Archive
The Sound Of Something Bad Not Happening…Yet
Last week, I discussed the fact that markets were behaving as if they were waiting for something bad to not happen. I suggested that having something not happen is inherently more difficult than having something actually happen.
But I forgot that equity investors often engage in through-the-looking-glass logic. Over the weekend, something bad did seem to “not happen,” at least if you believe the way the news has been spun. According to Bloomberg, stocks and the Euro were up overnight on “speculation that nations will pledge more aid to Greece.” Over the weekend, EU leaders rejected a “total” restructuring (not sure what that means), and the head of the EU finance ministers (Juncker) said that leaders will decide on a new aid package by the end of June.
The market’s reaction would be consistent with the removal of a Greek default as a threat (and thus, a shortening of the list of things that could go wrong, although to be fair one would then have to add to said list the possibility that ‘the deal falls through’), but the news is a very long way from doing any such thing. For if a new aid package was easy, it would already have been agreed to; what is more, as we have seen the decisions of finance ministers have generally been more generous than the subset that their countries have been willing to ratify.
It also isn’t clear that Greece herself would ratify a deal, or would be allowed to by her citizens. According to the Financial Times, under the hopeful headline of “Greece set for severe bail-out conditions,” it doesn’t seem that Greece is, in fact, “set” for the conditions that “would lead to unprecedented outside intervention in the Greek economy, including international involvement in tax collection and privatization of state assets, in exchange for new bail-out loans for Athens.” According to the more-realistic part of the story,
“Officials warned, however, that almost every element of the new package faced significant opposition from at least one of the governments and institutions involved in the current negotiations and a deal could still unravel.”
Accordingly, I am less prone to attribute the market’s behavior to a realistic sense that the risk landscape is improving than I am to give it technical provenance: we never had the convincing technical break in stocks. We never had the break in NYMEX Crude below $95/bbl. We never moved the dollar index appreciably above the 76-ish low from 2010. And the equity sellers/buyers in dollars are much likely to be antsy given the lack of follow through and the overnight news.
I wouldn’t think, though, that this presages a surge of new money into these markets. Yes, the performance of the markets today was positive, but it is predicated on the lessening of “bad.” For one thing, I doubt that the “bad” is going to stay lessened; for another, there is an accumulation of other “bad” that the market tastefully ignored today. All of the economic data today was not just bad, but quite bad. The S&P Case-Shiller Home Price Index fell 5.06% year-on-year instead of the 4.50% expected. The Chicago Purchasing Managers’ Report printed 56.6, rather than the 62.0 expected (and down 11 points from last month’s figure; it now stands at the lowest level since 2009 – see Chart below).
Chicago PM abruptly worsened. Not entirely shocking given the tsunami but the degree is surprising.
Consumer Confidence dropped to 60.8 from 65.4, confounding expectations of a rise to 66.6 that was based on the recent decline in retail gasoline prices from $3.98/gallon to $3.78/gallon. But in a surprising sign that the recent rise in Initial Claims may not be entirely due to one-off effects of the Japanese tsunami, the “Jobs Hard to Get” subindex rose for the first time since November, to 43.9. And jobs are much more important to confidence than are gasoline prices. If you don’t have a job to drive to, you don’t notice the gas prices so much but you’re still depressed.
The Dallas Fed Manufacturing Index, not usually an interesting release, plunged to -7.4 from 10.5 (and vs expectations for 8.5). Remember that all of these manufacturing surveys compare this month to last month, rather than the absolute level of activity, but still – the Chicago PM and the Dallas MI together tell a story of an economy that came (at least for a month) near to a standstill. And that should be a chilling thought, with interest rates already at zero. The Citigroup Economic Surprise Index, as a result of these recent data, fell to the lowest level since the immediate aftermath of the crisis (see Chart).
Economists haven't been this negatively surprised since Q4 of 2008 (which surprise took a few months to wear off).
I would say on this basis that maybe the bond guys figured this out early and the 3.06% yield on the 10y Treasury note (and the 0.76% real yield on the 10y TIPS) suddenly doesn’t look quite so silly in this context. But while 3% was defensible during the crisis, it is hard to see it so clearly right now as inflation is accelerating rather than decelerating as it was in 2008 when yields got to 2.05% and still in 2010 when we saw 2.40%. Three percent is awfully thin when the 10y inflation swap is still at 2.66%.
One of these markets is wrong. My vote is for the one that has been openly manipulated by the central bank and is a destination market for “least worst” flows. Traders may well flock to Treasuries right now, and chortle at Bill Gross for being on the wrong side of the rally, but I recall a conversation I had twenty years ago with a big investor when I was a lowly technical/quantitative analyst in the bond market. After I explained all the reasons for my view, the investor said “you’ve told me where the next 25 basis points are. Where are the next 75 basis points? My fund is too big to be bothered chasing 25bps.” Trading flows can piggy back on the safe haven bid, but for the investors the next 75 bps are to higher yields I think. In other words, we’ll see the lows of this year before we see the highs of last year. And I say that even though I believe the economy is going to be weakening, not strengthening.
And that is because the secular decline in inflation is over, and the secular rise is just beginning unless central banks abruptly get religion. Soc Gen had a provocative piece out on Friday regarding inflation called “The China Domino Has Fallen” (which was summarized by Business Insider in an article with a subheading “Big-Time Inflation Coming All Around The World”) The chart may just represent a spurious correlation, but it is suggestive. I can make a case for Chinese prices being more sensitive to global central bank monetary policy than our own domestic prices: the price effect is transmitted directly to China through commodities in a way that it isn’t in Western economies that are further down the production chain (although 20 months as a lag sounds suspiciously like data-mining).
Whether the impetus for the next inflation upswing is China, though, or rising rents as this Bloomberg story suggests (my models have this effect ebbing temporarily right about now, since home inventories are high, home prices are weakening again and rentals are a substitute for owner-occupied housing, but I am naturally skeptical about forecasting wiggles), the fact that inflation is plainly rising right now is hard to dispute. And, if you are a long-term investor earning 3.06% in Treasuries, hard to bear.
The markets were able to shrug off today’s run of weak data, but this will be much more difficult if tomorrow’s data are similarly soggy because ADP (Consensus: 175k from 179k) and ISM Manufacturing (Consensus: 57.5 vs 60.4) are much more important figures than Chicago and Dallas manufacturing surveys. If the recent data is any indication, there is considerable downside risk to ADP. A regression of ADP against Initial Claims from 2009 to last month (see below) suggests 129k is a reasonable central-tendency guess.
Recently-weakening Initial Claims may suggest ADP could surprise on the downside as well.
Note, incidentally, that if I include 2008 the estimated ADP print is much lower (actually negative), so if there is asymmetry there in a contracting economy compared to an expanding economy, it would tend to lower the ADP print. Either way, a 50k miss on ADP would constitute bad news. There is also room for a miss on ISM given the regional manufacturing surveys. Finally, tomorrow we need to even watch the monthly vehicle sales figures. The estimate is at 12.45mm (annualized), down from 13.14mm. Of course, the tsunami shouldn’t affect vehicle sales unless there are car shortages and demand isn’t being met, so if lower sales materialize it should be regarded with some concern.
What Are We Waiting For?
What, has everything gotten to fair value, so there isn’t any volatility any longer? The VIX index, despite everything that is going on in Europe, is back near the lows of the last four years (last month a 14.62 was recorded; today the VIX is around 16.3). The chart of the VIX has the self-similar nature of an EKG or a seismograph (see Chart), with spikes of decreasing severity ebbing with a similar decay function.
Seismograph or VIX?
I don’t know what that means, exactly. With the tension in the European sovereign crisis paused, but certainly not released, it surely doesn’t mean an “all-clear” has been sounded. I suspect it is also a function (as everything else is) of the low rate/low return environment. Low expected returns make it harder to buy options, since a bigger part of your return is going to pay for them, and more tempting to short since the income from a strategy of selling covered calls – which I enjoy reminding people is the same thing as selling naked puts, and watching their faces when they realize it’s not a particularly conservative strategy when you put it that way – or straddles is noticeable. I sure can’t figure out why selling options here makes sense, even if it might look like a good idea for a while.
The data continues to be sluggish, but at this point it may just be a temporary lull as sometimes happens in the ebb and flow of data, or the direct or indirect effect of the disruption stemming from the disaster in Japan. Yesterday’s Durable Goods was bad, even ex-transportation and even with upward revisions to prior numbers. Today, Claims remained elevated at 424k with an upward revision to last week. The longer this lasts, the more confusing the “Japanese impact” becomes to interpret. Is the impact lasting longer, or is there other weakness as well? Or is the disruption rippling down the line slowly?
One Wall Street sell-side shop I saw did an analysis that said auto production should be down 10% for a short time, which they said meant that (with 700,000 workers employed there) there should be a 70,000-job “Japanese effect.” But that’s not right, because each worker doesn’t contribute an equal number of cars. The math (0.1 * 700,000 = 70,000) is good, but the economics is bad. Assuming for illustration that every worker is doing the same job, basic microeconomics says that labor is added until the last “marginal” hires are producing just barely enough to justify that hire. Therefore, if you cut production 10%, and assuming that you cut the least efficient workers, you’ll cut employment more than 10%. (This of course would only be literally true in a stylized situation where the cost to hire and fire is zero.) There are also secondary and tertiary effects that trickle down, and we just don’t know how big those are – we merely know the sign.
Equities rallied today, Greek bonds rallied, the bond market rallied (10y Treasury yield down to 3.06% and looking for all the world that it wants to go back below 3%), TIPS rallied (10y TIPS down to 0.73%), and Unleaded rallied while NYMEX Crude fell to $100 again and the dollar declined. But with the exception of bonds, all of these markets are consolidating. Volumes continue to be pitiful in stocks, as they have been all year. Not since March triple-witching has NYSE volume been higher than 1.04bln shares. In fact, since I last showed this chart the aggregate volume for 2011 has begun to march off on its own. Compared to 2010, average volumes per trading day are a full 248 million shares per daylower.
Wall Street isn't exactly a ghost town, but volumes like this aren't good for the big boys.
And this begs the question – what are markets waiting for? Are bulls waiting for something good to happen, or for something bad not to happen? Are bears waiting for something bad to happen, or for something good not to happen? It is much easier for something – good or bad – to happen than for it to not happen, which is an open-ended statement. This may sound weird and convoluted (but that is sometimes how I think), but I believe the bears (on the economy and on equities) are waiting for something bad to happen while the bulls are waiting for bad things to not happen.
If I am right about that, then it means the bulls are essentially in a short-options position. That was fine when the market was priced at a level that permitted some bad things to happen without derailing everything (similarly, implied volatilities were extremely high, which allowed someone to sell them and be okay even if some things went wrong as long as a lot of things didn’t go wrong). But stocks, and economic expectations, are now at levels that reflect an assumption of no-bad, despite the obvious list of things that can go wrong. Bulls have had a good ride for a while as nothing really bad happened, but now that ‘option’ is a risky one. Gains will be trickling in like time decay, while bad things could strike quickly and move the market sharply lower. Although I am a former options trader, and comfortable with selling options when the circumstances and pricing are right, I experience a visceral reaction against selling cheap options.
In this discussion I separate the bond bears from the equity bulls, because I think the arguments are different for bonds. Both bond bulls and bond bears face conflicting pressures from the economy and from central bankers, and whether you’re bullish or bearish depends almost as much on your assumption of the central bank reaction function to weak or strong data as it does to the data (as well as any non-data calamities) itself. This is a confused mess, and the bond market is rallying by default in a risk-filled world. With rates falling, the technicals are bullish but I don’t see it as an easy trade to go along with the move. It may be that the bears need to be good and flushed by the time QE2 ends before we can have a bearish move, but I still think the eventual path-of-least resistance is to higher rates. But do I want to be short US bonds when Greece defaults?
As many observers have lamented, very little about equity and bond strategy right now has anything to do with economic data. Being bullish or bearish has more to do with evaluating political games (in the Nash sense) than the latest figures. But even if we’re not good at guessing what is going to happen next behind closed doors, that’s okay – the evidence is pretty clear that investors as a whole are pretty bad at guessing economic outcomes as well. It simply makes it more clear that we need to focus on the range of possible outcomes, and the risks and rewards associated with those possible outcomes. Even if we can’t handicap the probability of those outcomes, we can look for patterns such as the one I think I see right now: that stocks are an options bet. And we can take action to constrain the results of that bet, by trimming our exposures to stocks (my exposures across the board, except to commodity indices, are already pretty low).
The only economic data due tomorrow is the monthly Personal Income and Consumption data (Consensus: +0.4%/+0.4%, with +0.2% expected in the PCE Price Index) and a revision to the Michigan Sentiment data. Neither of those are normal market-movers anyway, and with an early close ahead of a three-day Memorial Day weekend the focus will be on trimming positions against headline risks.
Parallel Lines Do Not Intersect
The battle lines are being drawn in the Greek drama, and in increasingly-strident tones that will make retreat very difficult. This is one negotiating strategy: burn the bridges behind the army.
Here are some examples: the ECB’s Christian Noyer “ruled out” a restructuring. “There’s no solution possible” for Greece besides tightening its belt further in an austerity program. A default would make Greek sovereign bonds ineligible as collateral at the ECB, and according to Noyer they would become ineligible even if the country fails to meet the terms of the bailout. Since those terms appear to be impossible, this is a difficult situation.
It doesn’t help that the ECB is already understood – if not widely understood – to already be an “Enormous Bad Bank.” That’s the assessment of Der Spiegel, who says the ECB is “exposed to everything that could go wrong in Europe.” To some extent, a central bank is always exposed to bad things going wrong in its backyard, but Der Spiegel means exposed, as in “could need a bailout.”
Meanwhile, in the UK some MPs have begun vigorously protesting the use of any UK money in bailouts for the Eurozone. MP Mark Reckless (his real name) said “…it is unaffordable for this country to bail-out countries who joined a currency we chose not to when we ourselves are borrowing as much money, if not more, than those very countries we are bailing out…it is not our problem; it is not our currency.” It’s hard to argue with that! Reckless was speaking on the motion requiring the Government to oppose further use of the EFSM unless the UK is excluded.
The lines are being drawn in Germany, in Finland, in the UK, in Greece, in Ireland, and in Portugal and Spain. If the IMF gets further involved (as surely it will) then lines will be drawn by U.S. legislators. These lines are all parallel, in the sense that they are not set up as tradeoffs but as ultimatums. One side cannot gain except by making the other side cross its line. Parallel lines do not intersect, as we know from geometry. And where are we most likely to find parallel lines in the modern world? It is when we’re on a railroad heading inexorably towards our destination.
Nevertheless, Tuesday was a relatively sedate trading day. Equities consolidated yesterday’s move lower, which is actually a bad sign in that the lower levels were not rejected by the price action. Commodities bounced, thanks in part to Goldman’s declaration that it is turning “more bullish” on them. NYMEX Crude made a run at $100 but couldn’t break back above that (increasingly irrelevant) milestone. Bonds were mostly unchanged.
The economic data didn’t do much for the market. New Home Sales exceeded expectations at 323k, but this is both within the range of the last 6-8 months as well as below the lowest recorded rate in 2009. So it’s not exactly time to cue the fanfare.
On the good-news front, Goldman also put out a research piece noting that state tax collections continue to be strong, up 12% year/year among those states that have reported April numbers. Goldman notes that a significant portion of the rise is from prior-year tax settlements but takes an overall cheerful view of this data. But I think it’s important to realize that one of the main drivers of year-to-year changes in revenue is the level of the stock market (see Chart).
Federal tax receipts versus S&P index level, annual.
Higher equity prices result in more capital gains and more federal and state revenue. Given how much stocks have rallied (as well as bonds, commodities, and everything else) over the last couple of years, it would be really remarkable if revenues were not up quite considerably this year. The chart above is through 2010; a 12% gain looks about right.
What the bull giveth the bear may taketh away, however. If stocks go sideways, or heaven forbid lower, from here then tax receipts are going to stagnate. And our deficit projections do not incorporate ‘possible revenue stagnation’ as a potential outcome.
Note that I am not saying that revenues will fall if growth turns negative. I’m merely looking at the stock market, which is currently overvalued by many metrics. Federal revenues kept growing throughout recessions in the 1980s and the early 1990s, partly because nominal equity prices never experienced a major setback. It is also worth appreciating that this is a chart of nominal equity prices; although a rise in equity prices that merely accounts for a decline in the value of the currency isn’t a real gain to the investor it is still taxed. In the recessions of the early 1980s and early 1990s, inflation was high enough (and stock prices low enough) that there was a natural following wind to equity prices and therefore some support for ever-growing Federal revenues. We don’t live in that world any longer.
.
Wednesday’s data includes April Durable Goods Orders (Consensus: -2.5%, +0.5% ex-transportation), expected to retrench a little after March’s strength. The FHFA Home Price indices are out, and Minnesota Fed President Kocherlakota speaks on monetary policy around 1:30. The Fed speakers are also starting to draw their parallel lines, with some speakers advocating balance sheet unwinds while others demand increasing target rates first and still others think nothing needs to be done for a while. I have trouble reconciling this strong disagreement with Bernanke’s utter certainty that the Fed will have no trouble pulling back the liquidity without any side effects, when it is necessary. That can only mean that there are lots of good options, because otherwise someone is wrong and that would imply that certainty is harder to come by than he says it is. But I have trouble seeing that there are lots of good ways to unwind these unprecedented Fed actions. I guess that’s why I’m not a Fed official.
Run, Indy, Run!
It is hard to feel very sorry for investors who were surprised over the weekend by “signs Europe’s government-debt crisis is worsening and the economic recovery is slowing.” Those signs have been there for months; if you had to wait for Italy to be downgraded by S&P on Friday and for Spain’s ruling party to be gashed in local elections before you understood that yes, the periphery countries are having troubles, then you really should stop listening to the politicians.
This is another symptom of the trust-in-central-bankers disease. Investors try to eke out extra return by taking on more risk, trusting that if anything goes truly wrong the Fed or the ECB will intervene and help them out. Clients turn up their noses at strategies that match asset risks to liability risks (LDI) and other lifesaving institutional strategies, and insist on commitments to strategies that exceed some fantasy-derived “hurdle rate” that makes their situation seem tenable, actuarially, as long as things don’t get really ugly.
It’s a delicate operation, as investors take calculated risks with calculators that are a bit skewed. It is reminiscent to me of the opening scene in Raiders of the Lost Ark when another ‘investor’ is trying to get something for nothing. But sometimes, Indiana Jones doesn’t measure the sand in the bag exactly right and a great big boulder comes rolling right at him. This happens to investors all the time. The difference between Indiana Jones’ risk-taking and that of the average investor is that Indiana doesn’t expect someone to come save him from the rock. Consequently, he plans his operations with just enough margin of safety so that he can escape before he is crushed.
Some people were doubtless crushed by the Greek bond market over the last couple of days. The 10y yield rose more than 100bps (to 16.6%) and the 2y jumped to 26.25%. Both of these are highs for the crisis. The Irish 10y is at a new high of 10.63% and Portugal’s 9.38% is just a bit below the April high yields. Run, Indy, run!
Equities around the globe did poorly. The S&P’s 1.2% loss was better than what was seen in Europe (-1.9% on the FTSE, -2.1% on the CAC 40, -2.0% on the DAX) but they are all just different stages of red. The technical picture is messier than what I showed several days ago, but clearly negative. The dollar popped higher on Europe’s troubles, and reached the highest levels since April Fools’ Day. Commodities suffered, but not too badly ex-Livestock.
Bonds did well as might be expected in a flight-to-quality, but not as much as you might expect (US 10y 3.12%, down 3bps). And the VIX rose, but is still comfortably in the range of the last few months. Indy is running, but he isn’t really nervous yet.
Is that because investors think there isn’t a real problem? Or is it because they figure the central banks will ride to the rescue again? My fear at this point is that central banks don’t really have much they can do except more of the same. And if one of the periphery countries makes the eminently defensible decision to try the Iceland route and undertakes to exit the Euro and default, I’m not sure all the king’s horses and all the king’s men will be able to put the European banking sector together again.
In my own investing, it is difficult to figure out what makes a suitable hiding place. I am not worried about people laughing because I missed another 20% rally in equities. I know that while Indiana Jones might always survive, the median lifespan for people who follow that approach is still pretty low. I am just worried about finding a hiding place the rock cannot reach. Equities are a non-starter. Even stable dividend-payers of commodity producers have positive beta, and if equities swoon those solid companies are going down with them. Treasuries are exposed to inflation, and TIPS are still too expensive to have more than a token allocation (0.80% yield for the 10y) although as a true bunker they are hard to beat. Commodity indices are great but subject to abrupt repricing on growth fears. Our multi-asset model still leans heavily towards commodity indices and cash, but in the bond world I also find Australian Index-Linked bonds enticing with real yields above 2%. True, the OZ central bank is being more responsible than most, but most inflation for any country comes from global sources and the more responsible central bank will tend to keep the currency stronger than the USD. The difficulty is that as an individual investor it is quite hard to invest in Australian inflation-linked bonds!
There is not much data due tomorrow. The forecast for New Home Sales has institutionalized “flat-lining” with an expectation for an unchanged 300k in annualized sales. For the last 11 months, the range has been 270k-334k with an average of 295k, so this seems reasonable. However, there has been a distinct tendency for more sales to close in the last month of a quarter and for the first month of the next month to be a down month (see Chart) so there may be a little downside risk to that expectation…but it really doesn’t matter at these absolute levels.
New Home Sales - a small tendency for an uptick in the last month of a quarter.
Additionally, there are five Fed speakers (Duke, Rosengren, Hoenig, Plosser, and Bullard) on the schedule. The boulders to watch out for, though, will again come from overseas.
Food Fight!
The maxim goes that victory has a thousand fathers, but defeat is an orphan. The solidarity in official Europe that accompanied the original Greek bailout is fraying, and rapidly. EU finance ministers have been working furiously to put together some sort of package that would “re-rescue” Greece while giving some hope that the package would actually meet approval from the various constituent nations of the EU. They have had another constraint as well, which Citigroup thinks is throwing a wrench into plans to ‘soft-restructure’ or ‘reprofile’ Greek debt. According to a Bloomberg story,
“Officials struggling to stem the crisis want to avoid triggering swaps out of concern for stigma, contagion and rewarding speculators, whom they blame for worsening the region’s crisis, Hampden-Turner said.”
This seems to me to be a bad time to throw a hissy fit. Stop me if I am wrong, but weren’t the speculators who said the first bailout wasn’t going to work…correct? Can you seriously make the case that Greece, plunging output and all, would have been just fine if nasty speculators hadn’t bet the ‘under’? For goodness’ sake, let it go. Maybe next time, the ministers ought to look at the market signals and talk to some of those folks who suggested last year’s band-aid wasn’t going to change anything but the timing of the ultimate resolution of the crisis. Actually, perhaps now might be a good time to talk to those people!
Meanwhile, the EU ministers have a bigger fight on their hands anyway. Their flank has been exposed by the ECB of all institutions. Today the ECB warned the EU that if Greece restructured its debt at all – haircuts, maturity extensions, whatever ‘reprofiling’ it wants to do – then the ECB would cut off the bottomless credit line that it extends to Irish and Greek banks. Specifically, it would stop accepting non-investment grade paper…such as, for example, Greek sovereign bonds…as collateral for these loans. Apparently the fiction they have grumblingly accepted, that sovereign bonds are always worth par, is harder to put over when the bonds have actually defaulted.
Well, isn’t this a fine kettle of fish? Hang together, Ben Franklin said, or assuredly we shall all hang separately. They’re warming up the gallows right now, and while half of the policymakers are preparing to tilt at another windmill the other half are preparing their alibis. I suspect this makes the tilt more difficult.
What would really help these various crises is for a nice, robust recovery to take hold. But this looks like a distant dream. Today’s Initial Claims data were better than expected, at 409k, but Existing Home Sales were disappointing (5.05mm versus 5.20mm, with a large rise in the inventory of new homes as shown below).
You can still have your pick of existing homes. Inventory remains very high.
This just isn’t getting better very quickly; a year ago the inventory of existing homes stood at 4.029mm; today it is at 3.870mm. We might hypothesize that the steady inventory might still represent improvement as the ‘shadow inventory’ of foreclosed and nearly-foreclosed homes is gradually making it into actual inventory – we will look at some charts a little later that call that idea into some question.
The reallydisappointing number was Philly Fed, which showed 3.9 versus 20.0 on the headline figure. The table below shows the various subindices (which are independent from the headline question), along with last month’s number and December’s for comparison.
Philly Fed components
The fact that “Number of Employees” held up, and actually increased, while “New Orders,” “Average workweek,” and most other subindices dropped is moderately cheering, since it suggests the possibility that businesses are seeing the current slowdown as a temporary ripple of the Japanese supply-chain disruption. In that case, while New Orders might drop and people might not be working as hard, you wouldn’t necessarily want to be shrinking your workforce. I wouldn’t read too much into one month’s worth of the Philly Fed, but this is one interpretation that might soften the impact of the headline figure (who says I can’t be optimistic sometimes?).
Now, let’s step a bit further back and look at some other charts, which are from the New York Fed’s Quarterly Report on Household Debt and Credit. We read a lot about how credit trends are improving, and that’s surely true. Given how bad the economy was in the aftermath of the Lehman et. al. collapses, almost anything represents an improvement. This is why we can get excited about 400k Initial Claims, which ordinarily would be something less than thrilling. Back to credit, though. The following three charts are (a) the proportion of total consumer credit balances by state of delinquency, (b) the dollar value of new serious delinquent balances, and (c) the quarterly transition rates for 30-60 day late mortgage accounts.
–
–
There is no denying that all three of these charts are better than they were just a year or two ago. But there’s also no denying that each of these trends is still worse than it was at the depths of the last recession. Less than 90% of consumer loans are current, and around 4% are seriously ‘derogatory’ (somewhat more than 120-days late) The 120-day-late loans have either been curing or transitioning to the ‘derogatory’ category as fast as others are written off. The second chart suggests that mortgages are still going bad at very high rates. Think back to the ‘shadow inventory is draining’ hypothesis, which was a sunny way to look at the inventory of existing homes. The second chart above tells us that the shadow inventory continues to fill, albeit at a lower pace than it was filling last year. And finally, the last chart tells us explicitly how many of the 30-60 day late mortgages are getting current, versus getting more delinquent. In the good old days (when you could easily refinance yourself temporarily out of a bad situation and kick the can down the road, rather like Greece come to think of it), roughly four mortgages cured for every one that transitioned to 90+-days delinquent. Now, those numbers are even. Better than at the depths of the crisis, sure. But good? I wouldn’t say that.
The implication of this is that while the next hurricane isn’t hitting at high tide, it isn’t hitting at low tide either. The U.S. economy (and by extension, most of the global economy) is not healed, and not in a position to take another serious body blow such as might be associated with, say, a Greek default. Or an Irish default. Or a Portuguese default. Or a Spanish default. Or the Fed selling a couple trillion bonds.
I believe the Federal Reserve is serious about eventually withdrawing QE2, and steadfastly against QE3 (although the FOMC minutes left that door open wider than I had expected). But suppose that Greece can’t be saved without restructuring, and the ECB crosses its arms petulantly (they just tightened, after all), and various banks shudder and threaten to topple? Will the much more-dovish Federal Reserve ride to the rescue?
Do you want to bet they won’t?
Maybe this is why the TIPS auction went passably well today. The market had backed up 5bps, but investors were still being asked to buy a 10y TIPS issue with a real yield around 0.88%. The possibility that Bernanke might ride again – and we’re just now starting to experience the negative effects of his first ride – might be enough to persuade investors to hold small-upside paper in order to avoid the possible big downside if the food fight gets messy.
When In Doubt, Create More Choices
Nowadays, the FOMC minutes never cease to amaze and amuse.
“The first key issue was the extent to which the Committee would want to tighten policy, at the appropriate time, by increasing short-term interest rates, by decreasing its holdings of longer-term securities, or both. Because the two policies would restrain economic activity by tightening financial conditions, they could be combined in various ways to achieve similar outcomes. For example, in principle, the Committee could accomplish essentially the same degree of monetary tightening by selling assets sooner and faster but raising the target for the federal funds rate later and more slowly, or by selling assets later and more slowly but increasing the federal funds rate target sooner and faster. The SOMA portfolio could be reduced by selling securities outright, by ceasing the reinvestment of principal payments on its securities holdings, or both. A second key issue was the extent to which the Committee might choose to vary the pace of any asset sales it undertakes in response to economic and financial conditions. If it chose to make the pace of sales quite responsive to conditions, the FOMC would be able to actively use two policy instruments–asset sales and the federal funds rate target–to pursue its economic objectives, which could increase the scope and flexibility for adjusting financial conditions…”
My initial reaction to reading this passage in the minutes, which focused on some of the questions associated with the eventual shrinkage of the Fed’s balance sheet and rate increase, was “oh great, more levers?”
Here is a hypothetical question: If a trainee pilot is unable to keep his Piper straight and level using only the stick, does it improve outcomes to put him in a jumbo jet’s cockpit with 500 gauges, dials, and switches? Or would you prefer he practice on a simple system instead?
The nature of the problem the FOMC confronts, when it goes to figure out how to reduce its balance sheet without sending the bond market reeling, isn’t simple of course. There is no simple lever for monetary policy, and there will not be until and unless the Fed is able to get the SOMA account back to being just Treasuries and quite a bit fewer of them at that. So, don’t interpret what I am saying here as an indication that I think the Fed should ignore the problem. My point is that the market seems to have a robust confidence that the ultimate outcome will be decent growth with contained inflation and low rates, and when one reads passages like this it ought to lower one’s confidence in the ultimate outcome to the same degree that it raises one’s understanding of the difficulty of the problem. Because let’s face it, our pilots haven’t shown a high amount of skill over the last twenty years.
In my view, the Fed is underestimating the difficulty of unwinding its asset purchases. If the federal budget was moving into balance, so that there were fewer Treasuries splashing into the market every day, then it would be more feasible, but I suspect it will be many years before the balance sheet is meaningfully shrunk unless the Committee grows comfortable with the idea of much higher interest rates.
All of this remains academic at this point. The Fed took pains to point out in the minutes that discussion of how they would exit should not be taken to mean that tightening is “imminent.” Or as my friend Andy Fately succinctly and artistically puts it:
Debate at the FOMC
Revolved around ending QE
Should rates go up first?
Assets be dispersed?
Whichever, it’s months ‘ere we see!
.
That’s the news on this side of the pond, but the crisis in Europe continues to develop new wrinkles. I really don’t understand why policymakers, at least non-elected ones like Bernanke and Klaus Regling, the head of the European Financial Stability Facility (EFSF), feel they need to be quoted in the news all the time. It’s destructive far more often than it is constructive, and as I am fond of pointing out it is a short options position: very little upside if everything goes right, but tremendous downside if there is a gaffe. While Regling’s comments don’t constitute a gaffe per se, they are still words better left unsaid. In a Bloomberg story entitled “Regling Says ESM to Be Senior to Private Bonds, But Below IMF,” he said:
“The ESM will claim seniority just below the level of IMF seniority, but above everybody else. That’s a political statement which is there. It’s not questioned by anybody in the policy world. The question is how to implement it. We will probably do it like the IMF, which does not write this anywhere down in its lending contracts.”
Well, that’s just wonderful. Political statements trump contracts! Here’s a little thing about bondholders. They really like, one might even say they insist on, knowing where they stand in the payment waterfall. In well-written private bond indentures, it will state very clearly whether the debt is senior or junior (and to what other specific debt), and in what circumstances if any the creditor’s claim can be subordinated.
Sovereign issuers don’t usually have bond indentures (which might otherwise include covenants they’d regularly fail, like debt-to-income tests and so on). Probably that is because everyone knows that there is no recourse if they violate the indenture – you can’t sue the government into Chapter 11. But if third-party creditors can cavalierly insert themselves into the waterfall by “claiming seniority,” as Regling puts it, then it adds a new layer of risk. A friend of mine who is a widely-read and sage observer of (and has been ahead of the curve in forecasting) events in Europe noted in his comment this morning, “It is then, in my view, the risks of owning European debt that is driving capital into American debt and driving yields down in the process.”
That is a very insightful thought. Whatever the credit circumstance of the U.S., Japan, Germany, and the UK, they’re unlikely to see their debt subordinated if only because there’s no one big enough to bail them out and claim a senior position!
That’s all the news, but most of the interesting market action happened long before the Minutes were released. Commodities staged a rollicking reversal today, with NYMEX Crude +2.7% (remember the surprising inventory build last week? It turned into a surprising draw today, as these things do), Grains +4.1% (using the DJ UBS Grains index), Softs +2.8%, Precious Metals +2.0%, and Industrial Metals +2.7%. All of that is with the dollar unchanged. The S&P was +0.9%, messing up the clear chart I showed yesterday (this is why there are few billionaire technicians). Bonds actually sold off, with the 10y note up 7bps to 3.19%. Incredibly, TIPS only sold off 1bp and the 10y TIPS that is being reopened tomorrow (in $11bln) is still yielding only 0.78%.
Speaking of that auction, I am more concerned with this one than I have been in a while. For the last few months, the fact that the Fed was scarfing up all of the new paper at the same time that investors were wanting more inflation protection created a shortage of TIPS. In that environment, they were never going to sell off very much. But now we’re approaching the end of that buying, and I sense that the Street has learned that you’re not supposed to be too short into TIPS auctions. This may be the wrong time to rely on that lesson. While I still think the auction will clean up well, I would not be surprised to see it tail a bit.
Tomorrow also brings Initial Claims (Consensus: 420k) as well as Existing Home Sales data (Consensus: 5.20mm from 5.10mm), Leading Indicators (Consensus: +0.1%) and Philly Fed (Consensus: 20.0 from 18.5). Watch for the ‘homes available for sale’ part of the home sales report. The last number was a disappointing 3mm units. The low from the end of 2009 was 2.76mm units.
The markets have now backed off, at least for a day or two, from the critical levels beyond which we would have been at crisis pricing. This is probably appropriate, since the Greek/Portuguese/Irish crises don’t appear to be coming to a head imminently. It may be time for a zag now that we’ve survived the zig.
A Tenth-Floor Rescue With An Eight-Floor Ladder
Rotten economic data caused equities and energy to penetrate key levels this morning. In an utterly shocking news flash, Housing Starts were miserable at only 523k, although last month was revised higher by 36k. We should try to be even-handed here. Just as the jumps in Housing Starts in 2010 and early this year were nothing to get terribly excited about when put into the proper context (see Chart below), so too we ought to avoid growing too morose about the 10.6% fall in starts this month.
The "lazy L" recovery in Housing Starts.
Any way you slice it, the housing market is in hibernation and this surely isn’t a big surprise. Somewhat more surprising was the fact that Industrial Production was unchanged and Capacity Utilization declined a tick from last month’s downwardly-revised 77.0% (was 77.4%). The surprise was blamed on downstream effects from the interruption of Japanese production (especially in autos) following the tsunami/nuclear crisis. See the Chart below.
A pretty sharp recovery in Cap U, but there's more "output gap" left - if that matters.
It is easy to see why many policymakers roll their eyes at people who warn of inflationary consequences to too much money. If you believe the output gap matters, then here is another soothing metric! Underutilization of labor is represented by the high unemployment rate. Underutilization of physical plant is represented by the low Capacity Use figures. If the output gap matters, then we ought to have been in deflation and we ought to probably still be there. As I am fond of pointing out, this just doesn’t square with historical experience – big output gaps do occasionally exist contemporaneously with inflation.
The initial reaction of markets was as you would expect, but the more dangerous because of the proximity of several markets to important support. For example, no matter how you draw the lines the S&P today broke through what is ordinarily solid support at the apex of a triangle (see Chart).
Doesn't really matter how you draw the lines, this is pretty ugly.
Wherever you went to techie-school, that’s a bearish chart that shows an upside breakout from a rising triangle, a re-test, and a then a fail through the apex. NYMEX Crude held the important level at $94.50 and rebounded, but the risk remains (on the other hand, grains did well again as drought conditions – ironically – have caused the winter wheat crop condition to be rated the worst since 1996). The 10y Treasury rallied to 3.11% and is at the highs (low yields) of the year…just as the Fed is preparing to end QE2, by the way.
While a downward adjustment in equities makes sense, a severe move in other markets (bonds, dollar, commodities) really doesn’t in the absence of crisis. Bonds, arguably, are already at crisis levels (although in the Lost Couple of Decades in Japan, obviously rates got substantially lower than they are now, here). So we remain on crisis watch. Never has the most-likely source of the next crisis been so clear, but it is the timing no one is sure about.The headline on Bloomberg was “EU Sees Possible Greek Debt ‘Soft Restructuring’ in Aid Bid,” but linguistic gymnastics aside (if I were to extend maturities to, say, 100 years and declare a 10 year interest holiday, is that a ‘soft restructuring,’ a ‘reprofiling,’ or a default?) the first paragraph ought to be chilling.
“European finance ministers for the first time floated the idea of talks with bondholders over extending Greece’s debt-repayment schedule, saying that last year’s 110B-euro ($156 billion) rescue has failed to restore the country to financial health.”
When is a rescue not a rescue? The EU undertook to save a lady on the 10th floor of a burning building with an 8-floor ladder. Actually, the analogy needs a further detail, because the woman is in the process of climbing higher in the building and all the fire department has is an 8-floor ladder. Anyway, isn’t it just a little frightening that $156bln kept the wolf from the door for only a year? Do you think any of the European legislatures who need to vote on the $116bln Portugal bailout are looking at that vote a little differently right now?
It seems scarcely believable that the EU finance ministers actually expect to convince anyone that there is an end game here that represents a win for the strategy of ‘keep bailing them out to keep the Euro whole.’ But for markets, the question continues to be the timing. In my view, I would rather be short equities and that rotten chart, protecting my backside with cheap options (or a set-it-and-forget-it stop), than long the bond market where the biggest buyer is about to exit the stage and a lot of bad news seems to be priced in.
On Wednesday, the only scheduled event of note is the release of the minutes of the most-recent FOMC meeting, at 2:00ET.
Soggy
I am sure it is just pure chance, but sometimes it seems as if the market action matches the weather. Today in New York it was cold and rainy, with the prospect of more of the same for a few days. And the stock market (-0.6%) and many commodities (Crude -2.3%; Industrial and Precious Metals and Livestock all lower, but Grains and Softs +1% or so) were drippy as well. TIPS dripped, with the 10y real yield up to 0.77%. Treasuries rallied 2-3bps, because bond traders are happiest when everyone else is miserable (right??).
Or, perhaps, it may not have been the weather after all.
The Empire Manufacturing Index fell to 11.88, the lowest level of 2011. This isn’t really an important number, except that it has been confounding expectations on the high side all year and so a downward surprise is unusual (except in the context that most other indicators have also been surprising in that direction lately).
The United States hit its debt ceiling, provoking more discussions about whether the U.S. will default, and what it would mean. I have stopped worrying about this and the implications for the U.S. credit rating. As Mark Steyn pointed out a couple of weeks ago (thanks DS for bringing this column to my attention):
…generally speaking, when you hit your “debt ceiling,” your credit is at risk. If you’ve got a $10,000 credit card, and you run it up to the limit, but you need a couple more grand right now, pronto, because you outspend your earnings by 50 percent every month and you have no plans to change that anytime soon, well, the bank might increase the limit to $15,000, or $20,000. Or they might not. There is a question mark over your credit because there is a question mark over your credit worthiness: It is at risk.
That seems to me to be a good point, as long as we distinguish between the credit rating and creditworthiness. The credit rating measures the probability that an entity will default, whether because it cannot pay or chooses not to. In neither case should there be any chance for any outcome other than a narrow technical default, since the federal government can always print currency to pay its debts…or to buy goods and services directly, without even raising debt in the first place (indeed, if we’re never going to pay it back, it would be less dishonest to just print-n-pay). The credit rating of the U.S., Japan, and probably all countries that can print their own currencies – that is, not European nations – should be very high and probably uniformly AAA.
But creditworthiness measures the borrower’s probability of actually making good on the debt. In the case of a sovereign that controls its own currency, “making good” surely ought to include the addendum that the debt is paid back in currency that has not depreciated dramatically in real terms (some mild depreciation is probably okay, since after all that is part of the interest rate that the sovereign is paying). And, given that the Federal Reserve is currently buying all of the Treasury’s new debt, there is at least a prima facie case to be made that we are not a very creditworthy borrower. As Steyn points out, it really shouldn’t be surprising that the creditworthiness of this nation is being questioned.
Now, in market terms how significant is this debate? Actually, I think what would happen if the U.S. stopped spending more money than it took in is that growth would take a near-term hit, which is why stocks and commodities would tend to drift lower, while the credit of the U.S. would improve marginally and Treasuries would become relatively more scarce. Presumably, the Treasury would take some of the maturing Treasury Bills and reissue longer debt to hearty demand, keeping the total amount of debt outstanding unchanged. And in what would be the most dangerous thing to both political parties, we would discover that life actually can go on without the government spending like a drunken sailor. But that’s just my guess, and I don’t expect that there will be a government shutdown of any meaningful duration so we won’t get to test it.
Markets are probably reacting less to the issues with U.S. debt than to the issues with Greek debt. Over the weekend, European leaders seemed to decide to use the word “re-profiling” to describe what may need to happen to Greek debt. This word means, as far as I can tell, to change the maturity profile and potentially the interest rate of the debt. The other word we have for that is “default,” but “re-profiling” sounds more like you’re sanding down a door to make it fit better. Ahhh…fits like a glove! Greek 10y is still around 15.5% and the 2y around 25%. A lower “profile” there sure would feel better, wouldn’t it?
But for all the news, equities fell (and did on Friday as well) but did not have a meaningful breakdown. The dollar rallied over those two days, but didn’t break through important resistance to launch higher. Crude oil declined today (and on Friday), but has so far averted a collapse. Bonds rallied to new low yields on the year (3.15%), but haven’t exactly lifted off yet. Markets are doing one of two things: we are either bracing for a crisis-ish sort of break (sharply lower equities, commodities, and TIPS, and a sharply higher dollar and Treasuries) or we’re getting bears, bears, bears, bulls, and bulls respectively overcommitted ahead of that break and instead markets are going to reverse hard if nothing bad happens in the near-term.
The introduction of new terminology (“re-profiling”) suggests that the singularity is near. But I suspect it is further than we think it is. I would be cautious about following breakouts in any of these markets in the absence of crisis-type news, but as traders we might get sucked into such positions because market moves often precede the public news. If that happens, then for goodness sake make healthy use of protective stops!
On Tuesday, the expectations are for another tepid Housing Starts figure (Consensus: 569k vs 549k last) and decent Industrial Production/Capacity Utilization figures (Consensus: +0.4% vs +0.8% last, 77.6% for CapU). But traders main attention will remain on the tape.
No Coup, No Grace
The economic data failed to give an excuse to administer the coup de grace to the commodity bulls, the equity bulls, and the bond bears. Initial Claims was as-expected; PPI a tiny bit higher than expected but nothing alarming. Retail Sales was also about as-expected but with upward revisions. Without the tailwind from a weaker data print, markets couldn’t push through the relevant technical levels…at least for a day.
So stocks and commodities were able to recover a little, and 10y notes dropped back to 3.23%. This is at this point nothing more than a failure to commit, rather than a failure. The economic outlook is certainly less than completely rosy. 434k Initial Claims is not exactly soothing, except when compared to last week’s spike (see Chart). And, I suppose, when compared to a year ago when 470k was fairly routine. But it is still one of the worst levels of the year.
Good or bad Claims? Depends on what your frame of reference is.
Weak economic data weighs against overvalued equities and supports what look to me to be fully-valued fixed-income markets. It certainly doesn’t help commodities markets which have come a long way, but I will keep reminding readers that the long-term commodity play isn’t a supply/demand thing but a monetary-inflation thing.
On the other hand, as I said above the economic data is not so much weak as weaker-than-expected. Initial Claims would be considered weak if maintained at this level, but this is likely just a burp and I wouldn’t yet reject the hypothesis that employment is still improving albeit slowly. The other data we have seen recently have mostly been soft, though, only through the lens of over-ebullient economists and stock shills. The Citi Economic Surprise index has fallen all the way from an all-time peak of 97.5 back in early March to a 10-month low around -36 right now. There is plenty of room for further disappointment, but mostly this has been about splashing cold water in the faces of the Pollyannas to bring them to their senses. The old recovery paradigm is not the right paradigm. The economy is not launching.
Now, as the Economic Surprise index continues to drop and the economy continues to surprise on the downside, it may be instructive to remember that Bernanke’s suggestion that QE2 might be worth considering followed a month or two of downside surprises (and some positively ugly surprises in early August of last year). I don’t think there is any chance that QE3 is on the table; too many Fed officials have drawn battle lines too clearly for that to happen without a lot of people losing face. “Well, maybe they’ll lose face,” you might think, because surely monetary policy will not be held hostage to reputation. This is true, but the stronger message is that these officials were permitted to say these things. Remember that senior members of the Fed have their remarks vetted ahead of time. Some Chairmen are more relaxed about letting their colleagues sing a different tune, but you can be sure that even the relatively relaxed Bernanke would like to make sure they are not opening a different hymnal altogether.
The hawkish chatter from the hawks is probably not indicative of a growing interest in actually tightening policy. Indeed, the chatter may be in lieu of actually tightening, since this Fed believes very strongly (and, I think, wrongly) that inflation expectations are key. But at the same time, if further easing actions were being seriously considered you can bet your bottom Weimar Deutsche Mark that the hawks would be closer to the reservation.
QE3, if it comes, is more likely to come from Europe after the failure of its ill-considered and premature tightening policy, than from the Fed. But neither is especially likely I think.
.
And now we move on to what for me is the main event of the month, and that is tomorrow’s CPI data. Consensus estimates call for +0.4% on the headline figure and +0.2% on the core, bringing the year/year rates up to +3.1% and +1.3%, respectively. The expectations for the core are actually for a ‘soft’ 0.2%; if it is being rounded down to 0.2% then it’s more likely we will see 1.4% on year/year core CPI.
While I would like to see that for business reasons, I think the risk is lower. The assorted models I employ all “expect” (if you will allow me some anthropomorphism) core inflation to flatten out around this area for a few months before accelerating into year’s end. The main reason for this is that housing inflation, a key part of core inflation, appears to be a little ahead of itself. The high inventory of unsold homes (for the model, lagged appropriately) should keep Shelter inflation from continuing to rebound as aggressively as it has been. Six months ago, Shelter CPI was -0.39% year/year; three months ago it was +0.45%; two months ago +0.76%; and last month +0.91%. My model has it estimated at +1.0% to +1.2% for the next few months.
However, some observers who look more closely at things like the National Multi Housing Council’s Market Tightness Index (see Chart below) don’t expect the Shelter component to decelerate at all. If those people are right, then my 1.6%-1.7% estimate for 2012 core inflation is going to be end up being too low.
Apartment tightness index might suggest Shelter inflation will keep on rising.
And the inflation swaps market is still insisting just that. While 1y inflation swap rates have plunged from 2.83% to 2.20% in just two weeks days, that is all about the drop in energy quotes. The decline in year-ahead gasoline futures implies that while on April 28th energy was projected by the futures market to rise about 11% (taking into account the required lag) and to add 0.36% to headline inflation, the market is now pricing in an 8% decline in gasoline and a drag of -0.28%. The net result is that core inflation over the next year that is implied by the 1y inflation swap and energy quotes is stillabout 2.5%. The chart below (Source: Enduring Investments) shows 1y inflation swaps (black line) and the implied core inflation, extracting the market’s assessment of energy.
Market still sees core inflation around 2.50% over next year. Potential errors to my estimate are accumulating on the high side.
To my mind, this is still aggressive. While there is much uncertainty to the possible outcome, and all of the long tails at this point are to higher inflation rather than deflation, the central tendency of my models from March ’11 to March ’12 is still just shy of 2% on core inflation. As an investor, I’d view the 50bps difference as the option premium I need to pay to own that headline-inflation tail, but as a relative value investor I would consider selling inflation swaps and buying gasoline futures to implicitly short core inflation at around 2.50%.
The weird thing is that the markets don’t seem to be consciously pricing higher inflation. Equity prices are too high and Treasury yields much, much too low to be expecting core inflation around 2.5% in a year. And Fed funds futures for next year (99.70 for March 2012) are essentially pricing an aggressively easy FOMC. Now, it may well be the case that the economy remains too weak in early 2012 for the Fed to do much tightening even if inflation is creeping higher, but in that case what are stocks doing this high? If it’s because there is too much liquidity, then what are commodities doing going down? My problem isn’t with understanding the pricing of any one of these markets in isolation; it is with understanding their collective pricing. In my view, the resolution is likely to be higher real rates, higher nominal rates, higher inflation swaps, lower equity prices, and higher commodities. But there might be twenty zig-zags before we get there. The most vulnerable market in the short term looks, to me, to be the bond market, which has been riding the weaker-than-expected data higher and will be the first to suffer if the data merely stops surprising low.
Dicey (And Slicey!) Markets
If you like trading, as opposed to investing, then these are markets for you. Commodities markets dropped sharply last week, recovered, and then a number of them dropped again today. NYMEX Crude, which had been flirting with $105 yesterday, pierced through $98 today before closing at $99. NYMEX Unleaded had recovered almost all of its loss from last week before plunging nearly 25 cents today.
Attempts to explain these moves as the natural product of any rational process are bound to be frustrated. Of course, we try. Bloomberg tried by stating (early in the day) that “Commodities fell for the first time in three days, led by gasoline and silver…as reports on inflation from London to Beijing boosted expectations for higher interest rates.” While there was definitely discussion of the i-word in both of those capitols, it is a bit of a leap to suggest that commodities markets are starting to price hawkish central bank policy when the very interest rate markets are not. I guess you gotta write something! After the weekly inventory numbers came out, showing a higher-than-expected build for Crude and Gasoline (but a draw for Distillates), the stories changed to attribute the plunge to the “surprising rise in supplies.”
A 7% move in Gasoline doesn’t happen because of a surprising weekly build. It’s a weekly number and it bounces around some, like Initial Claims. More importantly, this hypothesis doesn’t explain why Silver dropped 8.4% again today, or why Sugar was off 4.25%. And it doesn’t explain why stocks dropped 1.1%, or 10y notes rallied 5-6bps (to 3.16%).
Blame it, if you wish, on a sudden “risk-off” trade. At least that is consistent with the movement in the markets (although I always wonder why TIPS are considered “risky” instruments since they are considerably safer than Treasuries if held to maturity). But now we have just pushed the explanation back one layer. What has triggered the “risk-off” trade? Bombing in Libya? The fact that Greece is in trouble? The rising temperature of unrest in Syria? Hey, I can agree that all of these things make me nervous, but none of them is particularly new. Besides, as of this morning the Wall Street Journal was running a piece saying that a new deal for Greece is expected…by Greece…by June.
The dollar rallied today, to its highest level in a month. It isn’t clear to me if this is effect (another ‘risk-off’ reaction) or cause. You can make a plausible argument that it is the latter. Perhaps traders are covering short-dollar bets because the Fed is nearing an end of QE2 and, whether they now start selling out the portfolio or not, the transition to at least not buyingis effectively a tightening of policy and arguably could strengthen the dollar. This would tend to weaken commodities, and to the extent that monies are coming back into dollars it would tend to support fixed-income. If this is really the root cause, then it’s probably mostly out of gas…unless the buck breaks above big resistance at 76 on the dollar index (see Chart below).
Nice dollar bounce, but the going is about to get tough.
If that happens, then there may be more near-term downside to commodities and stocks and upside to bonds. I don’t expect it, but the recent volatility sure makes it seem a dicier proposition than I thought it was a couple of days ago. Several commodities are at supports, the 10y Treasury note is back testing its recent highs, and stocks are re-testing the February and April highs, which they pierced through late last month. The proximity of so many critical points makes the situation inherently less stable. And yet…the VIX is still way down at 17. The MOVE is still near multi-year lows (see Chart below). Protection is quite cheap.
MOVE index of fixed-income volatility is near multi-year lows as well.
But inflation protection is still not cheap. While 10y TIPS sold off to 0.72% today, that remains a very expensive level. How then does one protect against inflation in this environment?
I continue to be a fan of commodity indices, but institutional investors should consider high-strike payer swaptions here. Some readers will remark that this is not a fresh idea, since that has been the default strategy for many institutions for a while. So let me be clear: while that has been a default strategy for a while, it hasn’t been the right strategy for a while. Here’s why. When you buy an interest rate option (for the uninitiated, a ‘payer’ swaption gives you the right to pay a fixed rate on a swap at some point in the future, so it is analogous to a bond put), you’re paying for protection against increases in both real rates and in inflation. Remember, Fisher told us that
Nominal rates ≈ Real rates + expected inflation (+ risk premium)
So when you buy an option that pays off if nominal rates rise, you win if real rates rise, if inflation compensation rises, or if they both rise. And you’re paying for all of those possibilities.
But when this strategy was first being proposed, in mid-2009, real rates were much higher (especially on a forward basis). So nominal rates were not very likely to rise because real rates were rising; they were going to rise, if at all, because expected inflation rose. But you were paying for both pieces of that option. In the event, expected inflation rose and real rates plunged, so you’re further out-of-the-money now than you were then. Moreover, implied volatilities were very high.
Now, by contrast, implied volatilities are very low and so are real yields. It is unlikely that, if inflation starts to rise, real yields will fall much further than the 0.72% where they already sit. So you’re paying less, and getting more. Now, even if what you want is protection from inflation and not from nominal rates, at least you’re more likely to have the moving pieces going in your favor, rather than against you.
The same reasoning applies if you are a retail investor, except that there are not many options for the retail investor who wants to buy a long-term option on inflation, or nominal rates, or almost anything for that matter.
.
On Thursday, we get another volatile weekly supply number. This one is the supply of new jobless, also known as Initial Claims (Consensus: 430k). Recall that last week saw a spike to 474k, which even though it had some reasonable explanations attached to it was still shocking for many observers. If that figure doesn’t drop substantially, bonds are going to go straight up and stocks and commodities straight down.
Retail Sales (Consensus: +0.6%/+0.6% ex-autos) is also an 8:30ET number. Be careful here as well. Anecdotal reports seem to suggest a chance of weakness to what has been a consistently strong number for almost a year now. Unusually, this is probably less important than Claims in the mind of the investor right now, but weakness here and in Claims is where to look for market risk tomorrow.
Also out is PPI (Consensus: +0.6%/+0.2% ex-food-and-energy). Core PPI is expected to rise to 2.1% year/year and the headline to 6.5%. PPI doesn’t matter, and especially since it is sharing the 8:30ET time slot with Claims and Retail Sales it will be mostly ignored.
.
Two administrative notes:
1) If you missed my column the other day on the kurtosis and skewness of commodity indices and the importance of that fact to traders in these things – it was mis-posted in one place you may have ordinarily seen it – please have a read.
2) I finally finished an inflation-related paper that I had been working on for a long time. A few years ago I submitted it through a couple of rounds to a journal and never got it cleaned up enough to be published, but it’s cleaned up enough to put on SSRN. The paper is called TIPS, the Triple Duration, and the OPEB Liability: Hedging Medical Care Inflation in OPEB Plans. If you have a role in hedging medical care exposures in post-retirement liabilities, take a look and remember that Enduring Investments can be hired as a consultant.
