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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.

  1. Nicolas
    June 1, 2011 at 6:00 am

    Hi Michael,
    I am not an expert like you on inflation’s stuff.
    What I dont understand, it is why the TIPS’ yield does not reflect the spread between 10Y Notes & 10Y Inflation swap.
    Otherwise I understand your skepticism about the last equity rally. I would say that given the last economic figures out over the last weeks, people are gambling on a next round of QE.
    Thanks for all

    • June 1, 2011 at 6:29 am

      There’s actually a complex answer to your question. In a nutshell, here it is: TIPS yields are approximately ‘fair’ (or at least, unbiased). Inflation swaps are reasonably close to ‘fair’. But Treasury yields are always lower than they would otherwise be, if Treasuries didn’t have an extra value as collateral in repurchase (“repo”) transactions. TIPS do not have this special value. This means that the spread between TIPS and Treasuries is artificially lower than what the market expects inflation to be. The better measure for evaluating inflation expectations is inflation swaps. Good question.

  2. Nicolas
    June 1, 2011 at 6:39 am

    Many thanks for your explanations

  1. June 3, 2011 at 6:27 am
  2. June 14, 2011 at 4:16 pm

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