy!). So, for example, we could blithely ignore the Wall Street Journal (Europe) headline that “Germans Remain Wary Over Boosting Bailout,” (link to story here) which certainly makes one wonder how those other Euro-area finance ministers are going to avoid ruling out boosting its size.
Spain canceled a 10y and 15y bond auction that had previously been scheduled for this Thursday. The masterful spin is that they preferred to get the better pricing offered by a syndicate of banks for the €4bln-5bln issue (link to story). Yes, that’s right: the story is that a group of banks are doing Spain a favor by paying more than the market would pay for a bunch of Spanish bonds. Is there any better sign that cynicism is in full retreat? It seems scarcely a year ago that banks were being flayed alive for their sins (actually, the Financial Reform Bill passed only seven months ago), and now we are expected to believe that in a spirit of generosity the gentle bankers are saying “shucks, there’s no need to go to the market, Spain! We’ll do it right here for you, out of the goodness of our hearts. Sure, we could simply bid in an auction but this is better for you, the client, and so it’s good for us. Peace out, y’all.” Right.
But I do detect a ripple of uncertainty, a tremor of doubt. Of course, it’s easier when that doubt is in the Barron’s Roundtable of this weekend’s edition.
The panelists were generally bullish on stocks, but almost all of them acknowledged that the market was fairly “fully” or aggressively priced and most of them could conceive of at least a correction. But what was striking to me was the exchange between several luminary investors who mentioned ‘concerns’ about inflation. The quotes are below. Please note that I don’t endorse any particular point of view here; these are just listed for the timbre of the comments:
Marc Faber: History has shown that giant countries on the way down are very dangerous because they are desperate…If you measure the stock market not in dollars but gold, it is down 80% since 1999. I no longer regard the U.S. dollar as a valid unit of account. People shouldn’t value their wealth in dollars because one day, in dollars, everyone will be a billionaire.
Bill Gross: I agree with Marc on many things, though not everything. I don’t know if the U.S. has reached a desperate point, but it is employing instruments and vehicles and policies that smack of desperation. We are not looking at a default here, but at years of accelerating inflation, which basically robs investors and labor of their real wages and earnings. We are looking at a currency that almost certainly will depreciate relative to other, stronger currencies in developing countries that have lower levels of debt and higher growth potential…
Marc Faber: It is much easier for a government to print money and default in the way Bill just explained than to come out and say ‘we aren’t going to pay half our debts.’…
Felix Zulauf: In the late 1970s and early 1980s, Paul Volcker crunched inflation by applying very high real interest rates for several years. Now we are getting the same process, just in reverse. Just as it took several years for the market to see that Volcker’s policies would lead to declines in inflation and interest rates, it will take several years for the market to realize the Fed’s current policies are highly inflationary…
And that exchange didn’t even include Fred Hickey!
There are a few nuances I don’t agree with here. For example, inflation doesn’t really solve all of our problems like a default does; we will have to ‘default’ on some of the promises made for our grand entitlements of Social Security (maybe) and Medicare (almost certainly). But ignoring those nuances, this is an amazing series of observations from some very heavy hitters in the investing world. No wonder TIPS did well today despite an impending auction. No wonder the dollar dropped to 2-month lows!
Since we’re talking about the viewpoints of Barron’s Roundtable participants, I should take pains to point out the Outlook for Inflation piece I wrote over the weekend and which you may have missed if you were on holiday today. I also should note that my company specializes in inflation and can examine how industry- or region-specific inflation impacts your business. If you share my views, and that of many Roundtable members, about the medium-term course of prices, you should carefully consider your risks here.
Also note that we’ve just posted a new website for the Inflation-Indexed Investing Association as a companion to the LinkedIn group of the same name. The website (www.inflationinfo.com) is intended to become a hub where investors can access high-quality research on inflation and other resources. There is a lot of work to be done yet compiling the information, but if you’re looking information on inflation this is a place you will want to look.
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Today’s Empire Manufacturing report was in line with expectations but mostly ignored. Tomorrow’s Housing Starts (Consensus: 550k vs 555k last) is not anticipated to move mountains. A sustained move of Housing Starts over 600k units is necessary before anyone gets too excited about the contribution of housing to growth; in the meantime, weak construction activity helps slowly clear the inventory (but it’s very slow, since most of the inventory is in the much larger stock of existing homes, so 25k or 50k per year in housing starts isn’t going to make a huge difference).
Bonds seem reasonably stable here, but I think we’re all staring at the branch stocks are crawling out on and waiting for it to break. Some people are waiting for that break because they’d like to buy the market 5% lower, while some see a much more severe move and/or trend ahead. The question is moot while we all stare dumbly at a market which is sputtering, but sputtering consistently higher. I feel a little helpless. Experience tells me not to address the feeling of helplessness by trying to do something, but the fact that the market keeps inching higher is a sign that not everyone feels that way. In my mind, it’s (still) time for waiting.
The Outlook For Inflation
Retail Sales was softer-than-expected (+0.6%, +0.5% ex-auto, plus downward revisions, versus 0.8%/0.7% expected), Industrial Production stronger-than-expected (+0.8% versus +0.5%), and CPI a smidge above expectations (maintaining 0.8% y/y on core, and rising to 1.5% y/y on headline). More on CPI later.
“Close enough!” cried the equity traders, who subsequently put up prices 0.7% on the day, to 28-month highs in the S&P. Bond traders also felt the balance favored a stronger economy and faster price increases, but moved yields only a few basis points higher with the 10y note to 3.33%. Inflation swaps curiously softened 2-5bps despite the reasonably sunny outlook for carry; some traders and investors feel the inflation market is a bit frothy right now – which it is, but supply is tight and I am not sure I’d be very aggressive about shorting inflation-linked bonds even at these valuations.
With Friday’s trading, the Jan-2011 TIPS have matured. The yield of the bond over its lifetime is a picture of the economy of the 2000s (see Chart, source MorganMarkets). The recession of the early part of the decade shows up clearly, as does the expansion from 2004-07; the dip in late 2007 as the developing recession became apparent was followed by the spike as Lehman collapsed and balance sheets became allergic to anything except TBills. It was clearly the buying opportunity of the last few decades in fixed-income, as the ongoing crisis was more consistent with sub-zero real yields, and the issue subsequently rallied nearly 700 basis points in 15 months from December 2008 to March 2010.
Jan 11s, we'll miss ye.
So now, let’s talk about CPI.
Core CPI was +0.092% month-on-month; the annual rate of change rose slightly to +0.804%. I’d mentioned yesterday the potential for a surprise higher in the monthly change because of the reversal of last month’s seasonal adjustment quirk (which, in November, held the monthly change down). This didn’t happen, and my suspicion is that the main part of the effect will actually be seen in this month: January 2010’s seasonally-adjusted change in core CPI was a rather surprising -0.14%, which accounts for most of the difference in the seasonally-adjusted and non-seasonally-adjusted year-on-year series. We will have to wait a month to see.
But that is just sharp-pencil trivia for the bow-tied set. The bottom line is that the year-on-year change in core CPI is now rising. The headline figure did surprise on the upside, printing +0.505% to put the year-on-year rise at +1.496%. This was accomplished mostly through the rise in commodities (gasoline contributed 0.37% to the headline number, so with core+gasoline you have almost all of the month’s change), and more of that is to come over the next few months.
Perhaps more surprising is that the second-largest contribution came from housing, which added 0.08% to the overall figure and therefore accounts for just about all of the rise in core CPI. This is remarkable – it was the largest such contribution in years. This is probably a reasonable time for a step back and a re-think about the overall outlook for inflation.
The Outlook For Inflation
Current Conditions:
The basic pricing conditions in the United States at present are:
- Housing continues to drag on core inflation, but far less than it had been. The y/y change in Shelter is 0.447%, compared to 0.804% for the overall core. The main two components of Shelter are “Rent of Primary Residence” (that is, if you are a renter rather than an owner) and “Owners’ Equivalent Rent of Residences” (that is, what is happening to the consumption value of your home, as distinct from its investment value). These two series are illustrated in the chart below. While OER is only up 0.282% y/y, Rent of Primary Residence has risen 0.798%: essentially in-line with core. The chart (source: BLS) illustrates that at least the near-term pricing dynamic has changed.
Surprisingly, housing is now contributing to inflation.
- Offsetting this surprising rebound in housing (Shelter is around 40% of core inflation), just about everything else has seen price inflation decelerating. The core-ex-housing number, which was cause for much alarm last year when it spiked near 3%, has plunged to just over 1% (see Chart below). Apparel (about 4% of core) has plunged from +2% to -1%, Recreation (about 8% of core) is contracting at -0.8%, Education inflation (about 4% of core) has shaved from 5% to 4%, and Communication inflation (about 4%) has gone from 0% to -1%. About the only major core element (other than housing) that hasn’t decelerated very much is Medical Care (8.5% of core), but it also isn’t accelerating.
To my surprise - although anticipated by my models - core ex-housing has regressed to the core number rather than the other way around.
- This is not wholly surprising. Two models of core inflation that I follow have predicted this declining trajectory of core inflation; both models predict a turn higher now. I wouldn’t have expected core inflation to evolve this way – with housing inflation bouncing higher while core-ex-housing provided a drag – but the outcome is approximately in line with my models, which broadly suggested core inflation declining to around 1% until Q3 or Q4 and then remaining at approximately that level through mid-2011. In the event, core inflation has overshot on the downside somewhat, but not egregiously so.
- Commodities will continue to place upward pressure on headline inflation relative to core inflation at least for the near-term, and I think probably for the medium-term as well.
- Because of the general decline in the volatility of price changes, and in the dispersion of price changes (that is, most items are experiencing broadly similar inflation), inflation feels lower than it has for some time previously. With reported CPI around 1.5%, I estimate the “real feel” inflation at around 2.7%, which is nearly as low as it has been at any time in the last forty years except during the financial crisis (You can read more about the “real feel” inflation temperature here). Consumers are perceiving a broadly stable pricing environment, which is probably one reason that the stock market is doing so well and confidence is rising. Gasoline, however, could change all that: the real-feel jumped from 2.4% in November.
Base Forecast:
Aggregated models of core inflation and one which separately forecasts housing inflation both project rising inflation going forward. The average of the models is 1.5% for 2011 core inflation. Interestingly, the model that separates out housing inflation projects 1.8%, but then converges in 2012.
The main influences on the 2011 inflation outlook are the late-2008 spike in money supply, the decline in the dollar over 2009, and the level of core inflation in late 2010. It is important to realize that there are long lags in the pass-through of monetary policy to inflation. Most of the broad currents of 2011 inflation have long since been formed. Policymakers are right now working on policies that will influence 2012 and 2013 inflation, but not much will drastically change the outlook for core inflation in 2011.
Risks to the Outlook:
However, the model is not “fully specified.” That is, not every possible influence on inflation is included in the model – mostly because there are all kinds of influences that I can’t imagine, or because some influences operate with variable lags. For example, my models do not include consumer expectations of inflation. Partly, this is because I don’t think they have a lot to do with inflation, but the Federal Reserve thinks they are very important and if they’re right, my model will miss inflation zigzags that are caused by changes in consumer expectations and not captured in other variables. I also do not model changes in money velocity directly, but this can be as important or even more important than the level of the money stock itself.
The risks to the outlook have been generally to the upside over the last year or so, but seem to be somewhat more balanced now that core ex-housing has decelerated. Of course, when we are near the lows we should expect that inflation feels saggy and that the risks seem more balanced. Here are what I see as the main risks to the outlook.
Downward Risks
- My models do not have a role for the output gap. In my econometric work, I haven’t found that the output gap adds any explanatory power to a model that already includes monetary variables (and I’m not the first person to notice this: Fama in 1982 is the first person I’m aware of to show it). But this may have happened if I looked for a linear influence, while the influence is actually nonlinear – that is, maybe small output gaps don’t matter but large output gaps, about which there is limited experience in the data sets, matter. If this is the case, then the large output gap we currently have will dampen inflation more than I expect it to.
- In my models, leverage plays an important role. High levels of private leverage tends to dampen inflation; moreover, since leverage is related to the velocity of money, stable leverage tends to imply stable money velocity and thus a stable quantity of money. After signs in 2008-09 that an important deleveraging trend was underway, that trend slowed in late 2010 as the Federal Reserve has worked hard to maintain the degree of systemic leverage. I think this is a really bad long-term idea, but in the short-term there’s no question that a collapse of leverage could lead to extremely bad growth outcomes. From an inflation perspective, though, high levels of private debt relative to public debt tends to dampen inflation, so by encouraging leverage the Fed is somewhat inhibiting medium-term inflation. If the deleveraging trend turns back into releveraging, it will tend to truncate some of the more bullish inflation scenarios.
Upward Risks
- Money supply growth has remained tepid although it is accelerating, but the Federal Reserve is clearly trying to increase money growth. As I noted before, normal money supply growth passes into inflation with a long lag but if there was sharp money growth then some of that increase would likely pass through into inflation in a shorter time-frame (quantitatively, my models assumed fixed lags but in reality the lags ought to be distributed…that is, the pass-through happens over time. When the changes are small this is not terribly important but for large changes we could feel some effects sooner). Now, the Fed doesn’t want a sharp increase in transactional money (e.g., M2) even though it is pumping massive amounts of liquidity onto bank balance sheets. As I wrote several months ago (see comment here), we don’t know how or if that money multiplier will return to normal. If it doesn’t happen until the Fed withdraws the M0, that produces one outcome; if it suddenly snaps back then that could cause a massive, uncontrolled rise in M2. That isn’t my null hypothesis, but we really don’t know how this will work (no matter how confident the Chairman is about it) and the direction of the risk is quite clear.
- The Fed, despite protestations to the contrary, has no way to unwind liquidity provisions in a rapid, yet orderly way and likely would be slow to do so even if inflation began to rise. This doesn’t affect 2011 inflation, but it implies that the medium-term trajectory for inflation probably needs to take into account the fact that the Fed will not be leaning against the wind in its normal fashion.
- Majority political preferences all favor higher inflation because it seems to solve some problems (at least at moderate levels of inflation) at a low cost. Therefore, most political decisions are likely to be made without particular concern for the effect on the pricing dynamic.
- The dollar is unlikely to rise sharply (although it may rise), but conceivably could fall sharply if public debt grows too onerous. See Iceland, whose currency fell 50% against the dollar in 2008. There is little doubt that Greece’s and Ireland’s currencies would have been similarly penalized had they not been on the Euro (incidentally, this is also the reason that Iceland will recover long before Greece or Ireland – the latter countries lack one crucial automatic stabilizer). It isn’t likely to happen here, but it could.
- I mentioned above the risk that private leverage reasserts itself, but the flip side of that risk is the risk that public debt simply explodes. What really matters to inflation is actually less the amount of debt but whether that debt is largely private (which is disinflationary) or public (which tends to be inflationary). For a long period of time, the ratio of Federal, State, and Local debt as a proportion of total debt has been fairly stable between 22% and 37%, but the huge deficits of the last couple years combined with whatever private deleveraging there was has pushed that ratio to the upper end of that range (as of Q3. When the Q4 numbers come out it will be shocking if we aren’t at new multi-generational highs of that ratio). Even if deleveraging stops, the increase of the public debt creates ever-larger incentives to inflate it away. This wouldn’t likely manifest as a 2011 risk except through a currency collapse as mentioned above, but it is a very large problem for the medium term. I’ve run charts before but the Financial Times had an excellent article on the debt problem on Thursday. Below you can see the key illustration from that article.
Source: Financial Times, Jan 13, 2011
I’ll end there. The bottom line is that the 2011 trajectory will be to roughly a doubling of core inflation with a good chance of headline figures outpacing the rise in core (and perhaps significantly). The less-stable pricing environment will also likely produce a larger jump in perceived inflation. There are both upward and downward risks to this forecast, but the upward risks in my view predominate – especially in the medium- and long-term outlooks.
The bond market is closed on Monday for the Martin Luther King Jr. Day holiday, but on Tuesday the Empire Manufacturing (Consensus: 13.00 from 10.57) report is due out. The next regular installment of this comment will be on Tuesday evening.
Perfect Drugs From Perfect Pharmacists
We prepare to head into the long Martin Luther King Jr. Day weekend with some interesting data today and some even more interesting data tomorrow.
The report from the Labor Department that weekly initial claims for unemployment insurance rose to 445k versus expectations for 410k. Again we see that forecasters have gotten a bit too ebullient about the recent data. While our eyes tend to see on the chart (see below) a clear downtrend since August, statistically that downtrend isn’t there – because in August, the true underlying level of Claims wasn’t 500k, but more like 460k. Remember, these data are only samples of an underlying distribution that we cannot perceive directly. The spike in August tempted us to wonder if the second dip was beginning, but in fact it wasn’t. The July dip was paid back by the August jump, while the underlying process remained fairly stable.
The horizontal lines indicate the previous presumed range.
It does appear, though, that we have enough data to suggest that the underlying pace of Claims has improved from the 440-480k range it had held for nearly a year, but consider how much we actually know about that improvement. This week’s 445k figure was probably higher than it should have been because claims offices were catching up on last year’s paperwork, so the last several weeks should be considered together. The 8-week average is at 420k, and I think that’s probably a reasonable estimate of where we are. But if we have moved from a 440k-480k range to a distribution with 420k as the central tendency, that isn’t so dramatic. The eye creates a trend here, but in fact all we can say is that the underling pace of Claims has moved from “about” 460k to “about” 420k over the last couple of months. That does not imply that further improvement is automatically in store. Remember – as if this week’s data wasn’t reminder enough – that late-year and early-year seasonal are extremely uncertain.
The number knocked a tiny bit of froth out of stocks…with an emphasis on a tiny bit. Prices recovered almost to unchanged, because that’s what stock prices do these days, but bonds rallied and inflation swaps declined 4-5bps.
Looking over the Atlantic, ECB President Trichet offered what some observers saw as a threat that the ECB would raise interest rates to combat inflation if energy-price increases pass through to broad price increases. The German bond market, and others, sold off on his “conditional warning”:
“We see evidence of short-term upward pressure on overall inflation, mainly owing to energy prices, but this has not so far affected our assessment that price developments will remain in line…Very close monitoring of price developments is warranted.”
This is an empty threat. There is no chance that the ECB will raise rates to combat inflation while they are simultaneously buying every bond in sight to try and lower borrowing costs for member nations (and especially the periphery countries). The ECB may be slightly more politically independent than the Fed, but tightening while member nations are trying feverishly to balance their budgets – with their only chance being either a strong resurgent economy or a cheapening of their nominal liabilities through inflation – is highly unlikely.
Trichet has more credibility, though, than our own domestic monetary policymakers. I have to take some time here to mention Fed Vice-Chair Janet Yellen’s speech from last weekend, since I have been meaning to for several days. It is important because the speech was an important defense of the Large Scale Asset Purchase (LSAP) program that the Fed has been conducting, and in that context we should be very afraid of what comes next. Because if this is the best thinking they have to share on the subject, then we are in a situation not unlike the baby who finds Daddy’s firearm in an unlocked position. Tragedy is likely to ensue.
In a nutshell, Dr. Yellen’s argument boils down to this:
- The LSAP program is not affecting the dollar.
- The LSAP program is not triggering “significant excesses or imbalances in the United States.”
- The LSAP program does not risk markedly higher inflation because there is slack in the economy.
- However, the LSAP program has had an enormous effect on jobs, adding about 3 million jobs to the economy.
So, the program has been hugely successful in the ways they needed it to be, without any side effects and no chance of anything going wrong. Does it make me a bad person that I am naturally suspicious of a drug that will make me immensely strong, lengthen my life, improve my love life, and cure hangovers but has no negative side effects? How about if that drug worked as intended the first time it was tested?
Incidentally, the claim that the LSAP program has created about 3 million jobs is interesting because the Administration claimed 2 million jobs were saved or created through fiscal stimulus. Each is not claiming that their policy in conjunction with other policies not under their control created jobs, so these must be additive. Fiscal policy, plus monetary policy, saved or created some 5 million jobs. Right now, the Civilian Labor Force is 153,690,000 and unemployment is 14,485,000 (9.4%), so these actions have prevented an Unemployment Rate of about 12.7%. This is interesting because no one was forecasting a 12.7% Unemployment Rate before these programs were put into place, so the people who are now telling us that the drug is working perfectly are the same people who had previously told us that no drug would be needed.
These results – the 2 million, 3 million jobs – are coming from time series regressions that are conducted with high mathematics and great rigor. But there are lots of reasons that econometric analysis should not be expected to work well in this case:
- The distributions you are trying to analyze are not static, which is a precondition for most time series analysis, nor normal. Indeed, you are actually trying to change the distributions with your policy.
- It is pretty plain that the model is not completely specified. That is, the people who were examining whether fiscal policy was effective didn’t include the separate effect of monetary policy, and vice-versa, so they both think it was their policy which worked. The fact that both of these policies are pushing in the same direction at roughly the same time also creates a problem of multicollinearity, a technical condition that basically means that with two people pulling on the same rope at the same time it is hard to tell who is pulling how much.
- The noise in the relationships far outweigh the signal, which means that all conclusions will (or should) have massive error bars on them.
- The analyst is analyzing the result of a single experiment. It is like trying to divine the laws of motion after hitting a cue ball a single time on the break of a game of billiards, except that the balls aren’t round, you can’t measure anything directly, and you have dirt in your eye. But in this case, the implications of reaching incorrect conclusions are far greater than if you were lining up your next shot in a game of pool.
Econometricians ought to be more guarded about conclusions such as this. Indeed, any reasonable experience with financial data sets tends to produce the realization that it is often hard to get any conclusive information out of them, although it is very easy to generate suggestive relationships that can’t be rejected simply because the error bars are too large to reject any particular hypothesis. It may be that the econometricians within the Fed who are actually doing the dirty work are providing the policymakers with all of the proper caveats, and warnings about the usefulness of the data, and that they policymakers are simply ignoring it. Or it may be that econometricians at the Fed feel pressure knowing that while 90% of the time there is nothing conclusive to say, it is hard to support your case for continued employment when your results most of the time are indistinguishable from not working.
The Fed continues to be especially cavalier about the end game. Yellen says the Fed remains “unwaveringly committed” to price stability, but says:
“I disagree with the notion that the large quantity of reserves resulting from our asset purchases poses some special barrier to removing policy stimulus when the right time comes. The FOMC will be able to increase short-term rates by raising the interest rate that we pay on excess reserves–currently 1/4 percent. That ability will allow us to manage short-term interest rates effectively and thus to tighten policy when needed, even if bank reserves remain high.”
Oh really? And you’ll be able to do that, politically, with unemployment at 9%? And you’re so sure that the effect will be immediate, perfectly calibrated, and won’t have any unanticipated side effects? She also suggests that they can withdraw stimulus by offering deposits to member institutions through a Term Deposit Facility, and also by selling portions of their holdings. The notion that you can have a huge effect by implementing a policy, but that reversing the policy will have little effect, is an offense against common sense. No, it’s an offense against financial physics. Yellen isn’t the first Fed official to make statements like this, and won’t be the last. And then, we’ll have several years of apologies when it doesn’t work out the way they said it would.
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Retail Sales (Consensus: +0.8%, +0.7% ex-autos) is released tomorrow for December, and also Industrial Production (Consensus: +0.5%) and Capacity Utilization (Consensus: 75.6%). I think these estimates are very generous.
More important is the release of December CPI (Consensus: +0.4%, +0.1% ex-food-and-energy). It is probably useful to hearken back to November’s release at this point and recall the odd quirk that we saw. In that release, the seasonally adjusted numbers produced different year-on-year rates than the unadjusted numbers – an effect that was most important for core CPI. On the unadjusted numbers, the year-on-year change in core CPI rose to 0.768%, 0.2% above the consensus expectation. But, oddly, the month-on-month rise was 0.1%, which was as-expected. This happened because the BLS used very different seasonal adjustment factors than the market expected. Had it used the seasonal adjustment we had all assumed, then core CPI would have risen 0.2% rather than 0.1%.
The fact that the year-on-year number rose a surprising amount tells you that core inflation last month surprised on the upside but the monthly change came in at consensus due to the dampening effect of the seasonal adjustment. But seasonal adjustments are just that: seasonal. Over the course of a year, they cancel out. There are two ways that can happen: (1) the offsetting adjustment can be spread over eleven other months, in which case the BLS has been doing this all year and we didn’t notice, or (2) the offsetting adjustment occurs in one or two other months. Since December is the only month left, there is a chance that the offsetting adjustment occurs this month.
This is all very confusing, but here is the bottom line. If the year-on-year rate of change in core CPI is to stay at 0.768% and the year-on-year change in the seasonally-adjusted and non-seasonally-adjusted series converges to that rate, the reported month-on-month change in core inflation this month will not be 0.1% but a little above 0.2%. If the whole adjustment occurs in December, and if there is any acceleration in core inflation, a print of 0.3% is possible. Imagine what that would do to the market?
To be sure, this is all guesswork. My models suggest core CPI ought to be slowly rising now anyway, as the lags associated with inflation-related variables are finally starting to pass through the python. There is a small offsetting effect to the seasonal quirk mentioned above, which relates to the fact that energy price increases actually tend to dampen core CPI in the short run because of how the BLS extracts utility price increases from rents, and that’s why I am not sitting around expecting 0.3%. But I am much more on my guard for that possibility than I have been in a long time. We haven’t seen a 0.3% from core since 2008.
The headline is much less significant from a monetary policy standpoint, but quite important from a consumer confidence standpoint. The forecasts for headline inflation also look to me to be shaded on the low side somewhat; I think that year-on-year headline CPI could easily jump to 1.5% from 1.1%-1.2% where it has been for the last 6 months (this represents epic stability in this indicator!).
None of those figures are anything to get excited about in the big picture, but as of tomorrow morning the underlying beliefs that Trichet and other policymakers are relying on – chief among them that inflation is dead so long as there is a lot of unemployment, regardless of the lessons of history in this regard – may begin to be tested.
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I will be making several visits in the City tomorrow, but will put out a comment concerning the CPI release sometime before Monday. There will be no commentary on Monday because of the bond market holiday; the regular schedule will resume on Tuesday.
The Farce Is With Us
The stock market leapt anew today, breaking out of the tedious range that has frustrated bulls for a whole week and a half.
Ostensibly an important part of the rally was the success overnight of Portugal’s €1.25bln debt flotation, but this has farce written all over it. Prior to the auction, the EU announced that it was readying a stabilization for Portugal in case its auction didn’t go well. And then, not much later, the auction went okay. Coincidence or con game? We don’t know who bought these bonds, and we don’t know what enticements (such as a healthy rediscount policy) the ECB offered other banks to buy the debt. It was important for the auction to complete, and it completed, but that is hardly a strong endorsement (as Bill Gross, of auction non-participant PIMCO, explained well on Bloomberg TV later).
The stabilization package mentioned shortly before the auction was too small to be serious (€60bln), so the announcement shortly before an auction that was designed to go well was likely timed to be a strong-sounding promise that there was no chance of keeping. The EU has tried bluffs before with Greece and Ireland, and it didn’t work, so they are trying to be more tactical and bluffing only when there’s no chance the bluff will be called.
Practically speaking, it doesn’t matter much to investors that Portugal is in trouble if everyone is willing to believe the con. At least, this is true for now. Tomorrow, Spain tries to sell €3bln and Italy is scheduled to sell “up to” €6bln. They’re in better shape than Portugal (Spanish 10y yields are 5.43% and Italian 10y yields at 4.77% compared with Portugal’s 6.58% and Germany’s 3.05%), and there’s little doubt that these auctions too will not be left to chance. One wonders how long this farce can go on, but while the farce goes on so does the dance. As former Citi CEO Chuck Prince famously said, “As long as the music is playing, you’ve got to get up and dance.” And with the same attitude, one might also add “and if the music starts again, you’ve got to dance again.” One wonders also how many investors and institutions are dancing again, so soon after the band stopped playing the last time. It strikes me that this isn’t like a real bandstand. There is no guarantee the set will last any given amount of time.
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The “success” of the Portuguese auction caused the dollar to weaken sharply for the first time this year. Although the greenback remains comfortably within its recent consolidation range, I suspect we may shortly see a trip back down to the levels of October and November, or even below.
The chart below shows the historical relationship between the dollar index (white) and the S&P GSCI commodity index. When the relationship is behaving normally, they move inversely to each other because most commodities (at least, in this index) are measured in terms of “dollars per unit of stuff,” and when the dollar buys less stuff that often (but not always) means that it also buys less of other currencies. In this explanation, the recent strength of the dollar is idiosyncratic flight-to-quality strength, and may be erased once the flight-to-quality has passed. The recent “risk-on” attitude in the markets seems to suggest this is on the verge of happening.
For the last two months, the usual dollar/commodity relationship has been broken.
Of course, this isn’t the only explanation for the commodity-dollar divergence of late. The divergence may be because all fiat currencies are declining in value compared to stuff (say, due to a huge increase in the supply of fiat money because of global QE), and if that is the case then the relative value of the dollar compared to another fiat currency is not germane to the value of commodities. In that case, the relationship will stay broken down, with commodities continuing to rise while the currencies fluctuate relative to one another. This is the definition, of course, of a global inflationary outcome. The fact that commodity indices put in a substantial low in late August, when Bernanke unveiled the notion of QE2 – and some commodity indices put in very significant lows then – is suggestive.
A more upbeat interpretation would be that strong and/or strengthening domestic economic growth is helping to support both the foreign exchange value of the dollar and commodities as global demand picks up. This seems less plausible since the fundamentals of the particular markets are not uniform, and yet just about all of them have been rallying for months. Corn, Cotton, Coffee, Copper, Cattle, Crude: all are up significantly. Since August 23rd through Tuesday’s close, the current contracts (so we don’t have seasonality issues with new crop/old crop, for example) are up for those commodities by these percentages: 36%, 79%, 28%, 31%, 11%, 21%. Even when the economy is booming, not all commodities go up from demand alone!
Let’s look at one particular commodity of special interest: gasoline. Since the end of August, gasoline is up about 30% (see Chart). Using the “normal” pass-throughs, this suggests a ~1% rise in headline inflation from this effect alone. With core inflation stable or (I think) bottoming, this suggests recorded headline inflation is going to be going up.
Keep topping off that tank!
But now the good news: if the upbeat interpretation is true and this is happening because the economy is belting back, then this is just an “automatic stabilizer.” The Fed normally ignores movements in energy prices, as unpopular as this is, because higher energy prices are already exerting a natural dampening influence on activity and lower energy prices are already exerting a simulative influence. Thus, if the Fed responded to higher prices that were caused by higher energy prices, it would be tightening into energy spikes and easing into energy collapses, and this would tend to amplify, rather than dampen, the economic cycle.
A 30% rise in wholesale gasoline prices, even back to the $2.50 level, will not kill the recovery. But in 2008, a rise above these levels certainly seemed to affect the animal spirits of consumers, and it bears watching especially since it is occurring coincidently with rises in food prices.
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Initial Claims (Consensus: 410k) are the main economic datum on tap for Thursday, although some will obsess over PPI (Consensus: +0.8%, +0.2% ex-energy) and/or the Trade Balance (Consensus: -$40.5bln). I already mentioned the Spanish and Italian bond sales, although I doubt there will be any surprises there; also of note will be Chairman Bernanke’s comments as part of a FDIC panel discussion on “Overcoming Obstacles to Small Business Lending.” It’s nice to know that someone out there still thinks there are obstacles! But it will be interesting to see how optimistic the Chairman is. This is one place where the Fed, in its direct conversations with bankers, has a lot more information than the private analyst does and ought to be able to add some value.
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By the way, by my count yesterday was merely the 30th Binary Day of this century. January 1st, 10th, and 11th, October 1st, 10th, and 11th, and November 1st, 10th, and 11th, of each year ’00, ’01, and ’10 makes 27 occurrences; this year we add 1/1/11 and 1/10/11, so 1/11/11 becomes the 30th. However, November 11th 2001 has the highest decimal value, as 111101 in binary is 61 in decimal.
Happy Binary Day! (1/11/11)
Earnings season has begun again, and investor ebullience is in high froth. This isn’t to say that every announcement, even announcements of “beats,” is being treated with generosity. Indeed, what the market seems to need most, day in and day out, is to be removed as far as possible from actual news. The stock market did splendidly in November, when we were thinking about what the new Congress might do, and December, when we heard blessedly little about anything except snow. Modestly better economic news helped, but to me it seems like investors feel good generally about the market but aren’t necessarily in love with specifics.
So, for example, Alcoa reports a 12% earnings beat, but is down on the day. Verizon makes the long-awaited announcement that it will carry the iPhone on its network, and the stock falls (Disclosure: I own some VZ). Bob Pisani on CNBC said that Alcoa wasn’t down because of its fundamentals but because of its valuation. Since when was “valuation” not a fundamental – indeed the fundamental – detail about a stock!? (Yes, I turned on CNBC again since it was so useful yesterday to me in generating content for this comment. I left the TV on for a full 10-minute dose, the maximum I recommend as consistent with your mental and financial health, and then turned it off.)
Japan’s finance minister said overnight that that country would buy bonds issued by the European aid regime with some of its foreign exchange reserves. Markets loved this general comment, without considering the specific point that in order to buy bonds from a quasi-sovereign bailout fund, Japan will obviously have to sell something else. True, it does give some much-needed credibility to a rescue plan that other central banks (see SNB) and big pension plans were running away from, but outside of those debt markets themselves it isn’t clear to me that many markets were pricing the risk of an EU collapse (or the collapse of a periphery country that turns out to be too big to save, which would amount to nearly the same thing).
Inflation-linked bonds had a banner day, outperforming nominal Treasury bonds by 5-10bps across the curve. I received many inquiries about the possible causes of this outperformance. One possibility is that many people made New Year’s resolutions to buy more TIPS. However, I suspect the real answer is more pedestrian.
In several days, the Jan-11 TIPS will mature and all of the Jan/July TIPS will pay coupons. Next Thursday, the Treasury will auction 10-year TIPS, and the Jan-12 TIPS will exit the indices at the end of the month since that issue will have less than 1 year remaining to maturity. So, there is a large net inflow of cash to TIPS owners, and the duration of the TIPS index will extend at month-end (dropping a 1-year instrument and adding some more 10-years). Also, on Friday the CPI print will probably push the year-on-year headline figure to its highest level since last May. Oh, and the Federal Reserve continues to buy TIPS approximately equal to the net supply from the Treasury.
All of that makes it hard to short TIPS, even at these low yield levels. The usual dynamics with value investors are missing, because while they’re happy to buy low it’s challenging to decide to sell high when you know it may be hard to buy them back. (Institutional investors ought to keep an eye on the repo market for TIPS, which almost always trades general collateral. If TIPS start trading special, then you know the supply is getting tight.)
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Incidentally, today 01/11/11 isn’t (of course) the first Binary Day. In this century the first was 01/01/00. How many others have there been? And which one converted to the highest decimal value? This is, however, only the second “Five Aces” Day, with the other one being 11/11/01.
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There is no data tomorrow of note, and a storm is ticketed for New York with 8-14 inches of snow in its luggage. Expect a slow trading day. However, you should still tune in for this comment, as I will be discussing energy prices and Janet Yellen’s latest comments on LSAP.
Some Borrowers Are Still Begging
It was a reasonably quiet Monday, as expected considering there was no economic data due. Stocks sagged in the morning, and both stocks and bonds rallied in the afternoon – the former to unchanged on the day, and the latter from unchanged to up a few basis points.
News was light, and I accidentally turned on CNBC.
It really must have been an accident, because the last thing I want is to let CNBC get into my head. Generally, it just outrages me to listen to the shilling that masquerades as “news” on this channel. I don’t mean the guests; they are doing what I expect them to do. It’s the talking heads who pretend to be analysts who bug me.
In any case, before I was able to operate the “mute” button I heard a brief discussion about the condition of the corporate borrowing market. The guest – I didn’t catch his name – was earnestly making the case that “the financing is there” even if not everyone wants to borrow right now.
For some reason, economic bulls have had a hard time for the last couple of years in understanding how tight credit availability was in the immediate aftermath of the credit bust, and how long credit has stayed very tight. Now, corporate borrowing is finally loosening up some. In late 2008, even highly credit-worthy accounts had trouble renewing credit lines, for the simple reason that banks couldn’t access financing markets either. In 2009, the markets continued to be tight although opening for top credits. In 2010, the borders were pushed further, and more companies were able to borrow. But credit availability is still tight.
The chart below shows the 52-week change in commercial bank credit (Source: Fed H.8) updated to the most-recent data. Bank credit is still contracting, slightly, on a 13-week rate of change as well. I would suggest, by the way, that one reason these numbers are no longer contracting as much is that foreclosures have stalled.
I've adjusted the series for the blip of MS and GS joining "commercial banks" in 2008.
But we’re really interested in credit availability to corporate borrowers. Is it true that “the financing is there,” or is it the case that the decline in credit is a case of a lack of demand?
Bloomberg has two indices that are interesting. They detail total issuance of all dollar-denominated public and 144A corporate bonds sold in U.S. domestic and global markets. It stands to reason that if the financing is “there,” and it doesn’t seem to be “there” at the banks, then it may be available in the markets. Helpfully, Bloomberg has broken the data down into high-yield and investment-grade markets, and those two series are shown below for the life of the data.
Inv Grade: left axis. High yield: right axis
What may jump out at you is that investment grade issuance dropped in 2010, but high-yield issuance…well, exploded. The $287bln of high-yield issuance was 76% above the next-best year, which was 2009, and just about double the issuance from the ‘lever up’ heydays in 2006 and 2007.
So if you look at total issuance, it looks pretty flat (down just slightly in 2010), and with the bank credit numbers leveling off you’d say “we’re back to normal.” And, clearly, things are better than they were in 2008! But the changing composition of the market suggests something deeper is happening. I suspect that the bank loan books are improving in quality by extending credit to large, credit-worthy names (politically, I think it’s hard in this environment to be showing off a contracting loan book) and cutting the weaker credits off. The big companies definitely see a healthy credit market for their names and their paper, and that’s who we are hearing from when we hear “anyone who wants money can get it.” Sure, General Electric can get it. Exxon-Mobil can get it. But what about those who don’t rate a top-tier credit?
The weaker credits are being forced, if they are large enough, into the junk bond market, where they are fortunate in finding lots of investors lusting for yield. But I wonder what is happening to the smaller, less-than-stellar credits? And I wonder what will happen if the market goes “risk-off” again?
None of this has direct investment implications for today, but is part of the detective work of figuring out what is going on with this economy behind the scenes. Conditions are definitely better now than they were in 2009, and in parts of 2010. The jobs market is better. The credit market is better. But in both cases, we can honestly ask whether it is better for everybody or just the lucky few? And is that coloring some analysts’ view of how good things really are?
I don’t think that deleveraging is a bad thing, even though it means slower growth or even contraction for a while. What worries me right now is that no one is braced for deleveraging, like we were at the beginning of 2010. And yet, the surge in high-yield issuance tells me that not everything is humming along smoothly in the credit markets just yet. If the next “risk-off” period is a couple of years away, this will be a moot point. If it is a couple of weeks or months away, then it will not be. Be careful if you see a well-known junk name default, or if there are outflows from high-yield bond funds.
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On Tuesday, Philly Fed President Plosser speaks in the morning, and Minnesota Fed President Kocherlakota speaks in the afternoon. Other than that, there is nothing on tap…except another NY-bound storm, scheduled to hit tomorrow night.
It Depends What You Mean By “Somewhere In Between”
Aren’t December Payrolls fun?
The economy generated 103,000 new jobs in December. While upward revisions of 32k to November’s data and 38k to October’s data blunt the pain of the miss, the market was looking for a blow-out report as the economy built momentum and capitalized on a strong Christmas season (so the story goes). The last three months’ worth of jobs generation read this way:
October: 210,000
November: 71,000
December: 103,000
Call that what you will, but it doesn’t look to me like strong positive momentum. To me, it looks more like what we’re seeing in the employment-condition surveys: bumping along with positive growth, but stunted positive growth. This is not a normal recovery, folks, where we see strong growth in early quarters yielding to steady growth near or above trend. And there’s no sign that it is about to become a normal recovery.
To be sure, this is a December number and the seasonal adjustments are difficult to make because the sheer number of workers being added to the workforce in December and dropped from the workforce in January dwarfs the net number. To be reminded of the difficulty of seasonal adjustment, look no further than ADP. Clearly, someone missed something.
Keeping the stock market from coming completely unglued today was the fact that the Unemployment Rate, rather than falling to 9.7% as forecast by most economists or staying stable or rising as I expected, plummeted to 9.4%. That must be good news, right? I read a number of stories that tried to treat this as a “some of this, some of that” number. The Payrolls number was bad news, the Unemployment Rate good news, so “the reality is probably somewhere in between.”
Well, no, not really.
The Unemployment Rate fell partly because the labor force participation rate fell to yet another 26-year low. The chart below, which I have shown a bunch of times, is truly ugly.
Labor Force Participation Rate is in an ugly trend. We may have already seen the highs for the next 30 years!
So what has happened over the last decade to discourage people from even trying to work? Remember, when the BLS calls up, they ask if you’ve worked, and if you have not then they also ask you whether you have been looking for a job. If you answer “yes” to the first question, then you are employed. If you answer “no” to the first question and “yes” to the second question, then you are unemployed. If you answer “no” to both questions, then you are not in the labor force (and this makes some sense: if you are at college full-time, then are you unemployed? Not in the sense that you are competing with people who are looking for jobs. Of course, the BLS asks further questions to find out why you’re not looking but that’s not a topic for this column.)
Between November and December, the number of people defined as Unemployed in the household survey fell 556,000. That’s great, and that leads to a healthy fall in the Unemployment Rate. But, the number of people Employed rose only 297,000. So what happened to the rest of the 556,000 people who are no longer unemployed? They left the labor force, which fell 260,000 (297k-556k≈-260k, with the 1k error there being rounding). This is not what you see when the Unemployment Rate declines for healthy reasons.
By the way, the average duration of unemployment rose back to almost match the cyclical highs from last year. The chart below gives some context. These people are looking for work, even if there isn’t a lot of hope, because they’re still drawing benefits while they look. Arguably, they otherwise may have dropped out of the workforce long ago, in which case the Unemployment Rate … and the participation rate … would be even lower. I think we can all agree that an Unemployment Rate lower for that reason would not represent health.
A long, long, long-term view of the average duration of unemployment.
Why is it such bad news that the labor force participation rate is dropping? After all, we expect that to happen eventually, once the Baby Boomers retire in large numbers. It’s bad because with fewer workers, productivity will need to rise even faster to make up the downward pressure on output.
Number of people making stuff (times) amount of stuff made per person (equals) total stuff.
That is the labor, times the output per unit of labor, equals output. Simple algebra. If, because workers are discouraged or because of demographic fate, the number of workers is rising more slowly or declining, then the amount of stuff made per person needs to rise faster to cover the difference.
Maybe productivity will surge to make up the difference. But this is mere hope. If it does not, then output (that is, growth) will be lower than it otherwise would be – and there are possible inflationary implications in that. And that is why the decline in the participation rate (and the outright decline in the number of workers since 2008, which almost never happens even in recessions and even when the participation rate is declining, since the overall population tends to be growing) is bad news and in my mind outweighs the wiggle between 9.4% and 9.7%.
The equity market suffered on the data, and the bond market rallied; stocks recovered later in the day on the “it’s somewhere in between” theory, to end with only mild losses. Bonds, though, never sold off, and it’s the bond guys who majored in math.
A report after the data from an economist I am rapidly beginning to like, Julia Coronado at BNP Paribas, summed up very well what all this means:
“On balance the report highlights ongoing headwinds and suggests that the recovery can stay on track but is likely to remain frustratingly slow.”
In my opinion that strikes just the right chord.
There is no economic data on Monday, and indeed until Thursday and Friday (when we get Claims, Retail Sales, Industrial Production, and CPI) market participants in New York are going to be almost as focused on the rumored next Nor’easter that is currently scheduled to hit the area on Tuesday. This means we will probably stay uncomfortably focused on this data for a few days and I suspect equities will have some trouble getting airborne again until there’s a fresh excuse.
Surprise, Surprise? Or Not.
In December, the Employment number was a dismal disappointment, weak on almost every count. And yet, a month later, we prepare for the next Employment number with the S&P some 50 points higher.
This might suggest that the underlying bond and stock market dynamic is not being driven by economic improvement, although it is perhaps more fair to say that the market dynamic is probably not being driven by improvement in the employment picture. And that’s fine. Equity bulls can find plenty to like in the (at least temporary) ardor for deficit-cutting on Capitol Hill (we’ll see how long that ardor burns), and both bond and stock investors can use as their causus belli for bearish and bullish trends (respectively) the money-printing by the Fed and other central banks. So it isn’t necessary that Employment be booming right now for there to be made plausible – if unpersuasive to me personally – arguments in favor of the prevailing trend.
Then why is there so much chest-beating about how strong the jobs number really must be, and that the stock market is merely discounting a rapidly-strengthening economy? It annoys me, but doesn’t particularly surprise me, when the markets move in advance of economic swings – although it is worth listening to the old wag who noted that the market has predicted nine of the last three expansions. But when economists seem to be looking at the market to justify their forecasts, I get worried.
Thursday’s Initial Claims number was not revelatory. It bounced about as-expected, but the current level of 409k would have been cause for much rejoicing during any of the last couple of years. A decline in the number of people being laid off, however, has a fairly uncertain relationship to the number of people being hired, and the former usually improves (worsens) well before the latter.
There are plenty of reasons, if one is looking for them, to be skeptical that tomorrow’s data is going to reflect the 250-300k number suggested by ADP, or even that it will exceed the 150k median estimate (some economists revised their guesses after ADP, but many did not so it seems a reasonable bet that the real median would be higher if we took the survey today). For example, Macroeconomic Advisors (who helped develop the ADP survey and continues to prepare data for it) mentioned that there was a seasonal quirk associated with the way the survey treats people who were carried on payrolls until the end of the year even if they had left the employer previously. The “Jobs Hard to Get” subindex of the Consumer Confidence survey continues to suggest that the man on the street isn’t seeing widespread hiring. And the employment subindices of the ISM surveys released this week both softened. (Incidentally, the Unemployment Rate is expected to decline to 9.7% from 9.8%, but because any improvement in the labor market is likely to be coupled with a rise in the abysmally low labor force participation rate, I think that is not terribly likely unless Payrolls is quite strong. However, some economists are expecting a drop to 9.6%.)
This is not to say that the Employment number is likely to be weak. Last month’s weaker-than-expected print may see some reversal this month. And after all, given the ADP report it will surprise nobody if the number is strong tomorrow.
And that’s just the point. Strength will surprise nobody. Including me!
So S&Ps sit 16 points higher than they did last Friday (almost all of that via a gap higher on Monday), and the strength of the number due out tomorrow is as widely anticipated as was the revelry last Friday night in Times Square. If I was a punter, this would seem a good place for a punt on a short. (The real suspense for me will be if relieved buyers who “kept their powder dry” but now worry about missing the boat will rush to buy such a selloff, or if all of the arms have already been shipped to the front).
It is less clear that this is a good place to punt a long on bonds. Yes, it seems that the market has stabilized, and a retracement of 10y yields from 3.40% back to 3.10% or so wouldn’t shock me in the slightest. But I can make a better case for stocks retracing the bull run than for bonds retracing very much of the bear. The latter market, I think, has begun a secular bear market and at 3.40%, the 10y note is already pretty exposed to lots of bad possibilities. Bonds are in the middle of the recent yield range, so from a day-trader’s perspective there’s not much clarity and a swing-trader buyer will be fighting a lot of larger-scale negatives.
The first trading week of the year is often fairly slow, and this one has been so. The percussion of the Payrolls release will be punctuated by testimony from Bernanke before the Senate Budget Panel at 9:30ET and four other Fed speakers throughout the day. But it will be dampened by the fact that meteorologists are calling for another half-foot of snow (with a chance of more) to hit the NY metro area in the late afternoon.
In other words…unlike the economic forecast, the meteorological forecast will likely impact actual trading tomorrow!
Stoking The Engine With Paper
The bond market was higher overnight, and the stock market lower, largely on news that the Swiss National Bank said they will no longer accept Irish government bonds as collateral (link to story here). This is fairly remarkable, and speaks to the determination of the Swiss body to stay a central bank rather than a thinly-disguised enabler of wastrel sovereign legislatures. Not surprisingly, the Swiss Franc leapt higher on the day. In the land of the blind, the one-eyed man is king, and the SNB today surely attracted some new capital to its land.
This introduces an interesting dynamic, when you think about it. Until now, the major central banks were apparently in a race to see who could be the most egregious enabler. The Fed is working on its second quantitative easing. The BOJ has gotten more serious with its QE. The ECB has been buying up any bonds that no one else wants (the biggest Danish pension fund today said they won’t buy bonds issued by the periphery countries) and permitting banks to carry questionable sovereign credits with a prime risk weighting. The Old Lady of Threadneedle Street (aka the Bank of England) continues to act more like a young flapper, although she has recently made some noises about being more concerned about inflation down the road.
But now, the SNB – right in the heart of Europe! – has won a battle for responsible central banking, and been rewarded with a stronger currency and a stock market which led continental Europe with a +0.4% gain (the EuroStoxx 50 was -0.4%). Could others follow suit?
Nah.
After all, most central banks these days want lower, not higher currencies to give a kick to domestic growth. Most are willing, even encouraging, of inflation to help grow out of large nominal debt burdens. How wide is the gate and broad is the road that these banks are taking? Many are entering through it. It seems much easier in the short run, and in the long run…
In the short term, the banks can affect the wiggles, a little, perhaps. But it feels oh so good to see an ADP report like today’s. The number printed at +297k, the highest number ever recorded in this survey (which dates to 2001). As I wrote yesterday, there is something real happening here, but seriously? The economy doesn’t seem to be booming, and that datum is inconsistent with lots of other readings of the employment situation (for example, while the Non-Manufacturing ISM released today was a little stronger-than-expected at 57.1 vs the 55.7 consensus, the Employment subindex fell, as it also did in the regular ISM report, to 50.5 from 52.7). I am more likely to believe that seasonal adjustment problems, always tricky but especially in December and especially for ADP, have something to do with the degree of strength.
But the markets were content to believe that the signs of strength in the U.S., as iffy as they are, outweigh the continuing issues abroad. Yes, we are parochial investors here in the ‘States, but it’s understandable that investors want to hope that if the American engine gets chugging it might pull the rest of the global train. Stocks managed to gain after the weak start, and bonds were smacked with the 10y yield back to 3.48% again.
It is understandable that investors want to hope that, but the engine is not being stoked with coal. Or wood. It is being stoked with paper, and the energy content of paper is probably not enough to get the engine up the hill with the entire train full of toys behind us.
I do understand, however, the desire to believe. I think I can, I think I can…
Inflation-linked bonds did very well again (compared to Treasuries), and inflation swaps continue to rise: to the tune of 7-9bps today. The 3y inflation swap is now at the highest level it has seen (over 2%) since September 8, 2008…and back then, oil was around $115/bbl and still coming down. Longer-term swaps have a little ways to go before they reach the highs of early last year: 10y inflation swaps are around 2.70% versus 2.88% highs early last year.
But it is easy to see the attraction right now of an asset class where there are two ways to win: if the engine makes it to the top of the hill and the global growth dynamic kicks into gear, then you might get demand-push inflation; if the engine coughs and slides back down to the bottom of the hill, then the central banks shovel more paper into the engine and you get incendiary results that way. (N.b. I am giving the argument, not my own view.) Result: congratulated if you do, congratulated if you don’t, or so the thought process goes. I still think inflation-linked bonds are
I don’t know how any of this fits in with Kansas City Fed President Hoenig’s unique view, expressed today, that a policy which is too expansionary can cause unemployment (link). The Fed certainly has the bases covered with theory. Kocherlakota thinks the Fed could force inflation higher by raising interest rates. Hoenig thinks that too much stimulus is contractionary. I think he is trying to convey a sense of the long-run tradeoffs compared to short-run tradeoffs of monetary stimulus, but it isn’t exactly helping the discussion when you say it this way. (He generally scores points with me, though, when he says “Money is not wealth. The productive capacity of economy is wealth.” Amen, brother.)
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The Initial Claims (Consensus: 408k) data released between ADP and Employment is normally not particularly important. It ought to be even less important when the week in question is the last week of the year. But in this case, the context is dangerously suggestive. Last week’s Claims figure surprised dramatically on the downside, plunging to 388k. This sharp improvement seems to have been echoed in the ADP report, although as I have noted it hasn’t been echoed anywhere else yet! But if the bounce in ‘Claims is smaller than anticipated, especially if it is actually below 400k, then we will essentially trade Friday’s presumed upbeat Employment release tomorrow (and set up a much less risky counter-trade into Friday, by the way). A higher-than-expected number will be less significant but still might cool the ardor of the most bullish equity investors. So I would recommend paying attention to this one.
Santa Claus Came To Town
I think it is good to start the new year, when possible, with a proper dose of humility.
Back in early September (in this comment), I mocked Wall Street strategists’ equity forecasts, which at that point called for a 7% rally over the remainder of the year – the bullish forecasts looked for 18%. What really had gotten my goat were not the forecasts, but rather Barron’s describing the strategists as “wary” with that call. I pointed out that the 21% annualized rate of increase (53% for the bullish strategists) was certainly not wary, considering the long-run expected return to stocks is around 4.5% plus inflation.
But credit where credit is due: the strategists were right; the S&P gained 13.9% from September 3rd to year-end, so the bullish strategists were even in the ballpark. I think the chart of the S&P, below, since that issue came out ought to support my view that this was actually a rather remarkable call, instead of being “wary”, but the bottom line is that they were right and I was wrong. I wish I could figure out how they knew the market would have a four-month straight-line advance, but congratulations all around.
Only thing more impressive than the melt-up is that a bunch of folks called it!
My skepticism, though, is deep-rooted, so I somehow have trouble letting go when I read that Laszlo Birinyi is calling for S&P 2854 by year-end 2013. This is based on the current rally being an “average length and size” bull market. Of course, there is a lot of debate about whether this is in fact a bull market (he is talking cyclical, rather than secular), and even more about whether we can expect an “average” bull market when we are at above-average valuations already, but Laszlo would say that widespread doubt is a sine qua non for starting such a rally.
That rally would represent a 322% gain over the lows reached 22 months ago. Birinyi looks to the bull markets that began 1962, 1982, 1990, and 2002 as his yardstick. Now, since I tend to be a value guy, I will note that in 1962 the Cyclically Adjusted Price Earnings Ratio (aka “Shiller P/E”) was 16.8 when the rally began and never exceeded 24.1; in 1982 it was 6.6 and never exceeded 18.3; in 1990 it was 14.8 although it did get to 44.2 in the bubble; in 2002 it was 22 and peaked at 27.5(but most strategists consider the 2002 rally as a cyclical bull within a secular bear). By contrast, the CAPE is currently 23.3. So how much are we expecting out of this market? If earnings also explode, then the P/E can stay in the 20s, but I have trouble seeing the kind of margin expansion that would be necessary to get that kind of surge in earnings.
All of which preceding commentary, of course, needs to be couched in the context of “but I didn’t see the big Q4 rally, either.”
There is no question that the economic picture is brightening, although I wouldn’t say it is brightening in a dramatic fashion. Car sales today were better-than-expected, but are still selling at a pace around 75% of what once was considered a bad month (see Chart, source Bloomberg).
Yayyyyy! 9.4mm units!
Just so I am not accused of picking-and-choosing: yes, some of the manufacturing surveys have been better-than-expected. But we need to remember that those surveys measure relative growth (how was this month compared to last month/year) and the output figures like car sales measure absolute output. I suppose Birinyi would say that gives the economy more room to expand, but I would argue those prior levels of output were only sustainable as long as the authorities were willing and able to keep adding leverage. All through the first part of the 2000s, auto manufacturers were offering ever-improving financing deals. Eventually, the steroids ran out. And this goes more broadly for the whole economy.
However, perhaps what equity investors are buying right now is the notion that the steroids are flowing again. The 10-year inflation swap has risen from around 2% at the beginning of September to 2.64% now. The chart below shows the S&P against the 10-year inflation swap. Looking at this, I don’t think equity investors are trading earnings at all. They’re trading leverage.
Equities are acting like inflation-protected securities...but they're not.
Stocks, as I have written here many times, are not proof against inflation. And you don’t need to see all of the pretty regressions and historical figures I can pull out to prove it to yourself. Just ask, “if stocks are good inflation protection, how did they do in the 1970s?” The prosecution rests.
The ADP report (Consensus: 100k vs 93k) is due to be released tomorrow. Economists are forecasting the highest print since November 2007. I mentioned last month that the fact ADP has been consistently underperforming payrolls suggests ADP ought to outperform and Payrolls to underperform, all else being equal.
Economists are justified in assuming some slow growth in Payrolls. While the significance of last week’s widely-touted Initial Claims figure is reduced by the fact that it is from late December (seasonal adjustments are devilishly difficult from now until late January), there does seem to be a slow thawing of the jobs market…but it is very slow, and slow enough that the Consumer Confidence “Jobs Hard To Get” response is still rising. I don’t forecast ADP or Payrolls, but if I did so then my forecast would be beneath, but probably statistically indistinguishable from the consensus this month…especially given the variance associated with December initial prints.
Those looking for strong jobs growth in December are hopeful that retail hiring played catch-up in December if sales were in fact stronger-than-expected (that is, stronger than the retailers, not the economists, expected). If that is the source of strength, then it will likely at least partially reverse in January. But here is the rub – ADP doesn’t give as detailed a breakdown as does Payrolls. So any enthusiasm resulting from strength in the ADP number will not likely be blunted until Friday.
I believe there is a good equity-shorting opportunity approaching, but I suspect I will probably miss it. The market seems to have forgotten about the European periphery and is addled on holiday eggnog. Too much is priced in, too soon. I don’t think we’re talking about a 25% decline, but a significant correction is due. But then, I didn’t forecast the Q4 blast-off so what do I know?!?
