Archive
A Hint – Just A Hint – Of A Breather
It may have been predominantly the ‘bots trading today (or, equivalently, the junior traders), because the market mostly ignored information that was mostly bad. Here is a quick run-down:
Initial Claims did not decline back to the prior trend, but rather printed at 403k and last week’s surprise was revised higherto 416k. This news caused a reaction in the bond market, as I had thought it would if it happened, but that jump in bond prices was erased quickly. The chart below shows ‘Claims. The couple weeks of higher numbers are not cause for alarm; only a couple weeks of data in this volatile series doesn’t add a lot of information. If you put your hand over the pre-March period, it looks like an uptrend, but this is an optical illusion. The fairer supposition is that Claims have temporarily stabilized around the 380-410k level. If that turns out to be true, it should be discouraging for those who are bullish on the economy because that level of Claims is not consistent with the steady job growth the economy bulls require (and the Fed desires).
It's not an uptrend in Claims, but neither is it still a downtrend.
There is a more benign possibility behind the jump in Claims. It could be that this bump higher is related to Japan-supply-chain disruptions. Goldman Sachs put out an analysis today about the effects of the supply chain disruptions on GDP, and made the point that one main supplier (40% market share) of auto microcontrollers has “several key facilities in the affected area [of Japan].” Goldman’s auto analysts expect roughly a 10% decline in North American vehicle production in Q2, due (mostly) to a shortage of MCUs. This is just a guess (albeit an educated one), but my point in bringing it up is to note that this by itself is clearly a disruption large enough to cause a mild blip higher in layoffs. And auto manufacturing will not be the only industry affected by supply chain issues.
As I said, though, this is a relatively benign interpretation, because if it is accurate then once MCU production and auto production and other supply wrinkles are ironed out then ‘Claims could and should move lower once again…assuming that the bullish view of the economy is correct.
Also casting a shadow on the economic outlook was the sharp and unexpected decline in the Philly Fed Index to 18.5 from 43.4, when 36.9 was expected (there followed another jump in bonds, and another retracement). That also is not a cataclysm: an index above 0 indicates that things are getting better, and this just means they are getting better at a slower pace. But, as with Initial Claims, this is a little discouraging to the economic-boom crowd because a moderation now in the recovery process is too early if we’re going to get unemployment from 9% to something reasonable in a bearable period of time.
The FHFA Home Price Index report isn’t usually worth pointing out, but in this case I will take administrative note of the fact that the 1.6% month/month decline was the second-worst on record behind only November 2008. There is a ton of noise in this series, but this is still a bad month. Nevertheless, even here you could try for a positive spin if you really worked at it: one might argue that higher home sales numbers at lower prices suggests that sellers are finally capitulating and the inventory is clearing. That’s a stretch, however, since the inventory numbers themselves haven’t declined.
Finally, the dollar today broke marginally below the December 2009 low in very light volume. This helped push commodities higher yet again.
To be clear, on my vacation next week I am not going to worry about automotive supply chain issues, the weakening in the Philly Fed survey, home price indices, or the dollar index. These are all concerns, but they are not big concerns at the moment. Evidently this is also true for equity investors. We will see what a week’s seasoning will do and what spin (if any) the FOMC puts on the deceleration in its statement after Wednesday’s meeting. And I will write again on or about May 2nd.
Clock (Still) Ticking, But Now Faster
The clock is clearly ticking on Greece and Portugal’s default or severe restructuring, and the clock seems to be speeding up. Today Greek 10-year yields rose to 14.75% and 2-year yields soared past 22%. If you think Greece is notgoing to default and force significant haircuts on its bondholders (including the ECB), you have a great opportunity to buy a 22% note that will pay off at par! Portuguese 10-years are at 9.28%; 2-years at 10.5% (see Chart below for the 2yr). The Irish 2y and 10y are both over 10% as well.
Portuguese, Greek, 2y or 10y. It doesn't matter, they all look this bad. This happens to be the Portuguese 2-year note yield.
This is starting to be an all-the-king’s horses situation. With all the powers that can be brought to bear on the problems, all of the ECB secondary market support, all of the rescue packages and promised rescue packages – and even after Spain and Portugal both successfully sold bonds over night – these markets are in free-fall.
One reason for it is that investors are newly skeptical that the European Financial Stability Facility, and its successor European Stability Mechanism, are going to work because of one little design flaw: the fact that member countries must cough up the dough. Well, make that two design flaws: member countries are by and large democratic, and the ‘little people’ seem to object to coughing up the dough. We saw the recent German election results, and the Finns this week gave a lot of votes to a “Euro-skeptic” protest party (although a Finnish friend of mine thinks it is unlikely that party will end up as part of the ruling coalition). Today, the ruling party in Slovakia declared that it won’t support the creation of the ESM, which means that two minority parties will need to form a coalition if Slovakia is going to participate. The words of the ruling party’s chairman resound:
“We are here to defend interests of Slovak citizens, not the interests of foreign banks, which have for a long time made profits on high interest on loans to irresponsible countries.”
Investors are gradually coming to realize that the cacophony in Europe right now isn’t merely distracting, but destructive to the notion of a unified Eurozone. And that is causing them to separate the (German) wheat from the (periphery) chaff when it comes to periphery markets. This may ironically be good for the Euro if only the periphery are jettisoned, but the behavior of the Euro bond markets look much like a film of the mid-1990s “convergence trade” being run in reverse.
Having a bailout mechanism that requires consensus of the members appears to be simply not workable. By contrast, the U.S. bailouts do not require state approval, nor Federal approval. The Fed just prints the money and voila! And so far, it has worked.
It has worked, that is, except for the fact that the dollar’s downtrend periodically threatens to become disorderly. Today the greenback reversed the rest of Monday’s rally and went to new lows on the year. It is challenging 2009’s low now. Partly as a consequence, commodities rallied again today, with NYMEX Crude Oil setting its second-highest close of the year (above $111). Softs, Precious Metals, and Industrial Metals all rallied.
The dollar’s problems and the imminent shuttering of the debt markets to Portugal and Greece didn’t impact the equity markets. Stocks soared overnight and then traded sideways on light-to-medium volume throughout the day. Supposedly this was due to Intel’s generous outlook in their earnings release yesterday. I’ve never understood why Intel’s earnings, or those of almost any other single company with the possible exception of a megaconglomerate like GE, matter to the other 5000 stocks, but this was the excuse. Stocks are back up near the 2011 highs again! I suspect that we’ll need some actual good news, rather than scattered positive quarterly earnings reports, to propel stocks much higher but to be honest I’m not sure why they’re levitating now.
Bonds sold off slightly, with 10y nominal Treasuries at 3.40% and the 10y TIPS at 0.78%. Tomorrow the Treasury auctions $14bln new 5y TIPS at 11:30ET ahead of the early close and Good Friday holiday.[1] The new TIPS will have a coupon of 0-1/8%, the lowest ever auctioned, and if they still issued paper bonds I’d buy some just to frame for that reason. They’ll be auctioned at a premium at that coupon, because the real yield will be negative. It doesn’t light my fire unless and probably only unless your alternative is the nominal Treasury note. The market needs inflation-linked paper because of all of the money flowing into inflation-linked bond strategies, but I think there’s a chance this one is sloppy and needs to be cleaned up next week.
The economic data today didn’t do much to push the inflation outlook higher. Existing Home Sales were somewhat above expectations (although, as with Housing Starts, the current level isn’t impressive), but the inventory of existing homes rose slightly to 3.549mm units. That implies CPI Shelter over the next 12 months should be expected to be roughly +1.1%, all else being equal (see Chart).
Housing Inventory like this augurs something like 1.1% Shelter inflation in the year ahead.
All else, of course, is not equal and this is a very simple regression. CPI Shelter could well be higher and could possibly be lower. But if CPI for Shelter is only +1.1% over the next 12 months, it will be difficult for overall inflation to really blast off. Still, if core CPI ex-Shelter continues to rise, it will still feel bad.
Tomorrow, we have another Initial Claims figure (Consensus: 390k from 412k), with the consensus hoping…praying…that the jump last week was an aberration. If we get another number around 400k-410k, bonds might get a bid into the long weekend. Also tomorrow is the Philly Fed index (Consensus: 36.4 vs 43.4), which should remain fairly strong, and some home price data. As noted, it is also a short trading session (in the bond market). I will write a comment after tomorrow’s session (or on Friday), but then I am out of the country for a week and will not be writing commentary from the beach. The next installment of this serial, after tomorrow, will be on or around May 2nd. Happy Easter.
[1] SIFMA, the self-regulatory body that ‘recommends’ early closes and holidays for the bond market, made a decision in 2009 to de-emphasize early closes and holidays. Oddly, although Good Friday isn’t always a holiday (unlike Christmas) in the market, they’ve decided this year that it should be even though they’re trying to make bond traders work harder. I don’t understand why, but I’m grateful.
Hogs + Corn + Silver = Diversification!
The dollar’s rally against the Euro lasted all of one day. On Tuesday, the greenback reversed most of its Monday gains, providing a boost for commodities and TIPS alike. Bonds continued to float slightly upward (lower in yield), with the 10y rate at 3.37%. Stocks rose 0.6% amid generally positive earnings, although it bears note that Goldman had a 20% ‘beat’ and the shares fell anyway. If that happens on a widespread basis, it would be cause for further concern about index levels and the possibility that amid stretched valuations “selling in May” might make more sense than usual.
On the economic front, Housing Starts showed a solid 7.2% rise over an upwardly-revised February figure. The resulting 549k level of Starts is still putrid (see Chart), but I always hasten to remind readers that a low level of starts is a good thing given the big overhang of unsold homes.
Housing Starts: above expectations but still sickly.
And that is, more or less, the extent of the news on another slow trading day. Tomorrow’s data provide another cut at the housing market, and a more important one, with Existing Home Sales (Consensus: 5.00mm from 4.88mm). Existing Home Sales has been very volatile for a long time now, thanks to the many and sundry incentive programs stopping and starting, but the headline sales number isn’t the most important figure anyway. Look at the “Homes Available For Sale” subindex, which was last at 3.488mm and a mild uptick. We want to see that back around 2-2.5mm eventually, but for those looking for improvement in the housing sector any improvement will be welcome. The recent low, in January 2010, was 3.277mm; below that and it would be the lowest since 2006 (yes, existing home inventories were an obvious problem as far back as that).
There will also be a continuing deluge of corporate earnings reports to pepper us throughout the day.
Since it was a fairly light day news-wise, I want to turn for a moment to a complaint I hear quite a bit when I discuss commodity indices and related strategies with clients and potential clients. Our ‘Four Real’ strategy currently has a 52% weight in a commodity index, and the classic objection is “I can’t invest in that – I need more diversification!”
So let me talk about diversification.
The people who say this, almost uniformly, have no problem holding 80% of their portfolio in equities. They assiduously ‘diversify’ their holdings of stocks so that they hold, perhaps, 15 or 20 names, or a ‘diversified’ equity fund.
If the alternatives are between holding a diversified equity portfolio and holding 50% of your portfolio in a single commodity – yes, even gold – then I have no disagreement. But a commodity index is diversified by its nature. More than that, it is actually considerably more diversified than an equity index. After all, it is the equity markets that brought you the concept of “beta,” which is a security’s covariance with the broader market index. What is the “beta,” on the other hand, of Feeder Cattle? It is nonsense to even think of such a thing. Almost all stocks have a positive ‘beta’ over short, medium, and long-term horizons. There is an old saying: “never confuse genius with a bull market;” this saying derives from the fact that if the market as a whole is going up, virtually every stock will also be going up too.
Let’s make this more concrete. The standard deviation of the 5-day returns of the 500 elements of the S&P 500 from Monday the 11th through Monday the 18th was 2.68% – that is, roughly two-thirds of the changes were between +2.68% and -2.68% from the average change and virtually all of them were between +5.4% and -5.4% from the average. By contrast, the standard deviation of the 5-day changes of the 24 commodities contained in the GSCI was 4.13%. In this admittedly coarse illustration/snapshot, the components of the commodity index were 54% more “spread out” than the components of the S&P 500. In other words, the components were more diversified.
(As I have mentioned here before, that’s good for another reason as well. It is the volatility of individual elements of a commodity index, combined with the low correlation between them, that creates a return stream tied to the periodic rebalancing of the index – you sell what has gone up and buy what has gone down, which systematically adds return. Equity indices, which are much more correlated, derive much less return from this source).
None of this means that a commodity index can’t be as volatile, or more volatile, than an equity index; although historically they have had similar volatilities there are times when a commodity index has been more volatile than equities and vice-versa. And investors may of course differ on their expectations for returns. So there may be reasons that a particular investor is uncomfortable making as large an allocation to commodities as they would be willing to make to equities. However, I hope that I have successfully argued that “lack of diversification” shouldn’t be one of those reasons.
Anything You Can Do I Can Do Worse
The tragic comedy continues to disgust and delight, depending on your position and demeanor.
Today S&P revised its long-term sovereign outlook for the U.S. to negative. Stocks didn’t like this very much, and promptly sold off 2%; the dollar also dipped and Treasuries went from very positive to somewhat negative on the day. However, the dollar and bond dips didn’t last very long. The outlook for the U.S. fiscal situation is long-term negative, no doubt; however, the outlook for the European fiscal situation, and the condition of her banking institutions and member nations, is short-term negative as well and this concern rightly dominated today.
Last week’s slaughtering of PIIGS continued today, with Greek 10y yields up 66bps even as the regime crosses its heart and says that no restructuring is planned. Where have we heard such promises before? Oh yes, I remember – when they said they wouldn’t need assistance in the first place.
Irish and Portuguese yields were also higher on the day, but of more concern is that Spanish 10y yields rose to the highest levels since 2000 (see Chart below, source Bloomberg).
Spanish yields are at 10-year highs.
This is probably a good time to remember that it was only 11 days ago that the ECB hiked interest rates. Muchas gracias, ECB! And then there was this as well, from an Associated Press story:
“Meanwhile, another European country is weighing on markets too – but this one has no debt problems. News that a euroskeptic party made big gains in Finland’s election Sunday has stoked fears that the EU’s “comprehensive plan” to deal with the debt crisis may not run as smoothly as hoped.”
I have always thought that one of the more amazing aspects of the entire Euro crisis has been that investors seemed to assume that continued unanimity of the Euro members…for unanimity is required before bailout monies can be disbursed…was the more likely case. Anyone who has ever walked into a movie rental shop with a family of four to choose a movie should have been skeptical that the apparent unanimity would hold. To pirate the old line about a fool and his money, the amazing thing is that they ever got together in the first place.
So the Euro has taken a hit, giving the dollar something of a breather even though the long-term outlook for the U.S. sovereign bond rating has worsened. The fact is that the rolling crisis in Europe has practical consequences, while S&P’s report on the U.S. fiscal situation does not. It surely can surprise no one that the state of fiscal affairs in the U.S. is in a parlous state. And an actual default remains extremely unlikely (the Fed can always continue to print money to pay for government expenditures), especially while most public debt is held domestically. So the S&P report has no real significance, which is why bonds and the dollar snapped back after the knee-jerk reaction. The fact that equities did not snap back very much, ending the day -1.1%, tells you something about the sponsorship for the market at these levels.
The 10y note ended at 3.37%, and a mere 0.76% on the 10y TIPS bond. That’s the lowest real yield since December. Commodities continue to look the least-worst of a number of inflation-related markets. Energy dropped back today but NYMEX Crude is still at $107.30 and continuing to defy many recent predictions of cataclysmic collapse. But grains, livestock, and precious metals all rallied today despite the dollar’s strength.
There was no important data today, but Friday’s CPI figures were near expectations at +0.549% on the headline number and +0.135% core (I’d suggested there was downside risk to the +0.2% consensus). Housing accelerated further, to 0.780% y/y from 0.657% y/y as of last month, but the pace of acceleration slowed as I’d expected. As the table below shows, most of the major groups are accelerating or going sideways, with the modest and surprising exception of Medical Care. Apparel decelerated this month, but it tends to jump around quite a bit. No group is decelerating markedly.
| Weights | y/y change | prev y/y change | 3m y/y chg | |
| All items |
100.0% |
2.682% |
2.108% |
1.496% |
| Food and beverages |
14.8% |
2.781% |
2.236% |
1.481% |
| Housing |
41.5% |
0.780% |
0.657% |
0.287% |
| Apparel |
3.6% |
-0.645% |
-0.421% |
-1.077% |
| Transportation |
17.3% |
9.829% |
7.100% |
5.290% |
| Medical care |
6.6% |
2.734% |
2.891% |
3.275% |
| Recreation |
6.3% |
-0.069% |
-0.143% |
-0.766% |
| Education and communication |
6.4% |
1.119% |
1.229% |
1.292% |
| Other goods and services |
3.5% |
1.803% |
1.959% |
1.901% |
On Tuesday, Housing Starts (Consensus: 520k from 479k) is expected to rebound from last month’s dismal performance. If it does not recover a fair amount, it will be very discouraging to current growth expectations – the current assumption is that the previous dip was weather-related. The European developments will probably still be more important for the markets’ near-term direction, however.
In-credibility
In Europe, it appears that today was unofficially “beat up periphery bonds day.” Greek 10y yields shot up 30bps to a new high of 13.15% (which sounds juicy until you remember you’re probably not going to get it for very long). Portuguese 10-year yields rose 14bps to a new high of 8.77%. Irish 10-year yields jumped 26bps to 9.15% but below last month’s 10% highs. Even Spanish 10-year note yields rose 9bps, to 5.3%. All of the high-quality names, such as Switzerland, Germany, France, the UK, the Netherlands, and Sweden for example, were roughly unchanged. These losses were provoked, in theory, by comments by Germany’s Finance Minister suggesting that Greece might need to restructure its debt if a June audit finds that it may have trouble paying creditors. There is no question that Greece will have trouble paying creditors; the only questions are whether an official audit would actually say so, and what “restructuring” means in the context of a country that has multiples of the debt burden that is sustainable. It sounds a lot like “socking it to the bondholders,” but surely no one who was holding Greek bonds actually expected them to pay off at par? If so, then the real problem here is the ease with which investors are sustaining disbelief in the face of obvious impossibilities.
Back on this continent, Initial Claims rose to 412k, the highest level in two months. It is, though, only a single week and nothing yet to raise many eyebrows.
Stocks opened weak after the overnight futures session had taken prices lower (well before the Claims data, incidentally) and proceeded to trudge higher throughout the day before eventually ending unchanged. Bond yields rose with the 10y note up to 3.49%, despite a good bond auction.
The Treasury announced a 5y TIPS auction for next week; the $14bln in new April-2016s was slightly larger than the market had expected and will be auctioned next Thursday (after a TIPS buyback on Wednesday).
There were several speakers today but the most interesting to me was Philadelphia Fed President Plosser. Plosser is supportive of instituting an inflation target to encourage public confidence in the Federal Reserve as an inflation fighter. This is a curious thought. It’s a lot like a baseball player trying to encourage public confidence by declaring he has a target to hit 0.375. Perhaps there are some really dim people who would say “whew, that’s good. We really needed our shortstop to hit 0.375!” But for most of us it’s not the target, but hitting the target, that inspires confidence, right? Suppose thereafter that the hitter proceeds to actually bat 0.250. Does the fact that he publicly declared his intention to hit 0.375 increase his credibility, or decrease it? I would argue the latter, since it establishes that he didn’t really have the control he thought he did.
I am not sure it’s any easier to hit an inflation target than to hit a fastball. The hubris of Fed officials, thinking that all they have to do is declare their target and then hit it, is arresting. Of course we’ll hit it. When have we made a big mistake in the past?!? So in a way it’s even worse than the hitter example I gave above. Instead, it’s a 35-year old career 0.250 hitter declaring a 0.375 target. It’s delusional, if not downright comical, or even sad.
None of the speakers today – Duke, Kocherlakota, Plosser – see any inflation pressures, or any real chance that headline inflation will pass into core inflation. This is good, since the consensus for headline CPI tomorrow is +0.5%, taking the year-on-year figure from 2.1% to 2.6%. Core inflation is expected to be +0.2% for the third consecutive month (a phenomenon we haven’t seen since early 2009) and to lift the year-on-year core inflation reading to +1.2% from +1.1%.
My models have a short-term peak in the housing contribution coming right around now, with year-on-year inflation drifting only a little higher between now and mid-summer before continuing to rise through the end of the year. Recently, the part of CPI that is attributable to housing has been on the rise, as the chart below illustrates, and your forecast for core inflation is necessarily going to be reliant on your housing inflation forecast.
Shelter CPI has clearly bottomed but might not yet be surging.
The trend looks very positive for inflation, but unfortunately this doesn’t appear to be the beginning of a sharp surge higher but rather the reflection of the meaningful decline in the inventory of existing and new homes for sale over the course of 2009. Because inventories bounced sharply higher into 2010 (see Chart below), it is too optimistic to expect the housing part of inflation to continue to rise as aggressively as it has been.
The rise in inventories last year should have a dampening effect on further near-term gains in Shelter CPI.
That being said, there are plenty of other elements of core inflation that are rising, and the uptrend is well-established. I think that the +0.2% consensus expectation for tomorrow might be a teensy bit ahead of itself but I wouldn’t put money on that forecast.
Also tomorrow, the Empire Manufacturing Index (Consensus: 17.00 from 17.50) is due to be released at the same time as CPI; later in the morning the consensus expectation is for a strong gain in Industrial Production (Consensus: +0.6%, with Capacity Utilization rising to 77.4% from 76.3%), which if the expectations are correct will be plenty to keep the inflation people happy even if the CPI report itself turns out to be slightly disappointing. Finally, the mid-morning release of the Michigan Confidence figures (Consensus: 69.0 from 67.5) will cap the week’s data. With this last report, remember to watch the consumer expectations for inflation 5-10 years ahead, which rose significantly last month.
Got Gasoline?
JP Morgan’s earnings were strong, as I suggested yesterday they probably would be (the stock fell, though, on news that they, and BofA, and a number of other firms will be forced to pay foreclosure “victims”). Retail Sales were good-to-strong as well, at 0.8% ex-autos and an upward revision to last month. The Beige Book was upbeat as well.
So, for a day, stocks managed to skitter to unchanged. The fact that they were only unchanged speaks to valuation levels. Bonds rallied a smidge to 3.47%, and TIPS rallied further as well. Breakevens declined slightly.
Oil recovered above $107, somewhat weakly. But gasoline jumped 2.3%. Over the last month, Crude is up 5.7% while gasoline is up 9.4% (17.0% and 32.4% over the last 90 days). There was no big mystery about gasoline’s outperformance today. The weekly DOE inventory numbers showed the largest weekly gasoline draw since 1998, at 7 million barrels (see Chart). Analysts were expecting a 1mm barrel draw. There are occasionally surprises at this time of year associated with the shifting of production from winter gasoline to summer gasoline, but the main draws usually occur near the end of the summer driving season in August.
Biggest weekly gasoline draw in more than a decade
Either way, while this is only one week it is something to note because retail gasoline prices suggest that there may be something to the supply/demand dynamic here. The chart below shows the DOE Retail Average Price for Regular Unleaded, nationwide. As you can see, retail prices at the pump are nearly as high as they were in 2008, when oil prices were much higher.
Prices at the pump are still climbing!
Gasoline prices are more directly linked to inflation and to spending (and consumer confidence) than are Crude Oil prices. Yesterday I noted that I didn’t think oil prices were “overbought,” and relative to gasoline prices they certainly aren’t. And gasoline prices, while they may look technically overbought, are hard to fade when the rising prices are accompanied by steep draws in physical inventories. The absolute level of inventories is still pretty high, to be sure (see Chart below), but this can change pretty quickly.
The level of gasoline inventories is still nothing to get concerned about.
It is also fair to note that there is an element of circularity here as well. When inventories are low, it tends to help produce higher prices (obviously) and a vulnerability to disruption that can lead to lengthy upper “tails.” But when prices are high, there is also an incentive to keep inventories low, because it ties up more capital. It isn’t clear which effect is predominant at any time. One positive thing we can probably be confident about is that at this level of inventories, we’re not yet worried about minor disruptions causing a price spike.
But speaking of prices, the PPI and CPI will be released over the next couple of days. I always pooh-pooh PPI, because it isn’t very predictive of anything (certain elements of it are predictive of certain elements of CPI, but a lot of big-wig economist predictions based on “pipeline pressure in core Crude Goods” have fallen on the rocks over the years). Still, the year-on-year headline PPI should pop to above 6% tomorrow and produce “highest level since 2008” headlines (in 2008 PPI reached 9.9%) which might pressure bonds and stocks as well. Core PPI is still below 2%, compared with 4.7% in 2008, but that doesn’t make for as good a headline. Again, none of this is very important. I’ll pay more attention to the weekly Claims figures (Consensus: 380k), but the main event is still on Friday with the CPI. I’ll have much more to say on that tomorrow.
Oily To Bed?
Suddenly, it seems like a growth scare is in the air. Sometimes it isn’t clear where these things come from, but the seeming decision of investors to lighten up a little on equities for bonds and to exit Crude Oil seems to point to an oddly-timed concern about the levels of markets considering economic growth prospects.
To be sure, I concur with the skepticism that the growth we are likely to get – slow, but with some chances of a relapse – can support this level of equities. But market interest rates were already pricing in very slow growth (10y real rates below 1%) and increasing inflation; slower growth may quell some of the inflation fears but it is hard to think that real rates are too aggressively high here. And as of the close, they are 7bps lower. 10-year real yields at 0.86%? Those yields are as low as they are because the Fed has been buying all available supply, but on my metrics they look rich (and remember, I’m not exactly sanguine on growth). Indeed, in our “Four-Real” model TIPS are now weighted even less than equities, and that hasn’t happened since the end of 2009. A portfolio needs inflation protection, and given the alternatives it’s difficult to dislike commodities.
Also, oil prices are not where they are because the economy is booming; oil prices are well over $100 because of unrest in the Middle East and a persistently weak dollar. Neither of those things has changed, so some part of the oil drop seems to be either hot money exiting or hot money getting short. With Libya a questionable exporter for the moment and increasing demand for fossil fuels from formerly-nuclear nations including of course Japan but also several European states, the supply/demand imbalance doesn’t seem to favor an extended slide in energy prices, especially if the dollar remains weak. Now, other commodities dunked as well, and the imbalances are not as favorable in all of them as they are in energy.
It always amazes me how investors can just flip from “risk-on, growth is great” to “risk-off, growth is looking weak” for seemingly no reason, after previously ignoring lots of good reasons to reverse. I don’t spend a lot of time worrying about the precipitating factor – the clouds were pregnant, and eventually rain was going to fall, but predicting just what causes those first raindrops to form is pure guesswork. Maybe the slightly-weak results from Alcoa spooked investors, or perhaps it was the weakness in Machine Orders and Machine Tool Orders in Japan that highlight the (not surprising) fact that the disaster will have a major effect on one of the world’s largest economic engines (and this fact has been amazingly unappreciated by western economists). Maybe someone big just decided suddenly to get out of commodities and a bit of stocks and sashay into bonds. Or maybe, with taxes due this Friday, investors chose the last possible day to unwind positions and still realize the cash in time to pay Uncle Sam.
So is the long commodity march over? The drop in front Crude to $106.25, down $4 in three days (it makes better news to say it’s down more than $6 in two days, but remember it spiked higher on Friday) isn’t really a big deal although it seems to damage the technical picture some. Still, the fact that the ‘sky is falling’ hyperbole was pulled out so rapidly – my favorite story was “Crude Oil Plunges as Higher Prices Are Forecast to Curb Growth”; in other words higher prices are causing lower prices – is comforting.
It is easy to run the sound bite that the decline “could have a lot further to go,” and to say that Crude (and other commodity markets) are “overbought.” Are they? Look at the chart below, which shows Crude denominated in dollars, Euro, and Sterling for the last ten months (to the dollar peak, basically). It is normalized so that they are all starting at 100 and therefore the price represents 100 plus the percentage gain.
Perhaps oil is overbought in dollars, but in Euro?
In dollars, oil is up 46% or so in ten months, which sounds a little overbought. But implied volatility for front Crude is 31%, so this is about a 1.5 standard deviation move. That 46% price increase, at normal sorts of pass-through assumptions, adds something like 2% to headline inflation on top of core. So it’s a lot, but not exactly outrageous. And if you’re in Europe, that rise in the dollar price of oil is defrayed by the strength of the Euro, so your prices have only risen about 23.5% over ten months. Considering there are multiple conflicts in the MENA region and nuclear reactors are being shut off all over the world…that doesn’t sound too “overbought” to me except in a narrow, short-term technical sense.
Tomorrow’s economic data are likely to temper the fear of an abrupt slowdown, at least a little bit (although that’s not guaranteed to reverse the “risk-off” mood if that is what is happening!). Retail Sales (Consensus: +0.5%, +0.7% ex-auto) is likely to put in the ninth straight solid number in terms of core retail sales. JP Morgan Chase’s earnings are due before the open, and it will be quite a surprise if they miss earnings given the shape of the yield curve (even though volumes and margins are down). The afternoon sees the Beige Book, which ought to be generally upbeat as well. This isn’t to say that I believe all the hype, just that I am very suspicious about a sudden change in mood. Bond and stock markets are expensive, whether there is growth or not, but there is more to the story than the growth dynamic. I am negative on stocks and nominal bonds; I view TIPS as expensive although I think they will remain fairly expensive until QE2 ends; I think commodity indices are still fairly reasonable.
Food Fights
A day after oil prices spiked, they turned around and plunged. The net effect was small: +$2.49 on Friday, -$2.87 on Monday (although at this hour oil continues to plunge, down another $1.50). This volatility is still preferable to the inexorable advance of the prior couple of weeks, but by my read unless front Crude comes back to close below $106.50 or so, the uptrend is still in place.
To really deflate energy, or commodities markets in general, the dollar is going to get up off of the mattress. But on Friday it dropped to lows not seen since 2009, and another 1% or so would put the 2008 post-war lows within sight.
For all that people complain – legitimately – about the fact that the steady expansion of the money supply has steadily eroded the value of the dollar against real assets, but the currency has not devalued appreciably relative to the other major currencies over a long period of time because all other central banks have been doing the same thing.
However, if the ECB is actually serious about their hawkish stance, this could be changing. While some Fed officials talk the talk, they’re the back benchers: Kocherlakota, Fisher, etc. The votes that matter, however – mainly Bernanke’s but seconded by Dudley and Yellen (the Vice-Chair is actually probably less important a voice than the President of the NY Fed, at least historically), continue to sound dovish chirps. Dudley this morning was warning that we shouldn’t overreact to rising inflation. Oil’s setback today notwithstanding, I suspect we haven’t seen the highs of commodities nor the lows of the dollar yet.
That being said, the food fight on Capitol Hill was temporarily suspended on Friday night just barely in time to avert a technical shutdown of the government. I say “temporarily” suspended since the big fights are still ahead with the negotiation over the lifting of the debt cap next month and the 2012 budget yet to come.
So, in the meantime, we can again become amused at the antics on the Continent. Two great headlines today were provided by our friends across the pond. One was “Political Fights, EU Bailout Fatigue Could Unravel Portugal’s Massive Bailout Deal” describing how the fact that Portuguese political factions are not in complete agreement about the bailout deal complicates the negotiations. The other, less immediate but more interesting at some level because it breaks the tacit agreement not to talk about how much better off certain countries in the EU might be if they weren’t part of the EU, was “Italy Threatens to Quit EU Over Lack of Help on Immigration.” That Bloomberg headline isn’t available online as far as I can tell, but the important content was confirmed in this New York Times story: Italy’s interior minister, Roberto Maroni, uttered the fateful words – “I wonder if it makes sense to stay in the European Union.” It isn’t Maroni’s decision, but it is a good reminder that despite how unified people are in Brussels, there is widespread discontent with the Union among those bearing the consequences of the ministerial decisions.
Now, that doesn’t necessarily mean the Euro is doomed. Indeed, if the periphery countries were to exit the Euro then it is in the long run probably good for the Euro. However, in the nearer-term this would create a lot more uncertainty about the unit. Personally, I think the long-run prospects for the EU are dim, but I still favor the uncertain outcome in that currency over the more-certain, but more negative, circumstances of the dollar.
So, we have food fights within the EU, within the U.S. Congress, recently within the energy futures markets, and in the Fed itself between the increasingly-vocal hawks and the still-solid doves. Perhaps these are not as dramatic as the live-fire fights in Libya and those threatened elsewhere, but market-wise these battles are starting to be fought in public and this can be unsettling for markets.
In a way, the economy’s success over the last year has been the sire of some of these battles. In a crisis atmosphere, conflicts are submerged; when the crisis recedes the muttering becomes audible again. (This is sort of the flip side of Buffett’s maxim that “it’s only when the tide goes out that you learn who has been swimming naked.” For it’s only when the tide comes back in that you learn which of the shipwrecked crew was ticked at the others.) Maybe this is one more reason – to be added to “valuation” and “proximate completion of QE2” that stocks are having problems breaking above February’s high.
There is no economic data on Tuesday, but Dudley, Hoenig, and Fisher will be on the tape in that order.
Tragic Comedy
There were two tremors today, but the one that was expected is likely the one which will have bigger long-term effects.
The unexpected tremor was a magnitude 7.1 aftershock in Japan. Initially reported at 7.4 (which is a much bigger difference than it sounds like), the temblor was also located 20 miles underground rather than near the surface. Even so, 7.1 is not a small earthquake, and it knocked out power to the Rokkasho nuclear-fuel reprocessing plant and the Higashidori nuclear power plant, as well as two of the three power lines to the Onagawa nuclear power plant. But this time, the backup systems were not swamped by the much-smaller tsunami that ensued, and more importantly the Fukushima plant sustained no further damage. No doubt the quake put jangled nerves further on edge, but there was no further extension of the disaster.
The “expected” tremor was the ECB rate hike. The central bank raised rates 25bps, as expected. Even as Portugal was preparing its formal request for $100bln or so, the ECB insisted that this was good for the collective (they didn’t use the word “collective,” since that would make it too obvious).
According to the FT, and unsurprisingly,
Germany welcomed the ECB action. Mr Trichet denied paying undue attention to Europe’s largest economy, asking what Ben Bernanke, Fed chairman, would say “if he was asked the question ‘did you do this or that because of California’”.
This is disingenuous, of course, since Germany is fully 20% of EU GDP but furthermore the main source of the central bank’s DNA, whereas California is only 12% of US GDP and not exactly a ‘thought leader’ when it comes to fiscal prudence. But I’ll concede the point. There is actually one piece of evidence supporting his view, and that’s that real-time measures of German inflation seem already to be ebbing, which would make the need for tightening much less (see Chart, source the Billion Prices Project at MIT).
The Billion Prices Project may not be as thorough as Eurostat, but it's faster. This is German CPI.
As far as I know, the BPP isn’t trying to pick up core prices, so the fact that this measure is declining even as Brent Crude futures reached a new high ($122.78; NYMEX Crude finished above $110) and is up 31% over the last three months is suggestive. The persistent strength of the Euro since year-end is helping restrain prices – a following wind that the U.S. doesn’t have. The fact that the ECB is raising rates (to be sure, there is still ample liquidity from other programs and no one will quickly starve for cash) is odd.
I would describe that move as “comical,” but if you want comedy you really can do no better than the U.S. fiscal circus. Incredibly, the U.S. government is 24 hours away from a partial shutdown and furlough of 800,000 “non-essential personnel.” The battle is between the Republicans’ proposal to cut $61bln from the deficit and the Democrats’ $33bln proposal. The Republicans, controlling the House of Representatives, insist on their number; the Democrats say this would destroy the economy, old people, and orphan children with a limp.[1]
Now, I can tell you that the 2012 budget expenditures as proposed by the President are supposed to be $3.7 trillion, and point out that these two numbers are literally rounding error, but the numbers are so big as to be meaningless. So let me try a couple of images.
Let’s suppose that in 2008 your household had an income of $50,000. In 2009, you got a raise to $53,500; in 2010 you got a raise to $62,000; and in 2011 you got a raise to $65,500. Nice job; in three years you’ve gotten a 31% raise. Now the company comes on hard times, and they ask you to take a pay cut to $64,500. So you quit, of course, rather than take the pay cut.
Or, let’s say that ten years ago you weighed in at 190 pounds. Well, you’ve sort of let yourself go and you now weigh 380 pounds. But you can advance to the next round on The Biggest Loser if you can trim six pounds over the next year. “Forget it,” you say. “I love my Haagen-Dazs!”
That’s the scale of what we are talking about here. In the first example, your 31% rise in salary over 3 years matches the 31% rise in federal outlays over the same time period, and the $1,000 pay cut is roughly equivalent to $61bln/$3.8trillion in FY 2011 outlays. In the second example, your doubling in weight echoes the doubling of federal outlays from the 2001 budget ($1.9 trillion) to the 2011 budget and the 6 pounds out of 380 is akin to $61 from $3.8 trillion.
What is amazing to me is how Obama is turning into the anti-Clinton. The President is actually making the Republicans sound like health nuts when they propose the six-pound diet! It isn’t like the Republicans (at least, the main wing of the party) are being particularly fiscally conservative. How can the President make losers look like winners? He’s the anti-Clinton!
Folks, this comedic interlude actually has real-world repercussions. I don’t see any auctions failing any time soon, but the burden of running these deficits compounds because each year you need to raise all the new cash plus roll all of the maturing bonds. In the first year of massive deficits, you’re mostly just funding the deficits plus the “typical” maturities. In the second year, you have to sell bonds to fund the deficit, plus the “typical” maturities, plus all of the stuff you sold the prior year that matures this year. In the third year, you have to sell bonds to fund the deficit, plus the typical maturities, plus all the2-year stuff you sold in the first big-deficit year plus all of the 1-year stuff you sold last year. Right now, the 2-year note is $36bln in size, or $432bln/year. So you can see how pretty rapidly, you are stuck running massive auctions every day, all up and down the yield curve. Heck, we’re almost there now.
Over the last few months, we have had the assistance of the Fed to hoover up about $400bln of those issues (and before that, the knowledge that the Fed would be pursuing QE2 helped backstop buyers). But if you believe what you hear from the hawks, not only is the Fed going to stop buying soon but they’re going to be looking to start selling their stake as well (I don’t believe this, by the way).
Think I’m kidding about the size of the problem? Look at the chart below (Source: Bloomberg). It shows the distribution of the maturing bonds of the U.S. Treasury. Remaining in this year (that needs to be refinanced) we have maturities of $627bln plus about $1.7trillion in T-Bills. Some of those will be rolled into 2012 and roughly $250bln into 2013 (via the remaining 2-year note auctions this year). But in 2012 we will have a further $1.1 trillion deficit to finance (in the President’s proposal it would be $1.1 trillion in 2012, although remember the budget years aren’t calendar years so this isn’t quite right) plus the $1.3 trillion in maturing Treasury obligations to roll (let’s assume that the Treasury keeps rolling the $1.7 trillion or so in bills). That works out to about $9 billion in new coupon-bearing bonds that the Treasury needs to sell every day, or $45bln/week. And again, that’s on top of the bills. And every year that we somehow manage to pull off this trick, we add a bit more to the out-year stacks – the 3yr, 5yr, 7yr, 10yr, and so on.
The debt distribution of US Treasuries and all subsidiaries (except FNM and FRE)
Oh, and do you think the budget is sensitive to short interest rates? About 40% of the debt is maturing by the end of 2012. Now what do you think the odds are that the Fed will aggressively hike rates to a neutral 4% or 5% any time soon?
And does this problem start to sound anything like what Portugal experienced? Greece? Enron? It isn’t the balance sheet that fells most countries and companies – it’s the cash flow statement.
Is there a way out? Not a pretty one. Cutting hard on the deficit might well stimulate the economy after the initial harsh blow, but if our leaders are arguing over $61bln or $33bln I doubt we will soon see $500bln pass.
The market reality is that today, the dollar is already weakening. After rallying through the first part of 2010 due to the sovereign debt problems in Europe, it began to decline despite the fact that those sovereign debt troubles have continued. A declining dollar tends to increase the price of imports, most obviously energy imports, and helps to push inflation higher (albeit with a long lag). And to the extent that investors expect the currency to continue to underperform – perhaps because we have a dovish central bank while Europe has a hawkish one – it makes them less anxious to buy U.S. dollar-denominated issues (like Treasuries).
Some people think that a declining dollar is good for stocks, because it increases the value of exports and makes our products more competitive on world markets. True, but remember the U.S. is a substantial net importer overall, so the balance is clearly negative. It surely can’t be that all of the bad effects accrue to households and all of the good effects accrue to business. Businesses have energy costs too, and a lower currency also diminishes the opportunity to manufacture more cheaply abroad. Higher inflation and higher interest rates overall are surely not good for stocks.
On that cheerful note, I will close for the day and probably for the week although if something dramatic happens with the government shutdown I may write a comment. Obama, Boehner, and Reid suggested tonight that there was a chance a deal could be struck by mid-morning, but as I’ve pointed out it isn’t something that’s likely to be dramatic. Unless, that is, you find six pounds on a 380 pound man dramatic.
[1] Actually, this isn’t true. Under the No Orphan Children With A Limp Left Very Far Behind Act, both parties agree that limping orphans should be protected by the government.[2]
[2] Just kidding. There isn’t a NOCWALLVFB Act, but everyone agrees that ambulatorily-challenged independent minors should get the government’s full support.
It’s A Big Graveyard
For some time now, the markets have been ‘whistling past the graveyard,’ impressively ignoring and/or shrugging off a fair pile of news that ought definitely to be negative for equities and probably somewhat negative for bonds as well. I’ve detailed these things previously and they don’t really need much repeating.
But it’s one thing to go whistling past the local church graveyard, something else entirely to keep whistling when the graveyard stretches on for miles. Today, Portugal formally asked the EU for a bailout. “I tried everything but we came to a moment that not taking this decision would bring risks we can’t afford,” said Prime Minister Jose Socrates. A day or two ago, there had been talk that Portugal wanted a short-term loan to float it past a big slug of bond redemptions that is approaching; the EU said ‘it doesn’t work that way,’ so Portugal was forced to throw itself on the mercy of the Union.
Well, this is something less than a total surprise, and indeed Portuguese bond yields rallied 17bps, along with Ireland’s 32bp rally and Spain’s 6bp rally. I don’t know how Portugal seeking aid improves the lot of Ireland, but there it is. Now, I don’t really care about a one-day rally but the significance of Portugal succumbing is that the market’s crosshairs will now be trained on Spain, Italy, or Belgium. Judging from market yields, it would appear Spain is likely to be the next one ‘on the clock.’ And that’s really the main event, because Spain’s economy is much larger than Portugal’s, Greece’s, or Ireland’s.
The graveyard stretches onward. How long can markets keep whistling?
U.S. 10y note yields reached 1-month highs at 3.55%, and I will not be at all surprised to see them keep going higher. I believe the economic data is going to be flattening out a bit here, but not quickly enough to get investors champing at the bit to take up the slack once the Fed stops buying in a couple of months. Real yields are back to 0.96% on the 10y – still too expensive for my tastes but it is easy to say that; harder it is to find good alternatives. Even OSM, which I wrote about a year ago when it was trading at 16, only sports a yield of CPI+4.8% or so. After accounting for the credit risk of the issuer, that’s not particularly cheap (although probably better than many alternatives – I am not selling mine yet).
Energy markets continue to ooze slowly higher. The impacts of the Japanese disaster are continuing to spread and be felt. The financial impacts won’t be measured by Geiger counter readings, but by guidance from companies whose supply chains have been disrupted by the crisis. That guidance and those calls will start to happen when earnings announcement season gets kicked off on Monday (although the companies affected probably aren’t those that report next week but in the week or two thereafter).
And the money spigot the Fed has turned on will be turning off in only a few months.
Some people would say that this is all part of the “market climbing a wall of worry.” But that’s not right. A “wall of worry” is when investors are timid because of the possibility that things might go wrong, and they’re worrying about what might go wrong. That’s not the situation here. These things are not possibilities; they are things that are actually going wrong, right now. It’s whistling past the graveyard (frankly I picture it more like Michael Jackson’s Thriller, with lots of ghouls and ghastly things reaching out to clutch at the passersby).
Tomorrow, there are two main events on schedule. The first is the announcement by the ECB of the results of the monetary policy meeting. There is total unanimity among economists (at least, the 57 polled by Bloomberg) that the ECB will hike rates by 25bps even as Portugal, Greece, and Ireland are foundering on high rates. I think that will be a colossal error, although if they stop after one tightening or indicate that there will be a pause of some length to let the policymakers evaluate the effect of the move then it may not be as big of an error. But tightening policy now, given what is happening in MENA, given what is happening in Japan, and given what is happening with oil (which price rise is already contractionary), is a mind-boggling decision. And, as I have said before, it clearly points out that the EU doesn’t care much about the periphery countries and that policy is being run for the core. That’s fine, unless you’re a periphery country! We will see, I suppose, how willing the consumers of Europe are to take slower growth or a return to recession in order to restrain inflation.
This was always going to be the battle. Inflation, given the scale of central bank response to crisis, was always doomed to turn higher long before the “economic slack” (which is to say, jobs for the people) had evaporated. In the U.S., I have long assumed that the Fed would be very slow to hike rates for this reason and because the institution – despite its apparent independence – isn’t insulated from public rancor or from the brickbats of Congressional blowhards.
The other report is the weekly Initial Claims data (Consensus: 385k from 388k), which is unlikely to have a major impact unless it spikes well above 400k. A 410k print would get people wondering whether Claims are turning higher again, but a better-than-expected number has a high hurdle because the presumption is that Claims are in a downtrend.
For my money, I’m watching the ECB, listening to the press conference afterwards, and wearing a garlic necklace.
