Archive for March, 2011

Take Me Out – Going To The Ballgame

March 31, 2011 5 comments

The day before Employment is often a quiet day, and today it also happened to be the Yankees’ home opener.[1] Had it not been quarter-end then the markets might as well have been shut. At 3:58ET, only 650mm shares had traded on the NYSE (the final tally, however, was 1.01bln due to rebalancing flows).

Scheduled economic releases were not earth-shattering: Initial Claims was a smidge weaker than expected at 388k (expected: 380k) and the Chicago Purchasing Managers’ Report was slightly stronger-than-expected at 70.6 (expected: 69.9).

Now, all was not quiet everywhere. The Libyans, who are notoriously uninterested in Yankee baseball (rumor has it they’re Phillies fans), insisted on continuing to fight; the ebb and flow of Gaddafi’s forces were on the “flow” side today and there was considerable fighting around one of the oil ports and another oil hub. This pushed oil higher, and today’s $106.68 close for front Crude on the NYMEX was the highest close to date.

The Irish, who probably see baseball as being a sissy sport (have you seen the sport of hurling played?), also showed little respect for Opening Day as banking regulators ordered four domestic banks to raise €24bln in capital after a stress test showed that they were (shocker!) undercapitalized. This may prove difficult. Consider Allied Irish, the biggest of the four. The Irish central bank says they need €13.3bln; meanwhile, its market cap is, um, €0.3bln.

JP Morgan Chase President Jamie Dimon (who is probably more of the horsey set, but these comments were made late Wednesday so we’ll give him a pass) remarked on the future of banking in the U.S., noting that clients will prefer to deal with banks in countries that have lower costs and therefore can offer better prices. “We’re starting to add up a whole bunch of things which are negative for America…if we have higher capital limits than the rest of the world, now you’re just starting to put nails in the coffin.” These comments may be surprising to those of us who have already buried the banks because lower volumes, tighter spreads on vanilla product that is being pushed to exchanges, and lower leverage should combine to lower the return on equity of a banking institution quite considerably. However, I do agree with his remark that the derivatives laws in Dodd-Frank represent some of the most “irrational” legislation he has ever seen. Dimon is not exactly trying to win friends on Capitol Hill right now (which I guess is one sign that he figures the worst is past); he also said that banks would not even consider writing down mortgages for homeowners who are able to make payments. Well, I also agree with him there – borrowing is a moral obligation as well as a financial obligation, fraud aside – but wonder at his reasons for making the comment.

Turning to the story which is increasingly on people’s minds (and high time, I would say; have I mentioned recently that my company consults on inflation-related topics and investments?), a friend sent me a link to a USA Today story entitled “Wal-Mart CEO Bill Simon expects inflation.” It turns out that he sees “serious” inflation ahead. “We’re seeing cost increases starting to come through at a pretty rapid rate.” When someone who is sitting in the crow’s nest hollers “iceberg, dead ahead!” it pays to listen and to take evasive action, even if you can’t yet see the iceberg.

But it’s baseball season, there’s new grass on the field, and hope is everywhere…which is, I suppose, why stocks just registered another 5% quarter.

Many hopes have been dashed, though, on Employment Friday, and it happens that Q2 kicks off tomorrow with just such a day. The consensus estimate for Payrolls is another +190k figure (last month was +192), with the Unemployment Rate holding steady at 8.9%. Given the way the ‘Rate has been plunging, remaining unchanged would almost seem to be bad news, but as I’ve noted before (and which hasn’t gone unnoticed elsewhere) the declining labor force participation rate has been largely responsible for that plunge. I want to see the ‘Rate decline, but almost more important at this point is that I want to see the participation rate rise.

Surveys of labor market conditions over the last month continue to show that if the employment situation is improving, the man on the street isn’t yet feeling it. The “Jobs Hard to Get” index in the Consumer Confidence report is still up around 45. And the JOLTS survey of job openings declined slightly in December and January (see Chart). That survey is volatile, and is released with a big delay so it isn’t very helpful to us in forecasting this release, but do notice on the chart that the number of job openings still hasn’t risen to equal the lowest level reached in the last recession. So it wouldn’t shock me to see the Unemployment Rate rise.

Job openings still aren't as widespread as they were in the depths of the last recession.

Also scheduled for tomorrow is the ISM Manufacturing survey (Consensus: 61.0 from 61.4), which is unlikely to be a market-mover, and monthly car sales for March.

Bonds (the 10y note at 3.47%) remain in a holding pattern, and inflation swaps are still waiting for an excuse to break to new highs or to retreat from their current levels (about 2.46% on the 5y and 2.74% on the 10y). Both are unlikely to find that excuse tomorrow. For what it’s worth, I still expect the next major move in rates to be higher (in rate), rather than lower, even if I am skeptical that the recovery is robust enough to warrant equity prices where they are.

[1] For the record, I follow the Mets.

Categories: Employment

When Velocity Feels Like Acceleration

March 29, 2011 4 comments

Continuing the list of exciting news that equity investors consider to be bullish, today the debt of Portugal and Greece were downgraded by S&P, and the Syrian Prime Minister resigned due to the continuing protests in that country. Treasury yields edged higher again (10y yield is now at 3.49%) and Crude Oil rose – continuing to toy with the $105 level on WTI.

Consumer Confidence was weaker-than-expected at 63.4, due to a sharp decline in the expectations component. But some observers had been bracing for even worse, due to the sharp decline in the Michigan Confidence figure, and stocks began to rally as soon as the number printed. After all, 63.4 is still pretty high compared to where it was last year, although it does bear remembering that the low print of confidence in 2003 was 61.4 (see Chart).

The current level of confidence looks high only because it got so low.

People (thanks, JH!) made a big deal about the 1-year-ahead consumer expectations for inflation that came out of the Consumer Confidence data. That number jumped to 6.7%, the highest since the energy spike of 2008 (see Chart). Initially, my reaction was that this simply was a trailing indicator indicating the recent rise in gasoline prices. But when you look at the chart on a longer-term basis, it’s really quite fascinating.

Consumer Confidence 1y-ahead inflation expectations

Inflation expectations were actually considerably lower in the early and mid-90s, despite the fact that inflation was demonstrably higher (see Chart below; compare to chart above).

The uptrend in expectations doesn't seem to be grounded in the reasonably-stable trend CPI.

Now, why this is fascinating goes to the next chart. The upper chart is the level of front Crude Oil futures; the bottom is the 12-month change in crude oil futures.[1] That is, the top chart is the price level, and the bottom chart is analogous to inflation, which measures the change in the price level.[2] This is where it is interesting to me. The Consumer Confidence index of year-ahead inflation expectations is clearly tied more to the level of gasoline prices than it is to the change in prices! And that is unexpected (to me) and surprising.

And it has some interesting implications for policy (continuing yesterday’s conversation, which if you missed it you can find here). The Fed’s view is, as they have repeatedly stated, that they can be measured with removing stimulus because consumers’ inflation expectations are “well-anchored.” In modeling, the usual assumption is that inflation expectations are related in some way to recent inflation, or trend inflation, or something like that. These charts suggest that consumers are responding to visceral sensations much more than is generally assumed. When prices were low, even a large percentage change didn’t bother the consumer, because at the margin it wasn’t changing his lifestyle much. At a higher level of prices, suddenly people notice the effect that the prices are having on the wallet, and translate the “I don’t like this” feeling into a sense that there is inflation.

I’ve written previously about some of the other cognitive biases we bring to the table when we consider inflation but this is a phenomenon I hadn’t included and probably ought to be.

The implication for central bankers is that even if energy prices (and even more importantly, food prices) flatten out so that they are not going up any more – and thus, food and energy inflation will revert to zero after a year – consumers may still encode a high level of inflation expectations because of the level of prices.

And that would really suck, to use a technical term. Because the Fed has very little control over the level of gasoline prices, especially if the world is retreating from nuclear power and there is anything to the “Peak Oil” hypothesis. Inflation expectations could come unmoored even as inflation itself was contained.

In that case, the Fed better hope that the “anchoring” hypothesis is false, since that anchor will be dragged to a new anchorage!

Again, note that there isn’t anything the Fed could do about this, besides trying to be extra hawkish and convince everyone that despite the high level of prices they don’t need to fear inflation. But I am still not convinced that despite St. Louis Fed President Bullard’s supposition that the Fed could trim $100bln from QE2 the central bank actually will do anything. I think that most Fed officials view the costs of tightening too early as much higher than the costs of tightening “a little” too late. And while I think that pulling back on some of the liquidity might not be a bad thing, as it would help take some of the steam from equity and commodity markets, that isn’t the same as saying that it would be helpful to shoot interest rates much higher.

At least, that’s true with respect to near-term growth. It might be better in the long run to deflate this liquidity now rather than later, even if it means another recession right now. But I don’t think Fed officials think that long-term, and the only way they’ll tighten is if they really do convince themselves that hiking short rates and selling a trillion in bonds won’t cause interest rates to rise. They seem to be talking themselves into that one.

Tomorrow we start the Employment-week windup with the ADP Employment figure (Consensus: 208k from 217k). Even at the peak of the last recession, ADP never got much higher than this for any length of time, so expecting a big gain here is probably not a high-odds bet. At the same time, the underlying strength seems real even if it could prove to be ephemeral given other crosscurrents, so I wouldn’t want to bet on a sharp shortfall. And let’s face it, whatever comes out is likely to be construed as good for equities, until suddenly it isn’t. I have no insight as to when that will happen.

[1] The picture is similar if I use actual retail gasoline prices, but the series on BBG only goes to 1993 and I wanted the Gulf War spike.

[2] Let this dispel any arguments about whether I am using “manipulated CPI figures.” I assume we can all agree that spot futures contracts are a pretty free market. (Incidentally, the monthly correlation between the level of gasoline prices and the level of the CPI Energy price index, back to 1993, is 0.988 so those dastardly economists at the Bureau of Labor Statistics are obviously very crafty about hiding their manipulation!)

Deranged, Faithful, or Phony?

March 28, 2011 4 comments

Happy days are here again!

Well, perhaps not. Over the weekend riots in London’s Trafalgar Square highlighted the fact that unrest over government cutbacks is not limited to the MENA countries and the European periphery. While the Queen as yet doesn’t need to fear overthrow, German Chancellor Angela Merkel is starting to worry. Over the weekend, her party lost power in Baden-Wuerttemberg, which combined with several other recent electoral drubbings is an increasingly strong statement of the people’s unrest. (Incidentally, I learned this weekend that Merkel had also previously ordered seven nuclear power plants shut pending a safety review. Again, this highlights the fact I pointed out right after the Japanese earthquake, that the nuclear disaster will tend to increase reliance on fossil fuels and the price thereof, rather than decrease it.) Already, Merkel was backpedaling from a pledge to contribute €22bln to the new European Stability Mechanism; after resounding catcalls from the media following the pledge, she went back only a few days later to renegotiate Germany’s contribution so that it will be paid more slowly.

In Japan, meanwhile, it looks like optimism (which I shared) that the worst for the nuclear crisis was past might have been somewhat premature. Apparently, radiation levels are still rising around the Fukushima complex, and the region was hit by a not-negligible aftershock (magnitude 6.5). Indeed, radiation levels have reached the incredible level of 1 sievert/hour, which dosage would be fatal in only a few hours of exposure.

Needless to say, the markets didn’t care about any of this.

More emphasis was placed in investors’ minds on the increasingly-incredible discussions about the eventual withdrawal of Fed stimulus and even a cessation of QE2 prior to its completion. Over the weekend St. Louis Fed President Bullard admitted that the FOMC needs to consider whether QE2 should be stopped prior to its completion, and on Friday Philadelphia Fed President Plosser suggested that when the Fed starts to hike interest rates, it ought to explicitly tie asset sales to the rate change so that every 25bps, for example, would be accompanied by the sale of $125bln of securities from the Fed’s balance sheet. Yes, that’s right: in addition to explicitly raising short rates, the Fed should try to force long rates higher.

I know that’s not the way the Fed thinks about this. There continues to be a surreal belief in the happy asymmetry of monetary policy. Buying bonds is very effective at holding down rates, but selling bonds won’t push rates higher. Quantitative easing “have helped boost private payrolls by about 3 million jobs through 2012” according to Fed Vice Chairman Yellen, but somehow selling bonds won’t reduce payrolls.

These extreme optimists must either be seriously deranged, immensely spiritual in believing that God has created an economic system that by happy accident contains opportunities for costless job creation, or simply don’t want to tell people that whatever jobs the economy creates over the next few years will be reduced by 3 million when the Fed sells its securities.

The fourth possibility is that the Fed now believes their stimulus didn’t do anything except stoke asset markets and inflation, so that (therefore) its removal will not do anything except slow asset markets and dampen inflation. This is the most plausible reality but I don’t see any signs that policymakers believe it. Make no mistake. I don’t think that quantitative easing does much for growth, although money illusion certainly seems to be operating with more strength than I would have expected (in the absence of money illusion, increasing the money supply should only change the price level). But central banks certainly think it does, or they wouldn’t have instituted QE in the first place!

We seem in any case to be living currently in an echo of history. A good friend (and reader of this column) forwarded me this terrific video, by MGM, touting the power of inflation to get the country moving again…in 1933. (For the record, the trough of the Great Depression in GDP terms was in 1933, but by most measures the Depression lasted somewhat longer).

Increasingly, the 1933-style reflation of asset markets seems the best excuse for what is actually happening. While corporate earnings are definitely improving, they aren’t improving nearly enough to keep up with the rise in equity prices. I estimate the cyclically-adjusted P/E (CAPE, aka the Shiller P/E) as 23.2 as of today’s close, implying a 10-year real return to equities of about 1.77% – which basically means zero price return since the dividend yield is currently 1.81%. Ten-year Treasury yields were essentially unchanged today at 3.44%. Commodities declined slightly (gasoline was -0.6% but virtually all commodities fell), and the dollar was unchanged. I have the least quarrel with yields, both real and nominal, at these levels; although I think they are eventually going to go higher I can see the argument that the growth outlook and the richness of related markets makes them a fair bet at the moment.


One data point from last week I wanted to return to. Last Monday’s Existing Home Sales number was weak, but over the weekend I was updating some charts and noticed that the Median Price of existing home sales has reached a new post-bubble low, and is the furthest below the level implied by the Owners’ Equivalent Rent series that it has been in a very long time. My belief that core inflation is going to rise steadily if not spectacularly from here is predicated on the belief that housing isn’t going to take another leg down in price. In my view, it would be remarkable if it were to do so given how much cash is in the system, and how much prices have already declined. At this point, buying a home seems to be back to the zero-plus-inflation long-term bet that it has historically been over time (housing, historically, has been a much better savings vehicle than an investment vehicle). But there are certainly many people who fear a housing overshoot, and if we have one then core inflation might rise in more-sluggish fashion than I forecast. However, inventories are declining, and the current level suggests small, but positive, year-ahead housing gains.

Home prices suggest that rents will not be advancing very quickly yet.

Tomorrow’s data are likely to be somewhat discouraging, which also means they are likely to be ignored. Consumer Confidence (Consensus: 65.0 from 70.4) is projected to decline a little bit from post-crisis highs. However, the combination of high gas prices and frightening geopolitics (and natural disasters!) could and, I think, probably will take more off of Confidence than that. However, more important than the headline number is the Jobs-Hard-to-Get subindex, last at 45.7. It needs to get below 43.5 before we can be confident that the recent improvement in labor market conditions will be maintained and built upon.


Categories: CPI, Economy

A Date For The Least-Ugly Sister

March 24, 2011 7 comments

It’s good to be the least-ugly sister.

American markets powered ahead again today, despite ongoing tensions in Europe and very bad economic data. Stocks rallied 0.9% on volume that is again slipping into the “sleepy” zone (the last three days’ volume is the lowest 3-day volume since the holiday season), but the indices seem dead-set on skittering to new highs over the next couple of weeks. Bonds sold off once again, pulling the 10-year yield up to 3.41%. TIPS, however, did marvelously after a terrific 10y auction that cleared well through the screens, 0.92%, on a 2.97:1 bid-to-cover ratio. Demand for inflation protection is plenty strong enough to sustain a market with no net issuance.

Initial Claims was on-target, but the Durable Goods report was awful. The headline printed -0.9% versus +1.2% expected. Ex-transportation, a more-relevant number, was -0.6% versus expectations for +2.0%. With last month’s -3.0%, that marks the first back-to-back negative monthly numbers in core Durables since March and April 2009 (and in that case, April 2009 was only -0.1%). It appears that orders may have gotten a bit ahead of themselves. Remember that these are February orders, so not affected by the Japanese earthquake. Shipments of capital goods ex-aircraft, a number useful in projecting GDP, was +0.8% (Bloomberg had no forecast for this number, which fell a revised -2.3% in January). Q1 GDP might be closer to zero than people were thinking a few weeks ago, but remarkably equity futures barely twitched when this bad news hit the tape.

Perhaps our markets just look better than other markets even with the caveat that equities might have discounted too much good news already. After all, in Europe (where the ECB is threatening to tighten, remember) we saw the resignation of Portuguese Prime Minister Jose Socrates today after he lost a parliamentary vote on austerity measures. German Chancellor Merkel  praised him for having sought those austerity measures, and this illustrates the problem. The people – of Portugal, Ireland, Greece, and other countries seeking to implement austerity measures – feel cheated because they were told for years that they could have their cake and eat it too, and besides someone else would provide the cake. Today, they are being told that not only is there no more cake, but they are also being billed for the cake they have already eaten. And the people are being asked to vote on approving the bill for the cake. Predictably, most of them are refusing.

This creates a problem, of course, because without those austerity measures any bailout package is just a stopgap. A $100bln (€70bln) stopgap, but a stopgap nonetheless. It’s analogous to trying to lose weight versus dieting and exercise, compared to having liposuction. These countries (and I include the U.S. in the category) need to change their lifestyles and live within their means, or they’ll be back under the knife before you know it. But it isn’t fun having someone else tell you that you need to diet and exercise.

I still don’t see how the ECB raising interest rates would help rather than hurt the overall situation. Raising rates is a declaration that the central bank places greater importance on defending the ability of the core countries to access capital at low rates than on using the inflation-default option to help periphery countries. In my mind, it is all but a declaration of war on the periphery countries – “you can’t default, because we won’t let you, and you can’t inflate your way out, because we won’t help you. Here’s some money. Now beat it, you ne’er do wells.” Well, we’ll see if the ECB follows through on its threats. If I were one of these struggling countries, I know how I would respond.

One way that the ECB is nuts is that they have press briefings after monetary policy meetings. There is just no upside at all to telling the world what the central bank believes. If it turns out to be correct, there is no credibility gain, but if it turns out to be wrong – as it has, repeatedly, in every test of the proposition – then there is a credibility loss. Moreover, having crystal clear signals is an invitation to over-lever, since it removes the question of monetary policy as a source of uncertainty. With the central bank promising to let investors know months in advance before they undertake any action, and furthermore promising to act in ways that are designed to support the market by lowering volatility, there is one less thing to worry about. Except for one little detail, and that is that the central bank doesn’t control the keys to the black swan pen. When the black swan hits, the central bank will respond suddenly, and over-levered investors will get steamrolled. If it stops there, then who cares because those investors made a bad bet and over-levered. But we all know who picks up the tab when the investor or trader is “systemically significant.”

So, of course, the Fed looked at the ECB with jealousy since those guys were getting all of the TV time. Why, Chairman Bernanke hasn’t been on a major program since 60 Minutes, and that’s despite doing his level best to make dramatic television by declaring his perfection, his “100% certainty” that the Fed can engineer the preferred outcome. That cannot stand, and thus today the Fed announced that the Chairman would now have a press briefing four times a year after policy meetings. Great idea. Terrific idea. This ought to give Ron Paul more ammunition in his crusade to do away with the Fed, that’s for sure! Just when you think that central bank process can’t get any worse, they find a way to make it worse. (By the way, the NY Fed recently added a blog, joining the fairly high-quality Atlanta Fed macroblog as places that central bankers can spout off both their good and their bad theories).


There was an interesting article on Bloomberg today by columnist/economist Caroline Baum. She pointed out that the Japanese disaster is a supply shock, not a demand shock; the implication is that it is inflationary and contractionary, instead of being disinflationary and contractionary. Therefore, a central bank (actually, all central banks) should be thinking about tightening, rather than easing, in order to avoid accommodating the inflation caused by the supply shock (think easing in reaction to the 1970s oil embargo as the wrong response).

This is textbook theory, and in a 2-good, frictionless world with perfect demand and supply curves that might be the right answer. In the real world, I suspect that it is not. We don’t know the knock-on consumption effects that follow from the initial supply-side impact. In fact, I could argue that the global supply shock is probably overestimated since most industries are multinational and other countries can pick up the slack for any lost Japanese production. But the important point is that all outcomes are less certain, the distribution of outcomes is more diffuse, and therefore the Fed (and all central banks) ought to move more cautiously, not less cautiously as Baum suggests.


Tomorrow’s data basically boils down to the final revision of Q4 GDP, expected to be nudged up to +3.0% from +2.8%, and a revision to the Michigan confidence figure. There are also a lot of Fed speakers scheduled – Kocherlakota, Fisher, Evans, Lockhart, and Plosser. Hey, they can’t let Ben hog all the limelight, right?


My oddball observation of the day – aside from whatever qualifies in the remarks above: yesterday night I was watching the Saturday Night Live episode from two Saturdays ago (God Bless TIVO) and saw a performance by a musician I’d not seen before. This is not surprising, since I am not an audiophile and there are almost no acts on SNL that I have seen before. But while the artist (named Jessie J) was okay the lyrics of the song, entitled “Price Tag,” really intrigued me. Help me out, readers. We’re 11 years into a flat market with two bubble-bursting recessions. As I said, I am not an audiophile but this is the first song I can remember hearing in a long time that was anti-consumption. I have probably just missed the trend, but I’m curious to hear if readers can name other anti-consumption lyrics from authors written in the last few years?

Categories: Federal Reserve, Politics, TIPS

Ask Not For Whom The Toll Toils

The good news about housing is that it has fallen so far that a contraction in that sector doesn’t have the same impact it once did. Today New Home Sales for February were reported at 250k (annualized, seasonally adjusted), yet another record low (see Chart below).

A new record low for New Home Sales. Construction won't be adding to GDP yet.

Keep in mind that this is with mortgage rates that are as low as they have been in a couple of generations at least. Now, some of this is caused by the fact that there are still plenty of distressed sales in the market for Existing Homes. Some of it may also be due to the fact that the actual inventory of new homes that are for sale has also fallen to near-record lows, and are easily at new lows when population-adjusted (see Chart below).

...but someday, Construction will add to growth again. Inventories are already very low!

Say what you will about the crazy overbuilding in the mid-2000s; the homebuilders have cut back on new building drastically, which is a precondition for the sector’s eventual recovery. It would almost be worth taking a look at home building stocks, if TOL wasn’t trading at a P/E of 3,382:1 (only 294:1 on estimated earnings!). (It’s trading at 2.3x sales; at its peak in 2005 it was only 1.9x. Now, you may say “sure, but keep in mind right now you’re at trough sales.” Fair enough, but revenues are down 75% from their 2006 level, and there won’t be another boom like that one for a long time. Suppose sales double from here. You’re still paying 1.65x sales, which is more expensive than the company has been since 1994, with the exception of the bubble top. And it’s by no means assured that home construction is going to boom in the short run, especially when interest rates start to rise again. (There are surely better shorting candidates, don’t get me wrong: I just mention this because I was looking at it thinking it might be a buy candidate. It’s not).

Besides the Home Sales data, there was little news out. There was nothing new from Portugal. Crude oil rallied 1.7% (now $105.75/bbl) and industrial metals jumped 2.3%. 10y note yields rose 2bps to 3.35% and are seemingly stabilizing now that the last frightening week or two is behind us. TIPS yields rose for the fourth day in a row; the 10y now stands at a still-slender 0.95%. Don’t read too much into the selling of TIPS here and the selloff in 10y inflation swap rates from 2.87 to 2.66 over the last couple of weeks. There is an $11bln reopening of 10-year TIPS tomorrow, and some of what we are seeing is dealers trying to set up for that auction. There is concern in some quarters that the low yields will make it hard for the government to sell $11bln TIPS. Remember, though, that the level of rates also indicates the supply/demand balance. TIPS yields are low because there is no net supply from the Treasury (thanks to the Fed, and there has been ample demand to push yields down this far. It may be that this auction pukes, but it has been difficult for a while to bet that inflation-linked bonds were going to sell off for any appreciable period. There is positive net demand as money continues to flow into inflation-linked bond funds, and no net supply. I wouldn’t be short TIPS here except to set up for the auction (indeed, one dealer pointed out that the current 10y TIPS are actually “on special” in the repo market, which almost never happens in TIPS and suggests there is actually a short base).

Also tomorrow, the Feb Durable Goods report (Consensus: +1.2%, +2.0% ex-Transportation) is due out. Remember the last one was disappointing and led to some downward revisions to Q1 GDP estimates as a result. Initial Claims (Consensus: 383k) will also be announced.

Categories: Economy

Taking A Punch

March 22, 2011 1 comment

Many things have happened since I last wrote, on the day of CPI.

  • Libya declared a cease-fire. Libya immediately violated its own cease-fire. A number of nations, including but not led by the U.S., imposed a no-fly zone in Libya at probably the last possible moment before the rebels faced defeat, and now may seek to secure the country by attacking Gaddafi’s troops by land. A member of the U.S. President’s own party declared that he should be impeached. Oil, seemingly oblivious of this drama, traded up another $4 over that time period and is near the year’s highs. I paid $72 to fill my Jeep today.
  • Existing Home Sales were dismal, and inventories actually rose slightly for the first time in six months. This is a small surprise given the low rates and slowing improving economic situation, but it may also be an insignificant wiggle. Still, economists have been revising lower their projected growth rates for Q1. Growing, but not booming.
  • The Treasury announced that it is going to sell “up to” $10bln of its $142bln portfolio of agency MBS per month. This is prudent since they are aware of a $1.25 trillion portfolio that supposedly wants to unwind over the next few years (I seriously doubt it will happen). The timing is good since there is no net Treasury issuance at presence, thanks to the fact that the Fed is buying all of the net paper. It is not a monetary drain the way it will be when the Fed sells securities, because in the Treasury’s case it is replacing other issuance that it would do. The money will be spent either way! When the Fed sells securities for cash, the cash just sits there. When the Treasury sells securities for cash, it is recycled into the economy in the form of spending.
  • Portugal’s government looks poised to lose a vote in parliament, and the event would effectively topple the government and push early elections. J.P. Morgan declared that “the likelihood that the Portuguese government will fall this week looks high.” This would, some people believe, force Portugal to seek support from the Stability Facility. If that surprises you, then you haven’t been paying much attention. Portuguese 10y yields are at 7.38%, below Ireland’s 9.66% partly because Irish yields keep rising. And yet, we keep hearing that the ECB is preparing to tighten monetary policy. If I was in Ireland, Greece, or Portugal, such talk would really irritate me. Slowing the economy right now is not exactly what these guys need, especially since the European economy is currently growing at a lusty 2% y/y. If there is a risk to the inflationary outcome being stoked by the Fed and perhaps finally the BOJ, it is that the ECB makes a horrendous policy error and tightens policy into a weak economy. I didn’t think this was very likely, because only fools would be thinking about tightening in Europe right now. It’s like taking someone on life support and deciding to remove their appendix. Without sterile equipment.
  • In an unrelated note, probably, Venezuelan strongman Hugo Chavez declared that capitalism may have ended life on Mars. He may have been joking.
  • Japan has gotten the nuclear situation seemingly under control, and the world is breathing a sigh of relief. The scale and scope of the catastrophe is still staggering. Some 9,000 people are confirmed dead, and with the number still missing and the number still without heat or food that number could still double. Into this great tragedy, the Bank of Japan and other central banks jointly intervened to weaken the yen several days ago. This is even less explicable than the saber-rattling of the ECB, because at least that could be stopped at saber-rattling. Why in the world would you want to weaken the yen? The fact it is strong is incredible in the first place – ordinarily currencies of countries with weakening economies, huge deficits, and loosening monetary policy will weaken on their own. A lower currency, induced by central banks, means that the people of Japan will have higher prices to deal with in addition to everything else, and since Japan imports most of its food and energy it means higher prices for those things. It helps the export sector, but right now they’re not making much of anything so it’s all downside.

Okay, now I think we are caught up as we head into Wednesday’s New Home Sales (Consensus: 290k from 284k) data. The bottom line is this: the immediate, nuclear crisis of Japan has passed. The Libya/MENA/energy price crisis is upon us. The Portuguese crisis is yet to occur.

The economy is no longer in recession, and is strengthening slowly. But what we don’t know is, can the economy take a punch? A robust, healthy, free-market economy can adjust to the vicissitudes of life on this big blue marble. In 1987, the global equity market crash happened when the economy was otherwise strong, and after some wrenching losses life continued more or less normally. In 2000, the market crash hit an economy that was already overextended and weakening, and the terrorist attacks in 2001 kept the economy on the canvass for another year.

I don’t think there can be much debate that punches are coming. They’re always coming. The biggest problems we have tend to be when the markets price out the possibility of a punch. In this case, we can see some of them coming. The Japanese disaster will have a measurable impact on global GDP and there is a potential for a ripple effect up the supply chain of some products. Oil at $100/bbl is dang inconvenient, but survivable; oil at $125 is a punch we’re probably not ready for. And the European situation seems to me to be destined to devolve into a barroom brawl (albeit one where everyone has interesting accents and is speaking very politely while they brandish the furniture).

How will the economy fare, and by extension the markets? I would feel better about the latter if stocks were not priced at a CAPE of 22.9, and if the bond market wasn’t being asked to absorb (starting in July) not only the $1+ trillion of new Treasury debt but also to brace for the possibility of absorbing the Fed’s balance sheet – at the same time that sovereigns globally are increasingly competing for that capital!

Still More Regime Change?

A second surprise higher on inflation was the most significant event of the day from the standpoint of U.S. investors. It also was completely ignored. More on CPI in a moment. Other data was mixed. Initial Claims was as-expected at 385k, but Industrial Production fell short (-0.1% vs +0.6% expected). The Philly Fed index skyrocketed to 43.4, its highest level since 1984 (see Chart). Recall, however, that unlike with the Purchasing Managers’ Indices the Philly Fed “General Business Activity” index records the response to a separate question rather than combining the results of the answers to the subindex questions.

Two weeks in Philadelphia never looked so good!

That matters in this case, because while respondents’ assessment of current General Business Activity was very strong, you have to look pretty hard in the ancillary data to figure out what the source of this ebullience is. Prices paid, Prices received, Shipments, Unfilled Orders, Delivery times, and the Average Workweek were all essentially unchanged. Inventories rose to 12.0 from 2.1 and New Orders rose to 40.3 from 23.7; on the other hand, Number of Employees fell from 18.2 from 23.6. Clearly, there is excitement about the level of new orders, but at the same time there doesn’t seem to be any excitement about hiring new people! (I have often wondered in the past, but never got around to figuring out how to do it, if the difference between the general index and an index built from the constituents would have any informational value as perhaps indicative of optimism or pessimism not necessarily warranted by the underlying metrics).

But the important release of the day was clearly CPI (not that I am biased or anything). As I said, CPI realized its second consecutive surprise on the high side. The print was 0.199%, so rounding played almost no part in the +0.2% print. Year-on-year core inflation is now at +1.1%, and over the next couple of months it should rise to 1.4% or 1.5% on base effects as a couple of zeroes drop off.

The gains in the index were broad-based. The table below shows the current year-on-year increases in the eight major subindices, as well as those from last month. The quick summary is that only Apparel is decelerating meaningfully and it is 3.6% of the index. Medical Care and Education and Communication neither accelerated nor decelerated from last month. The other 83.4% of the index seems to be accelerating (although “Other” was inflating faster six months ago. It is, however, only 3.5% of the headline index).

Weights y/y change prev y/y change 6m y/y chg
All items 100.0% 2.108% 1.632% 1.148%
Food and beverages 14.8% 2.236% 1.796% 1.000%
Housing 41.5% 0.657% 0.377% -0.391%
Apparel 3.6% -0.421% -0.012% -0.395%
Transportation 17.3% 7.100% 5.419% 4.918%
Medical care 6.6% 2.891% 2.919% 3.168%
Recreation 6.3% -0.143% -0.593% -1.075%
Education and communication 6.4% 1.229% 1.234% 1.929%
Other goods and services 3.5% 1.959% 1.863% 2.948%


News stories and analysis today have focused on the notion that “the deflation risk has passed.” I have news for ya – the deflation risk was passed when the Fed started buying Treasuries even though the current increase in inflation was baked in the cake over a year ago. I was saying in early 2010 that it was going to be late Q3/early Q4 when core bottomed, and it did so right on schedule. This isn’t mysterious! The Fed didn’t need to start spraying liquidity into the market again; their belief that they needed to was based on flawed Keynesian analysis in my opinion.

However, housing is still a mess and with the inventory overhang in Existing Homes we’re not going to seen a substantial further rise in Housing inflation for a while – at least, based on fundamentals. If we do see housing CPI continue to rise, it’s a sign that the Fed’s money is getting into that asset market as well and that would not be good.

Equities had a good day, +1.3% on sharply lower volume than yesterday. The VIX, which had risen to near 30 yesterday, retreated to 26.4 today. The nominal bond market sold off a bit and the 10y yield is now at 3.23%. TIPS actually rallied, though, so that breakevens and inflation swaps jumped higher by 6-12bps. It helped the inflation market that oil soared back over $101 and that Grains, Softs, and Industrial Metals were all +3% or better. A weakening greenback helped, but it looks like the people wanting to short what they think is a bubble just got run over by flows.

And there are going to be fund inflows into inflation-related product, even if most available alternatives are pricier than they have been in a few years at least. Higher inflation prints tend to provoke flows into inflation-linked bond funds, commodity funds, and retail inflation-linked corporate notes (also known as CIPS). But consumers were already moving this way. In the latest Michigan Survey, not only did 1-year -ahead inflation expectations rise (they tend to move with actual inflation as consumers project  recent moves forward), but 5-10-year-ahead inflation expectations rose as well (see Chart), to the highest level since 2008.

Last week's data, but related to today's inflation discussion.

You can see that inflation expectations also bumped higher in 2008, but at that time of course headline inflation was over 5% and core inflation was about 2.4%. In terms of the spread over core inflation, the Michigan numbers haven’t been this much extended for at least 20 years (the length of the Michigan data set on Bloomberg). See Chart below:

Michigan survey long-term inflation expectations are at near-record spreads over core CPI.

There are two questions here. (1) Why is this happening, and (2) why does it matter (or does it)?

It may be happening for either or both of two reasons. First, it may be that consumers are savvier about Fed monetary policy than we think, or that in any case their confidence in the Fed to engineer a good inflation outcome is diminished. It certainly would not surprise me to find that confidence in the Fed among consumers is at a low ebb, given the spastic nature of the Committee’s reactions over the last couple of years and the apparent ineffectiveness of most of what they did (the stuff that was effective, like the commercial paper guarantee facility, is not much appreciated outside of Wall Street). The other reason that inflation expectations may be rising is more related to the way individuals perceive inflation. Clearly, the prices that people pay frequently, mostly food and energy, have been rising rapidly recently. While food plus energy is only 23% of the consumption basket, it carries a very heavy mindshare weight and the now steady and extended trends higher in these consumption items certainly must influence consumers’ view of the current and likely future course of inflation.

Why does it matter? First of all, it is possible that it doesn’t. We don’t really know the role that consumer expectations of inflation play in the process of inflation. However, it should be noted that many economists (not least, those at the Fed) believe that one reason the Fed can run looser policy is that “inflation expectations are well-anchored.” The notion is that prices in the economy are set at least partly on the basis of economic actors’ rational expectations for price changes, rather than the direct observation of the immediately-preceding price change. Clearly, this must be at least partly true, because if every price change was immediately and frictionlessly transmitted then inflation would have no persistence at all, and if the trend was always immediately and frictionlessly transmitted then inflation would accelerate out of control (or decelerate out of control) with little initial impetus. So clearly, some mean-reversion or dampening tendency must be at work. Many theorists believe that the mechanism is inflation expectations.[1]

I think it could be true that expectations play an ‘anchoring’ role, but that isn’t the last word. The next thing you’d want to know as a policymaker is, what happens to the anchor when it moves? Does it move slowly, like a ship’s anchor being dragged along a sandy seabed, or does the line to the anchor suddenly snap, causing the ship to need to drop a new anchor in another location? Here is how the latter situation could manifest. I believe that people do not encode in their heads a precise number for inflation. I think people perceive that inflation is “near zero,” or “medium,” or “high,” and perhaps there’s another bucket for deflation.

For small deviations around that anchor, the anchor serves to pull inflation back to the mooring. But how long, or for what size deviation, will the anchor hold if inflation experiences are not matching the expectations-based heuristic that the consumer is using? That is, how long does the price of gas have to rise before I suddenly start expecting it not to be the same on my next trip, but to be higher, and higher again on the next trip?

We don’t know. Actually, it’s worse than that: we don’t have any idea. Actually, it’s worse still: as far as I can tell, no one is looking for the answer.

The assumption seems to be that inflation expectations follow some sort of moving average of past experiences. Certainly, the Michigan number shows than when current inflation jumps 1% from its prior reading, the Michigan survey of near-term (1-year ahead) expectations rises about 1%. So it’s plausible that expectations smoothly change.

I maintain that this only happens when a given regime is in force. When there is a regime change, you will probably get a non-linear reaction in expectations. This is really hard to test – but it is testable. It is ugly to model – but it is modelable.

From the standpoint of a policymaker, it just means they ought to be very, very careful when there are possible signs that a regime shift could be happening. I don’t know whether we are there yet, but the rise in the longer-term Michigan number, coupled with steady increases in food and energy consumables, would make me extra-cautious here.

There is no economic data due on Friday; the Fed will be joining everybody else and purchasing TIPS but otherwise the only significance to Friday is that it is the beginning of the weekend and a 3-day period of uncertainty in which markets cannot respond to developments in Libya or Japan. There may be some resolution in Libya if reports about Gaddafi’s gains are correct, and by Monday things in Japan will probably be a lot better but could also be a lot worse. The market’s reaction to this uncertainty will depend on how risk-averse investors are. Judging from Wednesday, they are fairly risk-averse right now; judging from today’s price action they are instead fairly cavalier. I would tend to put more weight on the higher volume, and although I believe we will get to Monday and feel better about the disaster in Japan I have a feeling that risk-reduction will be more in vogue. I think we’ll see stocks lower.

[1] It must be noted, however, that we really don’t know how to measure true inflation expectations. Asking people what number they attribute to their current experience of inflation is a very unsatisfying approach. You can see something I wrote on this topic last year here, and you can see my academic paper on the subject here.


Categories: Causes of Inflation, CPI

Cracking The Containment Vessel on Inflation?

…and now, I’m supposed to be a nuclear engineer?

Financial engineering is in some ways similar to nuclear engineering, which is one reason we use terms in finance like “nuclear waste” to mean a particularly toxic tranche of a deal that no one wants to have, or refer to a particular credit as being “radioactive.” The credit crisis has also been called a “financial meltdown.” But most of the products that Wall Street creates don’t actually kill people (on the other hand, they also don’t get better when you pour water on them, so perhaps the jury is still out on which is worse).

Markets reacted poorly for most of the day today on the news coming out of Japan. The Federal Reserve was forced to cancel its scheduled bond buy-back in mid-stream when the Dow Jones newswire ran headlines saying “EU ENERGY CHIEF: SITUATION AT JAPAN NUCLEAR PLANT OUT OF CONTOL” and “EU ENERGY CHIEF: POSSIBLE CATASTROPHIC EVENTS IN NEXT HOURS.” Bonds predictably shot straight up and stocks tumbled until the EU energy chief admitted that his “analysis” had been gleaned from details in news reports. The Fed re-initiated and complete the bond buyback, and everybody learned a lesson not to listen to the EU Energy Chief. Ever. Again.

The U.S. stock market, however, is also in slow-burn mode and starting to wilt. Today’s 2% decline in the S&P on the highest volume of the year (1.4bln shares or so) took the index to flat on the year. Easy come, easy go. Meanwhile, the Nikkei rallied overnight (5.7%) and the Yen strengthened to match its all-time strongest level, 79.80 yen to the dollar, last seen in 1995. Yes, you read that correctly. The U.S. market is all aflutter now while the Nikkei is rallying and the Japanese currency is actually rallying. Maybe nuclear engineering would be easier.


Speaking of the 2008 meltdown, a reminder of it was called up today when the Wall Street Journal ran an article entitled “Banks Probed in Libor Manipulation Case.” In 2008, there was another Journal story – and it probably prompted this investigation, as that is the way these things go – that pointed out that LIBOR was exceptionally low given the apparent difficulty many banks were having funding themselves in the LIBOR market. It was clear that it was predominantly hedge funds that were upset by the settings and stirring up trouble; after all, the banks are lending money tied to LIBOR and most of us are borrowing that money…so why would we get all bent out of shape because LIBOR was being mismarked too low?

This whole issue wouldn’t even exist if the British Bankers’ Association (BBA) hadn’t changed the way the LIBOR survey was conducted some years ago. Until 1998, LIBOR was set by a survey in which a large number of money market dealers were asked the following question: “At what rate do you think interbank term deposits will be offered by one prime bank to another prime bank for a reasonable market size today at 11am?” On the basis of that question, the crisis of 2008 wouldn’t affect the setting since it became merely hypothetical. There were no prime banks in late 2008,  but that doesn’t mean it isn’t possible to speculate where such banks might have lent to each other. This was a smart way to word the question because it meant that (a) no bank was forced to reveal its own cost of funds to its competitors and (b) it abstracted from the occasional funding difficulties that a bank or two might have in special circumstances. That bank, during its problem, wasn’t a prime name bank so it could be ignored for the purpose of the survey.

However, as the swaps market grew and with it, the importance of the LIBOR rate, I suppose the BBA thought it oughtn’t be so hypothetical. So the survey procedure was changed, and now banks are asked “At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?”  (Thanks to MM for helping me find that.) This is obviously a very different question. Now banks are expected to trumpet to the world when they are having funding difficulties. Moreover, the question leads to absurdities in the circumstances of late 2008. Complainers think that LIBOR should have been marking higher than it was, but how are you supposed to answer this when the real answer is “infinity. No funds are being offered to me or to any other bank at any price”? And that was in fact the situation. Banks were being ordered not to put out 12-month, 6-month, 3-month, and for a time even 1-month and shorter money. If you had offered 100% and been lifted, you would have lost your job (especially if that bank then collapsed the next day and your unsecured LIBOR deposit went down the hole with it). So there was literally no correct answer. Obviously, some banks unilaterally altered the question they were answering (since they are required to answer it, and amended to the question “…and the market was functioning normally.” Or perhaps they merely decided to answer the question in the original, pre-1998 spirit. Can we blame people for giving a bad answer to a stupid question? I suppose it makes sense to look to see if there was collusion among the twenty banks that make up the LIBOR survey, although it is a little hard to imagine how a secret agreement could have been kept with so many conspirators.


This just in: the housing market is still radioactive as well. Today’s Housing Starts figure printed at 479k, only 2k above the absolute low of April 2009. This is good, in a way, since less construction means less inventory, which means existing inventory gets worked off more quickly and more homebuyers get shunted to the existing home market where the inventories are really ugly. But it also means that construction is not going to be adding much to the growth figures for a while…

The housing data was lost in the global geopolitical news, as is appropriate. But it was harmonious with what the market wanted to do anyway. Stocks wanted to fall, and they did. Bonds wanted to rally, and the 10y yield declined 10bps to 3.20%, the lowest yield since December and starting to make Bill Gross look kinda bad (but seriously, Mr. Gross has many powers but the ability to predict earthquakes, I suspect, is not among them).

Commodities were flat, with the Ags and Industrial Metals down and energy up.  Crude oil regained the $98 level. Opinions on oil vary widely, but I’m a bull. Monetary policy, respectable global growth, damage to MENA production environments, and a decrease in the BTU that can be output from nuclear – that seems like a bullish mix to me.


Tomorrow’s data includes Initial Claims (Consensus: 388k from 397k), Industrial Production/Capacity Utilization (Consensus: +0.6%/76.5%), Leading Indicators (Consensus: +0.9%), and the Philly Fed Index (Consensus: 28.8 vs 35.9).

But by far the most important data is the CPI report. The consensus calls for +0.4% on headline and +0.1% on core, raising the year/year headline number to +2.0% and maintaining +1.0% on core.

I think there is risk to the upside on core inflation. Last month, the print surprised on the upside at +0.17% m/m, which brought the y/y number to +0.95% (rounded to +1.0% in news reports). What are the chances of another similar number, more than 0.1% but not quite 0.2%?

I think the odds are reasonable. Recall that last month, major subindices of the CPI constituting 83.5% of total inflation showed acceleration in the year-on-year numbers (to review what I wrote last month, follow this link). And, as I pointed out just 10 days ago, the recent rise in inflation swaps, especially combined with the decline in forward energy quotes, implies that the market also expects core to rise (updated chart below).

Purple line is expected core inflation over the next 1 year implied by current inflation swaps and forward energy futures.

As I said in that recent comment, however, the aggressive expectations that are embedded does create the potential for disappointment. The inflation market is far more likely to respond negatively to an as-expected print than it is likely to respond positively to a higher-than-expected core print. We’d need a strong 0.2%, not just a weak 0.2%, to really goose the market I think, and that seems a stretch.


Categories: CPI

America The Irrelevant

March 15, 2011 1 comment

It is a bit bewildering as a predominantly U.S. analyst to spend every day analyzing events in different parts of the world. Of course, the U.S. markets are global, and it has always been the case that a flapping of a butterfly’s wings in Madagascar is something we have to pay attention to and be aware of. But, since the U.S. economy is also far and away the largest economy on earth,[1] it is also usually the case that if you get the call on the domestic economy right, you’ll generally get the broad strokes outcome right.

This hasn’t been the case for months.

After Ireland and myriad crises in the Middle East/North Africa, we’re now swiveling our heads around the other way. I alluded to this in yesterday’s comment. But I seriously cannot remember ever deciding that it might be prudent to wait until the Japanese markets open before I write my commentary.

To be sure, the signs that the domestic markets are deeply concerned are fairly muted. The stock market fell 2.5% overnight, but that was in response to a 14% dive in the Nikkei  (trimmed to “only” 10.5% by the close), and by the end of the day the S&P was lower by only -1.1%. Volume was, however, reasonably heavy at 1.22bln shares and the VIX jumped to 24. But after a big start to the day, bonds managed only a 5bp rally to 3.31% on the 10y note.

Apparently, 17.5% in three trading days from the Nikkei is nothing to get too alarmed about. And as of this writing, the Nikkei has bounced 6.2%. That makes me much less comfortable in Japan as a trade, because normal markets don’t rally 6% without help. It doesn’t much change my attitude about Japanese equities as an investment.

I wonder if the panic cycle, and its recovery, is just ridiculously foreshortened these days. There were certainly elements of panic in the ridiculous coverage of the nuclear disaster. The Wall Street Journal today wrote “Japan’s nuclear crisis showed signs of spinning out of control Tuesday.” That’s crazy talk. A nuclear crisis can’t “spin out of control.” This isn’t a credit crisis. There is no contagion from one plant to another. A plant is damaged, or it isn’t. A particular meltdown is averted, or it isn’t. And everything that is knowable about the situation is known (by someone) within a few days. Compare that to the credit crisis, where the future path of the crisis was quintessentially unknowable because the 5th step depended on what happened during the 4th step. There is no time contingency here. So nothing is “spinning out of control.” It’s just really, really bad.

By the way, initial estimates of the insurance losses were somewhere in the neighborhood of $180 billion. Think about what that implies about the severity of our problems. Our monthly deficits are bigger than that. If the primary budget was in balance then the current deficit would be as if the government were compensating victims of about eight 9.0-magnitude quakes, the associated tsunami and nuclear meltdowns per year.

The strangest part of today’s price action in the various markets is that commodities got absolutely pounded. Wheat and Sugar were -7%. Gasoline was -5%, Crude -4%. Cocoa, Silver, Gold, Beans, Cotton, Coffee – almost everything was down by large amounts. That’s odd to me because I can’t think of why Wheat and Sugar would have anything to do with what is happening in Japan. If the dollar had strengthened…but it didn’t. What makes the reaction even stranger is that inflation markets ended up nearly flat despite the commodities slaughter and the rally in bonds generally (which tends to be associated with tightening inflation compensation as well).

Credit spreads ended near unchanged, bonds ended near unchanged, the dollar ended near unchanged, stocks even ended up fairly near unchanged. Does this mean the impact is nil (with the exception, for some reason, of commodities)? No: if something isn’t moving it either means that there are no forces acting on the thing or it means that the forces are offsetting. If a flag tied onto a rope isn’t moving, it might mean the rope is just lying on the ground or it might mean there is a vicious tug-of-war that is currently drawn. That doesn’t mean it will stay drawn, however. I suspect that there is a tug of war between folks who have been waiting for a long time to buy a dip, to get long spreads and other risky assets when there was a correction; they are taking positions from people who are realizing profits and reducing risk. I suppose that is always the case, but ordinarily there aren’t as many people desperately wanting to get on board a train they believe is leaving the station.

I really don’t think the train is leaving the station, but what do I know? The market is up an incredible 2% on the year (I say that tongue-in-cheek), and I’ve been underweight the whole time. On my valuation metrics, stocks are priced for 1.9% real growth per annum over the next decade. For that price, you can keep the volatility.

In all of this so far I have not mentioned the FOMC meeting today. How incredible is it to say that the Fed was completely irrelevant today? The Fed statement, as expected, did not meaningfully change anything about the directive. Recent data have made the Committee more confident, but they retained the statement that “economic conditions…are likely to warrant exceptionally low levels for the federal funds rate for an extended period.” There is no change to the bond buying program. It was a statement that was more dovish than was expected on average (some people expected the Fed to consider slowing purchases or to allude to the possibility that the period would not be indefinitely “extended”), but it doesn’t really matter. Right now, the biggest and most aggressively interventionist central bank in the world is mere noise.

Irrelevant too will be the economic releases tomorrow. Housing Starts are expected to fall to 566k from 596k and PPI is expected to be +0.7% (+0.2% ex-food-and-energy).

I can’t predict the outcome of the tug of war. We have just been hit by a series of unknown unknowns culminating (or anyway, we sure hope that is has culminated) in the classic unknown unknown of natural disaster. If markets had gotten rocked by these events then I would be the first one to say “this too shall pass” and climb aboard. But they haven’t. Stocks are still priced for continually-growing economies and continually-fattening margins. Bonds are still priced based on eternal central bank purchases and quiescent inflation. “Buy on the sound of cannons” is a maxim that only worked because most people sold on the sound of cannons so the rare buyer was getting a good price. I hear the cannons, but I don’t see the re-pricing. Accordingly, I ignore the cannons and wait for good prices (I did try to buy the iShares MSCI Japan ETF (EWJ) this morning but my bid wasn’t elected and I figured that if I have to chase it, then something is wrong). It’s boring, but good investing usually is.

[1] I am sure some reader will want to retort that the EU is as large as the U.S. Fine, if after all that has happened you still want to argue that the EU is essentially a homogeneous bloc…but I don’t buy it. “Who do I call if I want to talk to Europe?” still applies.


Categories: Uncategorized


The American economy and markets are now beset East as well as West.

Battle still rages in Libya and Saudi troops moved into Bahrain as part of the Gulf Cooperation Council’s effort to help pacify Shiite protestors. In the other direction, thoughts (and the fears of investors) reside in Japan where thousands of people were killed by the magnitude 9.0 earthquake, the ensuing tsunami, and (less dramatically but no less tragically) hardships in the form of hunger, lack of potable water, and lack of heat and shelter. A less-cohesive society than Japan’s would be experiencing riots, looting, and worse.

Oh, and then there’s the fact that several nuclear power plants are in various stages of meltdown. It is unclear how much radiation has been released, and how much will be released, but a half-million citizens have been evacuated and a quarter-of-a-million doses of iodine distributed so this isn’t trivial.

The Nikkei index plunged 6.2%, unsurprisingly. But what was a bit more of a surprise was that the initial reaction in global equity markets was very muted. Normally, even if damage done to a country’s market is due to reasons idiosyncratic to that country, there is an echo effect as some accounts liquidate positions in other markets. That there was no meaningful echo (although intraday today the S&P was down a whopping -1.4% around lunchtime before closing -0.6% on only 919mm shares) tells you just how irrelevant as an investing consideration most investors consider the Nikkei these days. Perhaps it is time to invest. Japan’s dividend yield is as high as ours, but in Japan’s case that’s 60bps above the 10-year bond yield and in our case it’s 160bps below. My only concern about that investment thesis is that the long-term solution for Japan is clearly monetization since they cannot possibly pay the accumulated debt, and I’m concerned  about buying a currency that could well underperform the dollar in the long run. (An arbitrageur can hedge this risk very cheaply since currency forwards indicate the yen ought to appreciate against the dollar, but an individual investor has few alternatives in this respect.)

Speaking of monetization, many people have raised the question about what the significance of this event is for global inflation. Oil initially declined because clearly this event will have a significant impact on Japanese growth, and despite the “lost couple of decades” Japan’s economy is still very large.[1] But that’s the wrong reaction, because unless Japan just ceases to exist it will still need to consume a large amount of energy. As of today, much less of that energy is likely to be coming from nuclear reactors for the foreseeable future. Roughly a third of Japan’s energy is generate from nukes, so if any number of them are taken offline for inspection the power will need to come from somewhere else. “From fossil fuels” is a fairly likely bet of a source. And let’s face it: this doesn’t exactly help the push in places like the U.S., where there is already a NIMBY attitude to the building of new plant, to begin producing more energy from nuclear power. By the end of the day, Crude was back to unchanged – although it is admittedly hard to disentangle the Japan reaction from the MENA reaction. It remains above $101 (WTI).

The bond market rallied, bringing the 10y yield down to 3.36%. Inflation breakevens declined a little more than would be expected with that rally, but the market is holding up nicely given the uncertainty. Perhaps “waffling” is a better term, given the upward pressure from the recent improvement in housing inflation and the unrest in the Middle East and the presumed downward pressure from diminished growth prospects in Japan.

But let’s examine this latter assumption because I am not so sure that even a strong negative growth response in Japan is necessarily disinflationary. Today the Bank of Japan (BoJ) added $186bln in liquidity to stabilize markets. If this disaster is what provokes the BoJ to finally begin monetizing in earnest rather than the temporizing half-measures they have taken over the last decade (half measures which are admittedly more prudent than seeking to monetize the debt), then this may in fact not be disinflationary at all. It is, after all, easier for a central bank politically to justify flooding cash into the economy to save freezing and starving people than to justify the same maneuver by declaring an intention to nudge inflation from -1% to +1%.

I am not saying that is what will happen, but I think a good case can be made that this event is at modestly inflationary after the initial growth shock. Think about it another way: to the extent that $100-200bln in real property was literally washed away and needs to be replaced, the same amount of money (in fact, more) will be spread around fewer real goods that are extant.

This is also not the same as saying the market will come to the same conclusion in the near term as I have. That often is not the case. In any case, I think the short end of the inflation curve is (as I wrote a week or so ago) expensive to the likely path of core inflation and the forward energy markets. It has flattened quite a bit recently and inflation swaps are inverted to the 5-year point. I like 5-year inflation at 2.36% better than I like 1-year inflation at 2.55%.

Tomorrow the Empire Manufacturing Index for March (Consensus: 16.10 from 15.43) is an 8:30ET release but the key event is clearly the FOMC meeting with the announcement due at 2:15ET. The only real question is whether the Committee will begin to soften the “for an extended period” language to foreshadow the eventual end of low rates and effectively foreswear any possibility of QE3. I am not sure there is much to be gained by their doing so at this meeting. There is little to no chance that the Fed funds rate will be raised this year, absent a true explosion in growth that takes Unemployment down several full points, and not much chance that the Fed will even venture to begin draining the “emergency” liquidity (let’s face it, draining it again almost immediately after having re-written the record books in implementing QE2 would show a colossal indecision attached to numbers with lots of zeroes). If I am right about that, then even if the Committee wants to beat its collective chest and declare its dedication to squash inflation – and the perceived value of the declaration itself is the only reason it would make any sense to do it at this juncture – then there is no hurry, and no reason to confuse the market by signaling higher rates while you still have three months of bond purchases to go.

The fact that the bond market has recently rallied to near the strongest levels of the year is one counterargument in favor of an announcement tomorrow. If you’re going to bomb the market with a scary, hawkish declaration, it is (a) better to do it when it is strong than when it is already week, and (b) better to do it when the Desk still has a couple hundred billion to buy and can help control any negative market reaction. But the FOMC has shown in the past a remarkable ignorance of, or at least complacency about, the importance of pre-existing market conditions when significant announcements are made.

[1] Actually, it isn’t so clear after all. If economic growth is unit root, then Japanese growth will initially fall but then accelerate to resume the prior trend (such as it was). No one is sure if growth is unit root or trend-stationary, though. See my comment here for a quick discussion of what the heck I mean.


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