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Virtuous Cycle of Optimism
One thing seems reasonably clear: in the absence of news, equity markets want to rally.
Heading into Friday, stocks ripped higher, and then ended up with a healthy gain on the day. Bloomberg attributed the rally to the revision in the February Michigan Confidence number to 77.5 from the initial estimate of 75.1 (“Stocks Gain as U.S. Consumer Confidence Exceeds Forecasts”) This is patently ridiculous – few people follow Michigan closely, and almost no one pays attention to the revision, and the revision was only a couple of points. That became the headline because no one had a better explanation. I didn’t write a comment on Friday, because I didn’t have a better explanation either.
Stocks ripped higher overnight again last night, heading into Monday. Again, there was no news. Bloomberg this time attributes the gains to Warren Buffett’s potential purchase of…something: (“Stocks Gain As Buffett Goes Shopping”). Again, that’s a crazy reason to explain a $50-100bln rise in the market’s total capitalization. He can’t buy everything, and it isn’t clear anyway how much value should be added to the market from one company buying another company (at least notionally, that’s a zero-sum game, so while I believe Buffett is attentive to synergies it’s hard to imagine $50bln of synergies). And what’s he buying? Telecom companies were up the most, followed by utilities, basic materials, and health care. There is not a lot of commonality there.
The same article also attributes the 1% decline in Crude Oil prices to the Saudis’ offer to make up for lost Libyan production, even though that was Thursday’s news (man, oil traders are slow!). No mention was made of the attack this weekend by insurgents in Iraq on an oil refinery north of Baghdad that took about 150,000 bbl/day from the market, but presumably that news will be traded on Wednesday!
What’s really going on is that volumes on Friday and today were much lighter than the three “news days” prior to them (although after I wrote that line, in the last 5 minutes of Monday’s session some 400 million shares changed hands, a third of the whole day’s volume and much more than is normal at the end of the session). There is clearly a wellspring of optimism right now that is difficult to divert and anything short of a steady drumbeat of bad news will fail to keep the market down.
There is plenty of bad news to be concerned about. Atop the Libya news – which is thinly reported because Gadaffi has done a fine job of keeping the media silent – and the explosion of the Iraq refinery, the results of the Irish election on Friday seems to put the new government on a collision course with the EU. On Thursday, the European Commission had made very clear that the bailout deal was with Ireland and not with “any particular government.” This is a very proper theory – governments should respect the agreements entered into by prior governments, or international relations becomes very challenging – but also not very realistic when the government entered into an agreement that is clearly (and was clearly, at the time) against the wishes of the electorate. The agreements of a rogue government certainly ought to be subject to reasonably timely ratification by the people, and in this case it appears that the people have not ratified the deal. I expect that the Irish citizenry will win this debate, since the EU is unlikely to roll tanks into Dublin to enforce the deal and the Irish can be excused for thinking that the long-term health of their economy is more important to them than the notion of European unity. In any event, it’s a source of uncertainty.
So there’s no shortage of bad news, but the news cycle is clearly on “optimistic spin.” I have never been able to figure out if optimism causes optimistic news coverage or if optimistic news coverage causes optimism, but there clearly is a virtuous cycle of good-feeling at the moment.
And I suppose that’s the issue. Is this momentary? The underpinnings of the optimism seem ephemeral – lots of liquidity, solid momentum, and economic data consistently surprising on the high side. The Citi USD Economic Surprise index last week moved above where it had stood in early-September 2008. The current peak was last exceeded in August 2007, and before that in December 2003. Right there, you see the debate. Does the current skein of positive surprises represent the early stages of economic expansion, as it did in 2003, or the overreaching of euphoria as it did in 2007?
Perhaps it is a little bit of both. There is no doubt that the economy is in better shape now than it was a year ago, and better still than it was two years ago. But on the other hand, there are many more unpriced risks now than there were two years ago (when although the economic situation was more uncertain, investors were being reasonably compensated for many risks). My calculation of the Shiller “Cyclically-Adjusted P/E” (CAPE) as of today’s close on the S&P is 23.7. My estimate of the ten-year expected real return to equities (reflecting a current dividend yield on the S&P of 1.7%, assuming 2.25% annual real growth, and incorporating a reversion of the CAPE two-thirds of the way back to the historical average of 16) is a mere 1.55% per annum.
So are 10y TIPS at 1.01% cheap, or are stocks expensive? I’m inclined to believe that they are both expensive, but TIPS somewhat less so. I don’t see very much room for disappointment, and while I have no idea what kind of disappointment will break the virtuous cycle of optimism there is one thing I am sure of: there will be disappointment in the future. There always is.
It doesn’t seem likely that Tuesday will see the beginning of that disappointment. The consensus for the ISM report is 61.0 versus 60.8 last month, but economists have been raising their estimates (not reported on Bloomberg, though) on the basis of the stronger-than-expected reports out of Chicago PM and other less-important regional surveys. However, at the very moment that report is released Chairman Bernanke will be starting his Monetary Policy Report to the Congress (neé Humphrey-Hawkins). It is a pretty decent bet that he will not be terribly downbeat, since the Fed’s entire gamble is that the economy will suddenly ignite with enough strength that the central bank can then drain the liquidity without any ill effects. It seems a bad bet, and one that is apt to meet with disappointment…but probably not on Tuesday.
It Depends On What You Mean By “Spare” Capacity
Oil prices ramped up further this morning, and then plunged nearly $7 when Saudi Arabia was said to be “in talks” to boost oil output in order to cover lost shipments from Libya. According to the Wall Street Journal, the Saudis have more than 3mbpd of spare capacity.
That’s all well and good, and the U.S. also has a Strategic Petroleum Reserve that can cover some lost output temporarily. But here’s the little problem. The source for our estimate of Saudi excess capacity is…the Saudis. But they’re currently producing around 9mbpd, and have never produced more than about 9.5mbpd. Furthermore, it seems the general consensus is that their major oil fields are in decline. Some people even believe that the decline has been accelerated by the Saudi’s efforts to keep the flow rate higher than it should be so as to make it appear as if they are not in decline. I will be interested to see if the Saudis can really pump their output up to 10.2mbpd just like that (snapping fingers). I am much more confident that the SPR can supply 1mpbd, at least for a little while, than that the Saudis can. I think energy traders are being surprisingly cavalier here.
And interestingly, there is a new way to play this outlook, if you want to. Some friends of mine at Factor Advisors rolled out “FactorShares” today, which the press release calls “The First Family of Spread ETFs.” These instruments allow you to take a levered long position and a levered short position in another market in a single package. For example, the FOL allows you to be bullish on oil and bearish on the S&P at the same time. Other flavors include FSE (S&P bull/TBond bear), FSU (S&P bull, USD bear), and FSG (Gold bull, S&P bear). You have a 2x position in each leg, so you are 4x levered.
While I like the idea of FactorShares, and I expect they will be quite popular, there are two niggling complaints I have. The first is that these aren’t spreads at all – most of them are going the same way. That is, being bullish on stocks is a position that should have a positive correlation with being short on bonds. It’s the old “Texas hedge!” However, for some of them it’s an open question: oil and S&P may sometimes move together and other times move inversely. But these are potentially quite risky. The second complaint is that the positions are chosen to be dollar-weighted. That’s not the way an arbitrageur would choose his weights. Someone going long bonds and short stocks is mostly just short stocks since the volatility of equities is much higher than the volatility of bonds. Still, this isn’t a fatal flaw in the FactorShares: they have to choose some weighting scheme, and something simple probably makes more sense (especially since correlations can and do shift all the time). Someone who really wants to weight the positions correctly has lots of ways to add a risk tail to one side or the other (for example, FSE might be combined with some TBT (the 2x inverse bond fund) to get volatility-weighted amounts.
It’s a good idea. Now they need to do a simple breakeven (long TIPS, short TBonds) so retail can get long inflation duration as distinct from getting long real rate duration.
The drop in oil (on a close-to-close basis it was only about $1) helped stocks to recover after breaking below 1300, and the market closed with a small loss but above the trendline I drew yesterday. Still, to say the position is tenuous is probably fair. Volumes were again respectable, and although the VIX retreated slightly it is still elevated by recent standards.
Economic data were mixed. Initial Claims was 391k, and as the seasonal flopping around seems to be diminishing I probably need to revise my expectation about what is the underlying trend to more like 410k than the 420k I had thought. Statistically-speaking I don’t have enough evidence to reject the 420k from just the Claims data, but there are enough other signs that nudging it lower seems reasonable. But I still don’t see it as a downtrend and more of a down-shift.
Durable Goods was weak, no two ways about it. Ex-transportation, orders fell -3.6% in January, although an upward revision of 2.5% to December helps take some of the sting out. Still, all of the measures that correlate to GDP growth started Q1 on a very poor path, although the quarter has a long way to go.
New Home Sales were predictably awful, at 284k only 10k above the lowest of the cycle. At least the level of inventory continues to decline, for both New and (more importantly) Existing Home Sales (see Chart, source Bloomberg).
Existing homes for sale (seasonally adjusted). Still high, but becoming reasonable.
The current level of Existing Home Sales correlates to a level of CPI Shelter inflation right on top of the intended FOMC target: about 1.8%…however, given the lags involved that y/y change isn’t to be expected until January 2013 (although the early-2010 dip should show up in early 2012).
Today was actually, when you compare it to the last few days, fairly calm. And yet, stocks couldn’t manage a rally of any note. The selloff has not been so long-lasting, nor so deep, as to call this lack of bounce “striking,” except in the context of the last few months’ worth of uninterrupted rally. What is striking is that such a feeble little selloff is itself striking.
On Friday the second cut of Q4 GDP is released, and the revision to the Michigan confidence figure. Neither should have much impact on markets. Far more important is the Irish election and the post-mortems written after the results come out, and the fact that the weekend’s approach will make investors commit to where they want to be for another couple of days. It has been some time since the market showed any signs of concern about the weekend. I am not sure whether the lack of information out of Libya makes things seem calmer than they actually are (since we are not bombarded with the news and pictures) or whether it contributes to an underlying sense of tension since we are used to getting that kind of information deluge.
It’s Easy To Talk Tough On Inflation
Two days does not a trend make, but then again all trends consist of at least two days.
I am sure it has been pointed out by others, but while it is early to call this a correction-in-the-making in equities-land, the behavior of the VIX (see Chart) certainly suggests that this may be a bit more than the somewhat-tepid, garden-variety consolidation we saw in November.
This looks more like a selloff-spike than the November sub-correction.
It bears noting, as well, that Tuesday and Wednesday in the stock market were the two busiest days of the year volume-wise, with 1.25bln shares changing hands both days. That being said, from a technical perspective (see Chart below) the rally has merely been nicked, not mortally wounded. Penetrating a steep uptrend-line is not necessarily antecedent to a plunge, anyway, but you can be sure that if today’s lows are broken tomorrow there will be technical traders who take note.
Steep trend for the SPX. Amazing how long it has held!
WTI crude oil touched the psychologically-important (I don’t even know why I say that) $100 level today, and though it finished below that level this little spike has some economist starting to wring their hands. As I said before, higher oil prices are not likely to make a significant direct impact on the economy unless oil goes significantly higher and maintains that level for a while. That’s partly because when you buy oil and petroleum-derived products (as an American; this is less true in other countries that do not produce much oil domestically) some of the money you’re losing is going to someone else. Call it “Big Oil” if you want, although Big Oil is owned by pensioners, orphans, and you if you own an index fund, but the point is that some of the direct effect of an oil price increase is a redistribution flow from consumers to producers. If you’re mainly a consumer (and most of us are more consumer than producer), then you will mainly see the costs and not the back-door benefit provided when the producers spend the extra money you sent them. In other words, it will feel worse for you than it actually is for the economy-at-large. Again, this is not as true if you live in, say, the Bahamas (but why would I feel sorry for anyone who gets to live in the Bahamas?!).
While the 0.6% fall in equities (back-to-back triple digit declines in the Dow) will get the most ink, that isn’t disturbing by itself. As I pointed out above, while the rise in the VIX and volumes is suggestive, no real technical damage has been done yet. But there are two other things that raise my eyebrows somewhat more.
First, the bond market declined today rather than extending the rally. Whatever the “flight to quality” that happened on Tuesday, it wasn’t repeated on Wednesday. Second, the same applies to the dollar, which not only declined on Wednesday but didn’t even manage much of an advance on Tuesday. The buck is back near February lows (see Chart).
The dollar surprisingly saggy considering the geopolitical landscape. Is it no longer "quality"?
Those two facts suggest that stocks are not declining merely because of unrest in the Middle East. Perhaps there is a whiff of a stagflation outcome, but that shouldn’t pressure the dollar since energy is an input into inflation globally. I think Libya may be the excuse for the equity break, in other words, but not truly its cause.
Inflation-indexed bonds (that is, TIPS) and swaps of course continued to do well on the rise in energy (and grains recovered some today too). The 5y inflation swap has now exceeded the Jan 2010 highs and is above 2.50%. The high in 2008, prior to the crisis, was well above 3% but that was with $147 oil and no sense of what was impending.
This seems like a useful time to step back and look at what has happened to inflation expectations since the Fed has begun its current easing campaign. The chart below (Source: Enduring Investments) shows the CPI swap curves for August 27th (the day Bernanke made it plain QE2 was coming), November 12th (the day QE2 technically began), January 4th (where we started the year), and today.
Inflation expectations have clearly risen and continue to do so.
The Fed makes a big deal about how forward measures of inflation expectations have remained “contained.” By that they specifically mean 5y inflation, 5y forward, which is a function of the 5y and 10y points on the swap curve. That forward point, it is true, has not risen dramatically because the 5y point has generally outpaced the 10y point higher. But as this time-lapse chart makes clear, it would be absurd to claim that inflation expectations have not risen. The short end of the curve may well have done what it did because of the rally in commodities prices, almost uninterrupted since August, but even longer-dated inflation expectations have risen if you measure them (properly) from when expectations might reasonably have been affected – when Bernanke first told us QE2 was coming.
These are curves for headline inflation, since that’s the only thing which trades in the market (although in principle we could use these to derive expectations for core inflation). But clearly, the curve is now telling us that the market expects inflation to rise above the Fed’s purported target and to remain there for a generation or so. Yield curves are notoriously poor predictors, but if the Fed were serious about wanting to keep inflation expectations reined in they would have to take a long, hard look at tightening credit right now. The fact that there is no chance of that – because of the parlous state of the economy generally and the growth risks from energy and renewed sagging of home prices – should tell you what you need to know about the Fed’s true credibility when they pledge to “be aggressive” on inflation. Easy to say, not easy to do.
Now, if inflation is indeed something we need to worry about, equity bulls will immediately suggest that this is a great reason to buy stocks. After all, equities are real assets (in that they represent shares of a business which participates in the real economy) so it stands to reason that they should do well in inflationary environments. Well, it may stand to reason but unfortunately it does not stand to the data. What the data show is that while earnings may grow with inflation, the multiple assigned to those earnings is lower when inflation is higher. So the intrinsic value of your share in the business may keep up, but the thing you care about, the market price of that share, will tend to lag as inflation rises.
The fact that this happens is actually somewhat odd. There is no natural reason that a share of a business should be worth a lower multiple at higher levels of inflation, and this is a big puzzle for economists (as opposed to investors, who tend to care less about the theory of why this happens than the fact of its happening). I’ve just finished reading a paper by John Y. Campbell and Tuomo Vuolteenaho of Harvard called “Inflation Illusion and Stock Prices” that demonstrates a very high correlation between stock market mispricing and the level of inflation. According to the authors, “…the level of inflation explains almost 80% of the time-series variation in stock-market mispricing.” In a nutshell, the question is this: if a stock price is the discounted value of future dividends, then when the interest rate at which we discount those dividends rises because of expected inflation, then the growth rate of those future dividends should also rise by a similar increment, and the level of inflation should not affect the valuation of equities. Or, put another way, the real growth of dividends and the real interest rate should be somewhat related and more stable than we actually observe stock prices to be. But stock prices aren’t just volatile – they systematically underperform when inflation moves higher and vice-versa. This suggests (the authors illustrate) that investors are subject to money illusion, and they test this hypothesis:
“Modigliani and Cohn (1979) propose a more radical third hypothesis. They claim that stock market investors (but not bond market investors) are subject to inflation illusion. Stock market investors fail to understand the effect of inflation on nominal dividend growth rates and extrapolate historical nominal growth rates even in periods of changing inflation. Thus when inflation rises, bond market participants increase nominal interest rates which are used by stock market participants to discount unchanged expectations of future nominal dividends…From the perspective of a rational investor, this implies that stock prices are undervalued when inflation is high, and may become overvalued when inflation falls.” (©John Y. Campbell and Tuomo Vuolteenaho)
They proceed to test this hypothesis and prove to my satisfaction that bond market investors are smarter than stock market investors (well, anyway that’s my summary of the conclusion).
It’s a pretty neat paper, and worth the $5 you need to pay the authors for a copy.
This is a basic truth, I suspect, with most assets that are purported to be inflation-linked. There is no reason that I can see that equity investors would be subject to inflation illusion while, say, timber investors or real estate investors would not be. If you want inflation protection, in other words, the closer you can stay to explicit inflation-linkage, the better.
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Tomorrow’s economic data includes Initial Claims (Consensus: 405k vs 410k last), Durable Goods (Consensus: +2.8%, +0.5% ex-transportation), New Home Sales (Consensus: 305k vs 329k last), and even the FHFA Home Price Index. I am not sure any of this really matters as much as Libya and the rest of the region; as much as the Irish elections on Friday; or as much as any erosion in sentiment among the true believers in the equity world. I remain close to home.
Just Say No?
Seriously, now it’s Libya that is shuddering under the mass movement of the citizenry? A regime that survived the reprobation of the international community for the West Berlin disco bombing, the Lockerbie bombing, and a decision to get into the nuclear club (and then out of it), is being brought down by riots triggered by …what? Food? Corruption in the housing market? The smell of freedom? Whatever the reason, the populace is showing remarkable depths of anger, able to overcome brutally repressive tactics from the Gaddafi regime and fight on.
I didn’t even include Libya in my illustrations on February 13th of the commonality of the “population pyramids” of many of the countries in the region. However, the pattern fits (source of the below is Wikipedia):
Libya's population pyramid looks like many others in the restive region.
It seems that suddenly, everywhere you look there’s a group of people who are mad as hell, and not going to take it anymore (although I prefer the simplicity of the Nancy Reagan “just say ‘no’” formulation). There are the rioters in Libya (and before them Egypt and Tunisia, and along with them some others).
Iceland’s populace has previously just said ‘no’ to paying back the €4bln it borrowed from the UK and Netherlands to compensate savings account holders when Landsbanki imploded several years ago; the legislature approved a new interest rate and schedule of payments, but the President of Iceland will put the new deal back to the people. How do you like the idea that the debtor gets to decide when, how, and even whether to repay a debt? I suppose that’s always true at some level since the debtor always has the option to default but traditionally they at least protest about the purity of their intentions.
Four billion Euros is pretty small (especially since the proceeds of the Landsbanki liquidation should cover most of the it), but the repercussions if Ireland just says ‘no’ to the EU by voting a populist line in its referendum on Friday are far more stark. With all of the other geopolitical rumblings, the Ireland referendum might sneak up on some people.
But both sides of the European bailout mechanism is being said ‘no’ to. German Chancellor Angela Merkel just saw her party suffer the worst loss in Hamburg since WWII. German voters are saying no to sending money to Ireland, and the people of Ireland are saying no to taking it. Is it just me, or does it sound like the only people who think the EU should continue to bail out failed banks and countries are the elite politicians who can make other people pay for it?
However, the global power-to-the-people thing isn’t limited to the proletariat against the bourgeoisie. Sometimes, it’s the proletariat who can make other people pay for their privileges. In Wisconsin, Governor Scott Watson is representing the view of the non-union citizens against the unions, which is leading to demonstrations which would seem impressive if we hadn’t recently seen much better. The latter group is better-organized and wields considerably more political clout; the former group is far more numerous. I am cheesehead, hear me roar!
Of these, the issue with the most elemental importance to today’s trading was clearly the Libyan situation. Crude oil prices shot up nearly 8% today (basis WTI, closing the gap with Brent somewhat). The knock-on effect on inflation-linked markets was substantial. Inflation swaps were up 25bps for 1y tenors, 5bps at 5yrs, and 2bps at 10yrs. Notice that the big flattening of the inflation curve clearly illustrates that the expected impact from an oil price spike is short-term in nature. Oil spikes higher, and even if it never comes down it ceases to add to inflation since the latter represents a change in price level. A spike manifests in a higher short-term inflation level but tells you little about what the long-run price level will be. Energy price inflation is mean-reverting to a rate something around the broad price index. The important point is that this move notwithstanding, you haven’t “missed your chance” to get inflation protection. Longer-term inflation protection hasn’t gotten much more expensive, yet.
Oddly, while energy did very well the grains and industrial metals both declined. The grains took the worst of it, with Wheat -7%, Beans -5%, and Corn -4%. The excuse seems to be that unrest in the Middle East will decrease demand for foodstuffs from the world’s breadbaskets, but I don’t think I understand that reasoning. It seems to me that if anything, people need to eat more when they’re fighting. An army travels on its stomach, after all. If the government is no longer procuring grain, then surely private entities will need to pick up the slack (or for that matter humanitarian organizations). It isn’t like people will stop eating.
Stocks didn’t take well the renewed uncertainty and the perceived growth effect of an oil price spike. The S&P dropped 2%. The growth effect is probably not the main cause; $7 on oil just doesn’t have a very large effect. Now, make it $70 and sustain it for a little while and it’s a different story, but in my mind the risk to equities now is not the chance of $170 oil but rather the chance that this becomes the checkered flag indicating to everyone who has been nervous about the rally that this stage of the race is done.
Indeed, the same might be true of the pullback in agricultural commodities. It has been one heck of a run-up (see Corn chart, below).
Front corn futures
Blending that observation with the somewhat-weak S&P/Case-Shiller Home Price Index data that came out today – home prices are weak, unless you live on a farm. Do you know how well farmland prices are doing? In 2010, the growth in land values was 12% in the Chicago Fed’s district, the second-largest jump in the last 30 years (thanks to BN for pointing this out). But this isn’t all about the recent run-up in the price of crops. Farmland prices should impound not just current prices, but expectations about all future prices as well. Since there would seem to be no reason to expect grains prices to accelerate faster than the overall price index for a lengthy period of time – after all, history tells us it has always worked the other way over a long enough time span – this rise isn’t merely about good prices for soybeans. It is significantly about the fact that farmland is now considered an investible asset class by pension funds hungry for real returns. While other real estate prices have been diving for the last few years, nominal farmland values have been lifting off. I’ve clipped the chart below from the Chicago Fed article linked to above.
Source: Chicago Fed. This doesn't look like the residential real estate chart!
Farmland isn’t like commodity futures. Pension funds cannot meaningfully affect the spot price of commodities by buying commodity futures unless they take delivery and so affect the final demand for the product (and they are quite loathe to do so). They can affect the degree of backwardation, to be sure, but not the spot price. But farmland and other real property that is directly owned for investment can see prices affected by investment demand. There’s no one to go short the farm and provide the bid later when the pension fund wants to unwind the contract. When a pension fund (or an investment vehicle funded by pension funds) buys farmland, it reduces the float of available farmland and drives up the price – much more akin to what happens in, say, the art market than what happens in commodities. If everyone is bidding on the Van Gogh, it isn’t the futures price of Starry Night that rises but its spot price. Same with farmland, and it creates the same opportunity for bust if investors pay too much to get in. This is not, however, a 2011 or even I suspect a next-5-years concern. Right now, it’s merely comic relief next to real, current global crises.
I don’t want to predict that today’s selloff in stocks is the beginning of a deeper setback. Investors have shown an eagerness to leap back into the fray at every opportunity since Bernanke first mused about QE2, and this may happen again. But if the uneasiness I feel is more widespread, then there may be more to come as investors “just say no” to stocks.
That may not mean that they “just say yes” to bonds. Although today’s rally to 3.47% on the 10y note effectively puts an end to the threat of higher rates in the near-term, long rates are likely to be supported in the 3.33%-3.40% range. The alternative may well be cash, and zero-yielding money funds, for now, and if that is the case it could also affect the money supply numbers. Money fund assets – a component of M2, by the way – have been on a steady decline since peaking right around the time the stock market bottomed. The chart below shows the S&P 500 (in red) against money fund assets reported by ICI (inverted and shown on the left scale).
Money fund assets (inverted) vs S&P 500
A significant correction in stocks, especially with long rates providing little buffer against inflation, could easily flow back into safe and low-yielding money funds and other components of M2. Wouldn’t that be interesting? What if the money supply were to begin to surge at the same time that oil prices were spiking and stocks were declining? How would the Fed respond to that? “Just saying no” isn’t an option!
The Fed’s problem with the Great Unwind to come isn’t merely that the unwind methods are untested. The far bigger problem is whether there is a will to unwind when asset prices are declining and there is an energy shock – or some other situation that isn’t perfect for the unwind. I don’t believe there is, but we may find out.
Disquiet
Like all traders who have done it for long enough, I have several habits that I have developed over the years to cope with winning and losing streaks. For example, if I look at a chart and I really think it looks bullish, I will sometimes turn around and look at it upside-down; if in that position I think it really looks bullish too, then I know that what I’m seeing is actually what I want to see. Sometimes, when trading doesn’t seem to be playing out quite like I expect it to – not merely losing money; losing sometimes is a part of trading, but losing in ways that are surprising me – I push my chair back and, as New Age-y as this might sound, I try to listen to my feelings. Really good traders (of which I am not one) can tell when their subconscious is urging a change of action. I have been around some good traders like that, but the classic example is probably George Soros. His son explained in Soros: The Life and Times of a Messianic Billionaire
“My father will sit down and give you theories to explain why he does this or that. But I remember seeing it as a kid and thinking…at least half of this is bull—-. I mean, you know the reason he changes his position in the market or whatever is because his back starts killing him. It has nothing to do with reason. He literally goes into a spasm, and it’s this early warning sign.”
So maybe there’s something to this.
When I lean back now, I feel an uneasiness – a disquiet. This isn’t because the market has been going up and I’m not on board. I am on board, and maybe some of what I feel is that I’m far closer to my neutral policy mix than I should be given valuations. But there is something spooky in the way the rally is unfolding. I don’t feel comfortable in my chair. To be sure, I have felt for a while that the rally didn’t make a lot of sense, but it never made me feel like my posture was off.
Incidentally, I suspect that one reason the market has been doing what it has been doing – a slow, extremely steady march higher on light volumes – may be because one of the more popular trades over the last couple of years has been the covered-call gambit in which calls are written against a portfolio position for a little “extra carry.” It is generally sold as something to do in range-bound markets, which is what many people expected out of 2010 (of course, put-call parity tells us that selling a covered call is functionally equivalent to selling an in-the-money naked put, but I’m not here to harsh on this popular strategy). The problem with it is that if the market rallies through your strike, your stock is called away and you are forced to buy it again, or to buy the option back before expiry, if you want to remain long.
If lots of people were pursuing such a strategy, you would see declining implied volatility despite dicey economic and geopolitical risks. The VIX currently is as low as it has been since July 2007, around the time of the first serious mortgage rumblings. (In the summer of 2007, most people thought the “subprime problem” was contained, and not many people were particularly concerned about it. The market was just about to set a new (nominal) high.) So this fits. It also fits the character of trading, which seems lackadaisical and as has been well-documented, low-volume. People aren’t running to “put money to work” and adding to their positions aggressively. They seem to be buying…reluctantly.
I am not saying that the market is exhibiting a sense of disquiet, though. I am saying that I am feeling uncomfortable in some way. That being said, there are some odd incongruities out there. The headline on Risk.net “ECB overnight lending rockets to 19-month high” (incidentally, if you don’t subscribe to Risk.net a little trick is that you can just put the headline into Google and a link will take you to the full article) caught my attention. It is expensive to borrow from the ECB. It could just be a one-week glitch for some reason, but it is curious. The 3-month Euribor rate hasn’t done anything interesting in the last week, but it is trading above where it was in the middle of Q4 when there was a turn premium included. Maybe someone else is feeling the vague sense of unease that I have.
The behavior of oil, given the striking wave of political unrest in the Middle East, is strange but seems less strange if you look at Brent Crude (over $102 and near a post-2008 high) than if you look at West Texas Intermediate (WTI), which is around $86 and seven bucks off the highs. But that discrepancy in itself is odd. Brent crude oil is deliverable into the NYMEX contract, but not vice-versa, so pure arbitrage isn’t possible, but the ICE Brent contract is cash-settled based on local commercial-size market trades so if Canadian oil is gushing into Cushing, it is surprising that a $15/bbl discrepancy isn’t enough to persuade someone to fill up a tanker and deliver it into that market. In any event, there has been a lot of ink spilled on the difference between the contracts but it doesn’t seem obvious to me that there is a definitive answer. In any event, even the Brent contract hasn’t responded in the usual, spiky fashion to the widening circles of unrest in the Middle East – the rally has been slow and steady. Is there no risk aversion? What is going on here?
I have trouble believing that all of the crosscurrents are simply canceling: gradually-building economic strength in the U.S., widening violence in the Middle East, China’s efforts to slow its economy (on Friday China raised reserve requirements slightly, but unlike when the CCB hiked interest rates a couple of weeks ago the market seemed to ignore it), signs that inflation is starting to rise, continuing debt problems in a number of European countries and uninspiring leadership on our own debt problems in the U.S.. Could it be that everyone is just confused?
Well, count me in that group. I don’t feel right, so one thing I am going to do is to cut my equity positions down. If that doesn’t make me feel less disquieted, maybe I’ll try increasing them.
I’m not happy with this article.
What You See Isn’t What You Get
For a while now, stocks have been behaving nonsensically (okay, since growth has improved let’s just say “quasi-sensically”), but bonds have been easy to understand. That’s not unusual – the bond market is fairly straightforward. It’s a WYSIWYG market – what you see is what you get. For a Treasury bond you know the dates and amounts of all future cash flows. It may be indeterminate what those cash flows will be worth in real dollars (although not if you own TIPS), but at least it’s easy to understand. We also have a decent understanding of how inflation and real growth interact to create nominal interest rates. So, ordinarily, while the overall market may or may not have any semblance of trading at fair value, at least the day-to-day moves tend to be fairly easy to explain ex-post even if it wasn’t so obvious what was going to happen ex-ante.
There are exceptions to every rule, and today was one of those exceptions in the bond market.
Bonds rallied, as did stocks (on the 12th consecutive day of sub-1 billion-shares). The 10y yield is now at 3.58%, and bonds are acting as if the meltdown from the first week of February was premature. I’m not so sure that’s the case, but the rally today is impressive. Let’s review the backdrop:
Initial Claims was a slight disappointment, coming in at 410k. That was better than I feared, although worse than expectations; it isn’t enough for me to reject my null hypothesis that the underlying rate is more like 420k, but as the week-to-week swings (also known as “variance”) diminish it will be easier to reject that hypothesis, quantitatively speaking…if Claims stay low.
But against Initial Claims was the Philly Fed report, which came in at a whopping 35.9. That’s a 7-year high, and merits a “wow!” The subindices were fairly strong across the board: Shipments were up from 13.4 to 35.2, “Number of Employees” rose from 17.6 to 23.6. This is a good number, although as noted yesterday this is a rate-of-change measure and it’s hard to believe the pace of improvement will continue. I could be wrong. This number certainly increases the chance I’m wrong! And it certainly would seem to increase the chance that the bond bulls are wrong. But not today.
CPI was higher than expected. The headline change of 0.398% was a bit higher-than-expected, but core CPI came in at +0.170%, the highest in a year and a half. That pushed the year-on-year changes to 1.632% for headline and 0.950% for core (which resulted in the rounded 1.0% widely reported).
At some level the increase isn’t surprising at all – I’ve said for almost a year that the low would be set in 2010Q4 and we would rise from there, and this increase is right about on schedule for 1.6% or 1.7% on core by year-end. It certainly isn’t out of hand, yet. A whole year of +0.17% would produce an annual rate right around 2% and nothing for the Fed to worry about.
What is interesting is the breakdown. The chart below shows the eight major subgroups (and their weighting) along with the current year/year change (Jan ’10-Jan ’11) and the year/year change through last month’s data (Dec ’09-Dec ’10).
| Weights | y/y change | prev y/y change | |
| All items | 100.0% | 1.632% | 1.496% |
| Food and beverages | 14.8% | 1.796% | 1.481% |
| Housing | 41.5% | 0.377% | 0.287% |
| Apparel | 3.6% | -0.012% | -1.077% |
| Transportation | 17.3% | 5.419% | 5.290% |
| Medical care | 6.6% | 2.919% | 3.275% |
| Recreation | 6.3% | -0.593% | -0.766% |
| Education and communication | 6.4% | 1.234% | 1.292% |
| Other goods and services | 3.5% | 1.863% | 1.901% |
Here come the food price increases! 14.8% of the CPI jumped last month as the rise in food commodities finally started to pass through in earnest. But the rise in inflation goes further than that. Five of the eight groups, constituting 83.5% of the index, accelerated y/y price increases (or slowed price decreases) from last month to this month. Those five accelerating groups collectively added 0.16% to the year/year rate of headline inflation. The three decelerating groups (Medical Care, Education/Communication, and Other) subtracted -0.03% from the overall rate of inflation. The difference, roughly, is the difference between last month’s 1.496% rate of change and this month’s 1.632% rate of change.
There are any number of ways to skin this cat but none of them read particularly well for bonds. That is, except for TIPS. That market had a slow start today despite the data because of the threatening overhang of $9bln in 30y TIPS supply. Well, that overhang is no longer around and no longer threatening, as the issue cleared at 2.19% with a healthy 2.54:1 bid-to-cover ratio and 55.2% to indirect bidders. The data certainly helped but in my mind the paucity of available long-dated linkers, combined with the not-too-bad real yield, made for a slightly more-filling meal than at the August auction when the clearing yield was a mere 1.768%. The long TIPS have been well-received so far.
But how is all of this good for bonds? You got me.
I can think of one reason bonds may be more appealing today than they were yesterday, but it’s a slender reed. Unrest in the Middle East continues to bubble. Protestors were killed in both Bahrain and Libya over the last few days. Yemen is unsettled. Iran is moving warships to Syria. There is a lot going on that could produce something dramatic; meanwhile, the markets will be closed on Monday for President’s Day, so we have a three-day weekend looming and bonds might be a safety blanket for whatever develops over the weekend. That’s not a very satisfying answer, though – because stocks were up, the VIX was down; oil was up, but only $1.37. If bonds are sensing impending drama, they’re alone.
“Thin liquidity” is starting to be a relative term, but tomorrow ought to be thin. With no economic data and leading into a 3-day weekend (and did I mention it is supposed to reach the 60s in Manhattan?), markets will have a tendency toward illiquidity.
Still Skeptical
It was another low-volume day on the stock exchange, but at least there was some interesting news and some intriguing undercurrents. And, of course, CPI day tomorrow!
On the data front, strong Housing Starts (596k vs. 539k expected) kicked off the day. The market reacted with characteristic giddiness to the 14.6% rise month-on-month but as the oft-shown chart below shows, the correct response is “who cares.”
Wow, 14% improvement. Wheeeeee!
On the flip side, Industrial Production was surprisingly weak although off an upwardly-revised prior print. Overall production was -0.1%, but that represented a rise of 0.3% in manufacturing output and a strange drag from mining and utilities (strange because, if I remember correctly, January was pretty dang cold). This, and the PPI release generally (core PPI was an unpleasantly-high surprise, but with the usual caveat that “it’s PPI”), ought to be jointly tossed into the bin of irrelevancy.
There were some geopolitical events. Oil jumped 0.9% when the Israeli Foreign Minister suggested that two Iranian combat ships are planning to sail to Syria through the Suez Canal imminently. This hasn’t happened in quite a while, and since it represents two of Israel’s implacable enemies greeting each other with a brotherly embrace they are unsurprisingly concerned. Even with the Egyptian pinch point past, the region continues to look like a frying pan on which some drops of water have been sprinkled, with sizzling and jumping all over the place. (I suppose that’s why it’s called a ‘hot spot.’) There were demonstrations in Libya, too. Was “Iranian warships provoke a military confrontation with Israel” on anyone’s list of possible buzzkills for the market? This is why value, and a margin of safety, matter so much – after you have planned for every foreseeable eventuality, you need to prepare for the unforeseeable ones (although, in the grand scheme of things, I suppose that Iran trying to tick off Israel isn’t exactly a bolt from the clear blue sky).
The Fed provided some entertainment today in their release of the minutes from the January meeting. According to the Fed, yields rose during the intermeeting period “…in response to data releases that generally pointed to some firming of the economic recovery,” but inflation breakevens “…moved up, likely pushed higher by rising prices for oil and other commodities and by the firming of the economic outlook.” As far as anyone can tell from the minutes, the Fed thinks QE2 is hardly being noticed (which raises the question, “then why did they do it?”).
Now, in reading this next section keep in mind the great confidence that has been evinced by the Fed Chairman (and other Fed speakers) publicly when the topic of tightening comes up. We are told that it’s not a problem because the Fed is keeping an eye on inflation and can pull the plug at will.
“Regarding risks to the inflation outlook, some participants noted that increases in energy and other commodity prices as well as in the prices of imported goods from EMEs posed upside risks. Others, however, noted that the pass-through from increases in commodity prices to broad measures of consumer price inflation in the United States had generally been fairly small. Some participants expressed concern that in a situation in which businesses had been unable to raise prices in response to higher costs for some time, firms might increase them substantially once they found themselves with sufficient pricing power. In any case, the factors affecting the ability of businesses to pass through higher prices to consumers were viewed as complex and hard to monitor in real time. Most participants saw the large degree of resource slack in the economy as likely to remain a force restraining inflation, and while the risk of further disinflation had declined, a number of participants cited concerns that inflation was below its mandate-consistent level and was expected to remain so for some time. Finally, some participants noted that if the very large size of the Federal Reserve’s balance sheet led the public to doubt the Committee’s ability to withdraw monetary accommodation when doing so becomes appropriate, the result could be upward pressure on inflation expectations and so on actual inflation. To mitigate such risks, it was noted that the Committee should continue its planning for the eventual exit from the current exceptionally accommodative stance of policy.”
This is a treasure trove of interesting clauses. “Hard to monitor in real time” is not exactly comforting given the sums of money involved and the stakes at risk if the FOMC is wrong about inflation. And the last sentence reads, to me, more like “we all decided that it is important to keep talking about how well-prepared we are to unwind all this stuff.”
Consonant with this intention, Dallas Fed President Fisher said today that the most logical way for the Fed to begin pulling back the stimulus, when appropriate – and Fisher is likely to be one of the earlier advocates of that, by his own admission – is “to undo what you did last.” That is, the Fed should consider selling off their Treasury portfolio as a first step in tightening. This is eminently sensible, except for one objection – if they do that, the bond market may collapse. Now, perhaps not, but as I have pointed out before the difference between the Fed buying $100bln per month and the Fed selling $100bln per month is the difference between 0 net issuance of Treasuries and $2.4 trillion/year.
It is still a reasonable thought experiment, though. If the policy to date isn’t reversible, what does that say about the real point of the policy? If rates will end up much higher, it implies the market is, in fact, close to saturated with Treasury securities and that in turn implies that the Fed did, in fact, act as an enabler to a profligate Administration and Congress. The Fed needs to unwind these purchases if only to prove that they are indeed independent.
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Tomorrow is a big day in inflation. We start with CPI (Consensus: +0.3%, +0.1% ex-food-and-energy) and end with the auction of $9bln 30yr TIPS. Oh, there’s also Initial Claims (Consensus: 400k from 383k) and the Philly Fed index (Consensus: 21.0 vs 19.3).
The consensus estimates for both Philly Fed and Claims imply not just growth, but accelerating growth. The cycle high for Philly Fed was 21.2 in May of last year when the Census was hiring workers with both hands. But more to the point, values much about 20 are not all that common. In fact, since 1985 a 21.0 would be at the 84th percentile of all values of the Philly Fed Business Outlook (see Chart). So 21.2 isn’t “a little improvement over last month.” This is a rate-of-change survey, and getting much above 20 (at least on a sustained basis) suggests a booming economy. I don’t see it.
Philly Fed much above 20 is not an easy bet.
The 400k estimate for Claims, too, represents expectations that most of the 27k downward surprise last week was real and that the economy is kicking to a higher gear. This may well be so, but again I don’t see it. The average for the last 4, 8, and 12 weeks is between 415k and 419k on Initial Claims. That looks closer to the central tendency to me. I suspect last week’s low level of Claims was snow-induced. We will see. Another low print would force me to reconsider that hypothesis, because (ex-blizzard) we are in a part of the year that is usually easier to seasonally-adjust.
Now for CPI, clearly the star of tomorrow’s show. For a review of last month’s number and a general outlook for the year, see my comment from Jan 16th and a subgroups-summary here. The consensus figures would push the annualized headline number from 1.5% to 1.6% and core from 0.8% to 0.9%. The consensus forecast for headline actually is closer to 0.25%, just barely rounding up to 0.3% although comfortably bumping the y/y number higher. It is that extra edge with respect to rounding that makes the risk of an 0.2% or an 0.4% about even. A true 0.3% month/month change should cause the year/year rate of headline to go to 1.7% actually.
Here’s a fun exercise. If we take the year-on-year rates of change for each of the eight major subgroups of CPI (Food & Beverages, Housing, Apparel, Transportation, Medical Care, Recreation, Education and Communication, and Other) for Nov ’09 to Nov ’10, look at how those rates of change evolved last month (Dec ’09 to Dec ’10), and extend all 8 of those trends one more month, the headline y/y tomorrow would be 1.9%. The core figure would be 0.9%, but just barely. For example, two months ago the y/y change in Housing CPI was +0.01%. Last month, the y/y change had risen to 0.287%. If that improvement continues to 0.564% this month, it will go a long way to offsetting any drags from the declining/decelerating groups. But this also shows you what sort of momentum the declining groups have had.
The risk this month in the headline is clearly to the upside. The risk in core is muddy because of the conflicting crosscurrents, but it has been more than a year since we saw a bona fide 0.2%. It is hard to disagree strongly with the consensus this month.
After CPI is out of the way (be sure to read tomorrow’s commentary where I will break down the subgroups a bit), the Treasury will be auctioning $9bln of 30y TIPS at something around 2.25% real yield. Recall that last month, a 10y TIPS auction tailed 6bps and then sank in the aftermarket to consume that entire “Dutch treat.” That was sloppy, and people are concerned about the Treasury’s ability to sell $9bln 30y TIPS (so is Treasury, which is why they’re selling just 9bln and not 10bln).
But here’s what you need to know about a 2.25%, 30-year inflation-linked bond yield: on a global basis, that’s a pretty fat long-term yield at the moment. The French 2040eis yield 1.70%. The Canadian 2041s yield 1.48% (if you can find them) and the 2044s about the same. In the UK, inflation-linked bonds maturing in 2040 flash a sporty 0.85%; the 2042s are 0.80%; the 2047s are 0.74%; the 2050s are 0.71%, and the 2055s are 0.68%. And that’s about it for long-dated issuance (unless you feel game to invest in Italy for 30 years, in which case you can earn 3.15% plus European inflation…whatever that means in 30 years). So if you want long-dated inflation-linked bonds, you can invest sub-1% in the liquid UK market, or 1.4% in the illiquid Canadian market, or roll the dice on Italy. Or, you can buy 2.25% or so from the U.S. Treasury.
There is ample global demand for very long-dated inflation-linked returns, but the supply is scarce. Buying the US instead of the UK gives you a 1.4% advantage. Since most of what causes inflation in both of these countries are factors in common and the rest can be hedged,[1] it should be a popular investment for non-US investors. Despite the rotten performance at the 10y TIPS auction last month, I think that this auction will see good end-user demand and dealers ought to be comfortable owning some.
[1] Well, it isn’t easy to do but Enduring Investments has a method.
Fumes
In case you missed yesterday’s comment (it came out quite late), a link is here. It was both lengthier and pithier than today’s offering.
On Tuesday there was a very mild disappointment from Retail Sales, which clocked in at +0.3% on the aggregate and ex-autos number along with a downward revision to the prior months. Economists blamed the weather, which is probably right…but it is interesting that no one jumped to blame the weather when Initial Claims surprised on the strong side last week. And I am not sure how the weather can explain the downward revision to December. On the other hand, the Empire Manufacturing number was on-target, so nothing in today’s reports should be considered a show-stopper.
And that includes the UK CPI release, which put headline inflation in the UK at 4.0% year/year. This produced lots of anguished cries for monetary tightening, but core inflation is only at 3.0%. Yes, 3% is much higher than the BOE’s target, but it has been in that range since early last year. To be sure, the BOE doesn’t want inflation that high, but the money supply (M4) is already contracting in Britain (two years ago it was +17.5%), and with unemployment around 8% there it seems unlikely that the BOE is about to get aggressively hawkish. The money supply contraction already means relative disinflation is in store for late 2011 or in 2012. Our quant model has a serious underweight in inflation-linked Gilts, which makes sense since the 10y UK II Gilt yield at 0.85% doesn’t give a lot of protection against the declining relative inflation implied by the tight monetary conditions.
I keep saying “relative” inflation there, however, because we must always remember that liquidity is fungible. Banks and companies can borrow in a rainbow of currencies in the global capital markets. If the Fed and the BOJ add enough liquidity, then prices in general will rise although currencies of countries with more-prudent monetary policies will be more likely to appreciate and help to keep inflation in those countries comparatively lower.
The UK merits a comment today because so little seems to be happening domestically. Obama’s budget will cause an ugly battle but doesn’t affect the day-to-day ebb and flow of the market. Indeed, not much seems to be affecting the daily ebb-and-flow. Today marked the 10th consecutive trading day in which NYSE volumes have not reached 1 billion shares. That happened only once all of last year, and not at all in 2005, 2006, 2007, and 2008. Year-to-date NYSE volumes are down 15% over the same period last year, and -36% compared to the average of the last five years. Perhaps the stock market continues to rally because “fumes” are lighter than air.
The problem with many kinds of fumes is that they ignite easily. While there seems to be no catalyst to send equity prices sharply lower, the diminished volumes suggest that there are not a lot of buyers committed to these higher prices. The real test will be when a good break comes and we find out if volumes are light because everyone missed it and is waiting desperately for lower prices to get in, or because no one trusts these levels or the market as a whole and investors will remain on the sideline cheering when prices decline. To me, the fact that higher prices do not seem to be resulting in swelling volumes suggests the latter is more likely. But for a test, we will need an ignition source and I see nothing immediately obvious.
It need not be immediately obvious, of course! The impact will be greater if it comes as a surprise, either because no one saw the particular event coming or because no one thought it would be significant. For example, something as innocuous as a 4% 10y note rate could in principle trigger a movement into bonds from stocks in asset allocation models. It would certainly be surprising if that was a big event. No one is looking for a jump in CPI, and a bad surprise there may serve as a catalyst no one was worried about. Obviously, I don’t know. I’m curious about what the readers of this article think are the most-serious potential catalysts for an equity correction.
Bonds probably don’t need much of a catalyst to keep going down. Weak data and Fed buying may keep them treading water, but tomorrow’s Housing Starts data (Consensus: 540k) is unlikely to trigger a rally even if weak – this is January data and it would be a bit surprising if it didn’t show signs of weakness. Besides, we already know housing is weak. PPI (Consensus: +0.8%, +0.2% ex-food-and-energy) isn’t a candidate because, after all, it’s PPI. Industrial Production and Capacity Utilization (Consensus: +0.5%/76.3%)? No one really worries about these series when they are at middling levels. And, while FOMC minutes from the January meeting will be released tomorrow, there isn’t going to be a surprise there.
No, the better chance is for Thursday’s CPI release. I expect we’ll have another day of fumes on Wednesday.
Love Is In The Air
Ah, there is nothing quite like the manufactured holiday of Valentine’s Day.
It is a time to reflect on the impact in our lives of all those whom we love: family, friends, commentary subscribers, Twitter followers, et cetera. It is a time to salute Pepe Le Pew as being a tireless suitor rather than an annoying stalker. It is a time to be moved by Elizabeth Barrett Browning’s Sonnet 43 and not to disparage it as a cloying attempt at one-upping her secret love (and future husband) Robert. And it is a time for letting people we love know that we really do love them.
For example, it is clear that I do not often remember to say “I love you” enough to Alan Greenspan. Without the Maestro, how would I ever have been inspired to write Maestro, My Ass? (Note that you can still get a discounted copy here.) And my affection for Ben Bernanke burns even hotter, for he is really trying to help those of us who specialize in inflation markets. God bless his little heart. I adore Obama’s cute little Socialist tendencies; socialism creates such wonderful opportunities for entrepreneurs to offer efficiency as a product. Every dollar of expenditure in the Federal Budget (the President’s proposal was released today with a record deficit projected for the recovery year of 2011 before dropping to “only” 1.1 trillion in 2012) represents an opportunity to do something better than the government. Would FedEx have ever gotten started if the Post Office wasn’t run so well? I hope Fred Smith sends a valentine every year to the Postmaster General.
I don’t really much care for Congress. There’s just not room in my heart for those little dickens. You can’t love everyone.
More seriously: the budget proposal released today is amazing and, if you are think of buying 30-year nominal Treasury bonds you really ought to give it a read. While the bond market managed to eke out a small gain with 10y Treasury notes closing at 3.61%, it is hard to imagine those low rates will be available to the Treasury a year from now. The budget contemplates a $1.1 trillion deficit next year and never less than $600bln over the forecast horizon. By comparison, before 2009 there had never been a full-year deficit of more than $455bln (see Chart below if Valentine’s Day puts you in a charitable mood that makes you feel uncomfortable).
Calendar-year federal deficit (source: Bloomberg)
For another comparison, interest on the national debt is expected to be $474bln in 2012. That’s up 14.5% for fiscal year-on-year and that, my friends, is with record low interest rates! But don’t let your blood boil: it’s Valentine’s Day after all. And another observation: until 2008, the amount of currency in circulation had never exceeded $830bln (it is now not quite $1trln). So if you gathered every U.S. penny, nickel, dime, quarter, half dollar, dollar coin, and every bill in every wallet and piggy bank in the world, you still would be more than $100bln shy of covering next year’s deficit. Not debt, folks: just the single-year shortfall.
What is amazing to me (and I don’t want this to become a political comment, but large deficits have a market effect and an economic effect and so it’s worth discussing) is how many parts of the budget are increasing at the very time when we’re running pan-trillion-dollar deficits. Look at the wonderful color-coded chart that the NY Times has up here. This is true even among discretionary items, but let’s be frank here: if the alternative is that the nation is unable to fund this budget and unable to borrow it, these are all discretionary items.
It is a depressing reminder of the state we are in to look at what is considered a reasonable budget proposal. But again, for an inflation consultant these should be lovely times. For many people, and although I am an optimist I increasingly count myself among them, can’t figure out how we get out of this mess without completely changing the structure of the budget and the scope of the entitlements and then inflating ourselves out of the existing debt. Make no mistake, just doing the latter won’t work because the entitlements are inflation-linked and the average maturity of the debt is right around five years – meaning that in five years, your interest payments will rise to reflect the new inflation reality. We must put the budget into surplus and then inflate.
Except that I don’t think there is anything approximating a plan to do this in a rational way. We are guiding the ship of state through the murkiest, most-dangerous shoals in the world and no one is steering. (And is that perhaps one of the reasons the equity market is rallying? Because the only hope is to spin the roulette wheel and get lucky?)
But this should be a happy occasion. This is no time to bicker and argue over who killed who. (Apologies for the Monty Python and the Holy Grail reference). Let’s focus on the good news, for there is at least some.
The good news is that for whatever reason, the financial markets are not yet punishing us for what is surely an increasingly obvious denouement to the predicament. The Federal Reserve is right, at least presently, that the cleanest read of inflation expectations indicates that no one has caught on yet. The chart below shows 5y inflation swaps and then the 5y inflation swap starting 5 years from now (the 5y, 5y forward inflation swap).
Forward inflation measures are calm and contained.
While the 5y is near multi-year highs around 2.25%, the 5y5y is only just above 3% and seemingly in no danger of breaking out to new highs. While 3% is well above the Fed’s stated target, there is always a little risk premium in the forward since all of the long-tail risks are to higher inflation (there is no chance of -10% inflation, but +10% isn’t even all that difficult). Even back in the halcyon days of 2006 and 2007, the 5y5y ranged between 2.70% and 3.05%. So there certainly seems to be scant alarm in the inflation derivative markets. The chart below shows a scatterplot of the last year’s worth of data with the latest point in red. Arguably, 5y5y is even lower than it should be, given expectations for inflation over the next 5 years and the “usual” relationship between these two measures.
5y CPI swaps (x-axis) vs 5y5y CPI swaps (y-axis) suggests that if anything, forward expectations may be low!
Now, let me be clear. There ought to be some alarm. Given a choice between buying the 5y5y at 3% and selling it there – not as a trade but as a bet to hold for 5 years, mind you – the choice is simple to me. I can tolerate a loss of 1% per year if I am wrong and inflation expectations in 5 years are at 2%. I can tolerate a loss of 2% per year if expectations are for a mere 1% inflation over 2016-2021. But I don’t want to be in the situation, five years hence, of possibly having to buy inflation protection at 10%.
Some of this is due to the fact that the Fed is trying to hold down long-term nominal rates, and while this chart shows inflation swaps rather than inflation breakevens the two measures are kissing cousins. But the Fed is also buying TIPS, and that will tend to drive up the same spread, so while 10y nominal yields are clearly lower than they otherwise would be if there were no $600bln gorilla in the room, it is not quite as clear that forward inflation metrics are as perverted as nominal yields themselves.
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In contrast to last week’s desert of economic data, this week’s more-interesting slate gets moving tomorrow. The Empire Manufacturing Index for February (Consensus: 15.00 from 11.92) will be released at the same time (8:30ET) as Retail Sales (Consensus: +0.5%, +0.6% ex-auto). I expect bonds to resume the recent trend to higher yields, but at 3.57% on the 10y yield I’d reconsider the immediacy of that stance. Stocks will someday fall, and fall appreciably, but I see no reason to expect that yet. Love is in the air.
Overtaken By Events
One day after Egyptian President Mubarak stated flatly that he would “die and be buried in Egypt,” he evidently began to be concerned that his prophecy would be fulfilled sooner than he had planned. The incredible swiftness of the change in direction and sudden resignation shows clearly a man and a government who tried to manage a process that was larger than they were and who were swiftly overtaken by events.
The stock markets took this as good news and shrugged off for a second consecutive day the overnight weakness. This is a kneejerk reaction that doesn’t make a ton of sense to me. While I am firmly in the camp that believes a spreading of democracy – even if we don’t like who wins the elections – is a good thing in the long-run, in the short run we don’t even know who is in charge of Egypt. “The military,” we are told, but “the military” isn’t the one who makes the decision to pay the coupons on the debt (nevertheless, Egyptian credit improved with the news). Moreover, while this removes some uncertainty and that is clearly a small positive for stocks and a small negative for bonds, it also encourages other democratic movements in the region. It wasn’t obvious that Tunisia was a big enough first domino to cause any other regime to topple. But there can be no doubt that regime change in Egypt is a big deal. Maybe there is relief that the situation is resolved, but how long will that relief last if, say, the Saudi “street” shows some unrest?
I am not saying that some natural “thirst for freedom” is going to drive the dominos. Consider however a more pertinent similarity between Egypt and other candidates for unrest: demographics. The chart below shows Egypt’s “population pyramid.” The population in each age range is shown by a bar. Having the skinny part at the top and the fat part at the bottom shows a country where “disaffected youth” isn’t just a parental headache but, when times are difficult, a societal one.
Egypt's population pyramid.
You may say “it’s normal, isn’t it, for the skinny part to be at the top?” Well, sure, but there are degrees of skinniness. For contrast, here is Germany’s demographic pyramid (incidentally, the source for all of these is Wikipedia; type “Egypt demographics” into Google and you’ll get the right link). In Germany, as to a lesser extent in the United States and to a greater extent in Japan, the problem isn’t disaffected youth; it’s dispossessed senior citizens.
Germany's population pyramid.
Now, are the following charts of Saudi Arabia, Syria, and Yemen more similar to Germany or to Egypt?
Saudi Arabia's demographic pyramid - look at the bulge especially among young males!
Syria's population pyramid.
Yemen's population pyramid.
So you see, the perils of texting these days may be worse than we think. Revolution could spread by Vodafone. I am not sure what that means for equity valuation. But I know I’d rather be long the “high dollar” tails in energy futures than short those calls!
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Not to compare the deposed ruler of Egypt to the second-most-powerful man in the world, but Mubarak isn’t the only person around who believes he can manage a process that is larger than he is, nor the only one who is able (and even likely) to be overtaken by events. Chairman Bernanke is staking his entire reputation, as well as (more worrisomely) the credibility of his institution – and perhaps much more – on his belief that buying trillions of Treasury and agency securities will resuscitate the economy but not produce inflation.
It seems to me that he balances that belief on three major premises:
- Right now, expansive increases in the monetary base are not translating into goods and services inflation, and any effect that it has on asset inflation is apparently desirous given how much the Fed has trumpeted such. But the major premise is that large increases in zero-maturity money will not precipitate into inflation because economic slack will absorb any inflationary forces.
- In addition to economic slack, well-anchored inflation expectations will retard an actual rise in inflation, and
- If there is any sign of incipient inflation pressures, the Fed can swiftly remove the stimulus at will.
These premises may prove to be entirely correct. But they’re not uncontroversial.
1. Many people, myself included, believe that there is no conclusive link between economic slack and inflation. I demonstrated in this space on February 3rd that while there is an understandable connection between labor market slack and labor market wage growth, there is no identifiable connection between labor market slack and overall inflation. And there’s the little matter of the 1970s to explain, if economic slack prevents inflation.
2. The whole “well-anchored expectations” thing is an incredible bit of Greenspanian mind control. I believe Greenspan popularized the notion that if people do not expect inflation to accelerate, then it won’t (but the idea derives from rational expectations arguments). It was a puzzle to the Fed to explain why in the 1990s, despite quicker-than-expected money growth, inflation remained quiescent. The “well-anchored expectations” hypothesis sounds plausible. But there’s no data to prove it with because nobody has measured inflation expectations in any meaningful way.
For example, in 2007 Frederic Mishkin described recent changes in the persistence of inflation, the tradeoff between inflation and unemployment, and the responsiveness of inflation to other shocks as a function of well-grounded inflation expectations; to proxy inflation expectations he used the Livingston survey and the FRB/US survey which itself consists of the Hoey survey and the Survey of Professional Forecasters (SPF), and also referred to the Michigan Survey of Consumer Attitudes and Behavior (Michigan survey). But what in the world does a survey of professional forecasters have to do with consumer inflation expectations? And the Michigan Survey shows strong evidence of “anchoring,” a cognitive bias where a respondent starts the process of determining an answer by choosing an “anchor” and then making an adjustment to arrive at his/her conclusion. So, for example, a Michigan respondent is probably aware (unless they live in a hole) that inflation was just reported at 1.5%, or that it is “around 2%”, and then says “my experience is a little higher.” The chart below shows the Michigan Survey “1 year ahead” inflation expectations versus actual reported headline CPI.
Inflation expectations are anchored all right - at the most recent CPI print.
That’s anchoring, and it renders the data useless for analyzing the point that we are supposed to believe in so strongly. Michigan Survey respondents’ inflation expectations may be “well-anchored,” but not in the sense that they will continue to be expect low levels of inflation even when prices are rising. By the way, notice that the “1 year ahead” expectations are very strongly correlated with inflation experienced over the past year. That doesn’t suggest to me, even if this was good data, that expectations are anchored and will be resistant to change; it rather suggests the opposite (and more reasonable) conclusion: that expectations will follow actual inflation higher.
3. I have no confidence whatsoever that the Fed could easily sell $110bln in securities per month for 12-18 months without causing a crash in the bond market and probably in the stock market as well. That would basically be doubling the amount of net Treasury issuance to his the Street every month (that is, doubling it from what it would be if the Fed wasn’t already subtracting that much net issuance every month). And if the Fed could pull off this trick, that pace – which is close to what the Desk says is its limit – is still probably too slow if they wait until they see inflation rising into the danger zone. Perhaps the Fed could withdraw lots of liquidity very quickly through their new term facilities and by raising the interest paid on excess reserves, but would it really choose to make a dramatic tightening of unparalleled magnitude in any case? And even if all of that is negotiable and a way can be found to drain sufficient reserves to backpedal on the massive rise in the money base, I can’t imagine that they have the political will to do so when the Unemployment Rate is over, say, 7% and the country needs to generate several hundred thousand new jobs per month to keep the Rate from rising. Is that really plausible to anyone?
So of those three major premises, I don’t buy a single one. And they really matter. If #3 is false, or if both #1 and #2 are false, then the error is fatal and the outcome pretty ugly. I may well be wrong, and it won’t be the first time. But these are plausible arguments (I think), and at the very least a prudent manager of the central bank would employ great caution on the chance – however remote he thinks it is – that his read of the situation is wrong. The man who is overtaken by events is the man who didn’t prepare for those potential outcomes. See Mubarak, H.
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Once again, I defer my discussion of the state and levels of the inflation-linked markets for another day. I apologize to anyone who was tuning in expecting to see that, but while some people are overtaken by events, I am occasionally overtaken by rants. However, on Monday I ought to be able to get to that topic, since there is little on the calendar (but then, an overthrow of the Egyptian President wasn’t on the calendar either). There is a TIPS buyback scheduled, and NY Fed President (and former Goldman guy) William Dudley is speaking to a regional economic conference. He is scheduled to deliver remarks at 10:00ET.
