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Goodbye QE2, We Hardly Liked Ye
QE2 is now over. Long live QE2! The following table illustrates the effect of the second bout of quantitative easing from start to finish. I’ve chosen two potential start dates – the actual start date of November 12th last year, and the date we knew we were going to get QE2: August 27th, when Bernanke more or less said it would happen when he discussed “Policy Options for Further Easing” in his speech at Jackson Hole.
|
Aug 27, 2010 |
Nov 12, 2010 |
Jun 30, 2011 |
Net (Aug-Jun) | |
| 2yr Treasury Note |
0.55% |
0.51% |
0.46% |
-9bps |
| 10yr Treasury Note |
2.65% |
2.79% |
3.16% |
+51bps |
| 10yr TIPS |
1.02% |
0.66% |
0.70% |
-32bps |
| 10yr Inflation Swaps |
2.10% |
2.51% |
2.81% |
+71bps |
| Grains (DJ UBS) |
100.2992 |
115.8296 |
117.3552 |
+17.0% |
| Livestock (DJ UBS) |
73.7738 |
70.6753 |
72.3312 |
-2.0% |
| Softs (DJ UBS) |
127.0117 |
170.2196 |
197.7473 |
+55.7% |
| Gold |
$1236.00 |
$1365.50 |
$1502.80 |
+21.6% |
| Ind. Metals (DJUBS) |
329.6994 |
375.1198 |
392.2899 |
+19.0% |
| Crude (WTI) |
$75.17 |
$84.88 |
$95.42 |
+26.9% |
| Retail Unleaded Gas |
$2.682 |
$2.886 |
$3.541 |
+32.0% |
| Dollar Index |
82.918 |
78.082 |
74.404 |
-10.3% |
| Stocks |
1064.59 |
1199.21 |
1320.64 |
+24.1% |
| M2 |
$8,650.5 bln |
$8,767.9 bln |
$9,067.4 bln |
+4.8% |
So let’s analyze the effect of the Fed’s purchase of $600bln in Treasuries (plus reinvested coupons and principal payments) over seven months and change. If the Fed’s intention was to lower the 2-year note yield, then mission accomplished: 60% of a trillion will apparently buy you 9bps (only 5bps if we just count from November). If instead it was trying to lower longer-term rates, which was supposedly the more important goal, it failed utterly. 10y yields are half a percent higher. Now, the Fed did succeed in decreasing the real cost of debt; TIPS yields fell 32bps (although all of that happened in the Aug-Nov period) while expected inflation increased steadily.
The farmers like Bernanke, of course: Grain prices are up 17% since August, even after today’s 4.4% drop in Corn and 8.9% shellacking of Wheat. Ranchers, not so much, as livestock prices are flat, but softs (coffee, sugar, cocoa, cotton) are up a whopping 56%. Of course, the rest of us are consumers and have to buy this stuff. If we want to be very uncharitable, we should also point out that the skyrocketing cost of grains helped trigger unrest in a number of countries around the world. Bernanke will get no gifts from Mubarak!
Of course gold and industrial metals are up, around 20% each although you wouldn’t know it from how precious metals advocates have been whining. Crude is +27%; I’m sorry if you have to buy gasoline since retail prices at the pump are up 32%.
The dollar is worth 10% less on world markets. On the other hand, stocks are up 24%!
So if the Fed was trying to pump up stocks or nudge 2y note yields, they did a fine job. Beyond that, what we can see is…and what I’ve been saying all along…if you increase the quantity of money, the main thing you increase is the price level. The only reason you might expect a growth effect is if there is money illusion, meaning people see more money in their pockets and perceive themselves as wealthier because they don’t realize that the dollars are worth less. That is certainly somewhat true, but the figures above suggest that the most pronounced effects were on inflation expectations and the prices of raw commodities.
Well, we shouldn’t forget about this little effect as well: QE2 also kept Tim Geithner in his job for far longer than was good for the country. Obviously, Geithner knows that his job was made easier by the fact that the Fed was buying 85% of the Treasury issuance since November, and virtually 100% of the net TIPS issuance: he has apparently decided to “weigh” moving on from Treasury as soon as the budget deal is done. I’m sure the timing is completely coincidental and has nothing to do with the fact that the next guy is going to have to find a new $600bln buyer to take the Fed’s place (and maybe a bigger buyer, if the Fed ever decides to sell). “Not it!”
To be fair, Initial Claims did decline from 468k in August to 441k in November to 428k last week, and to be even more fair I should point out that monetary policy typically works with a lag. Not, apparently, on inflation expectations, but perhaps we should wait a while before judging the efficacy of turning on the money gusher.
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In other news, Greece voted a second time to affirm the austerity measures, prompting much relief (again). It led to such comments as that by Belgian Finance Minister Didier Reynders, who said today “I expect we will be able to organize the payment of the next tranche of €12 billion.” Hang on, “expect”? Boy, if the EU doesn’t approve the payout after Greece’s politicians did everything asked of them…one hopes that the statement merely didn’t translate well.
Equities rallied, a semi-predictable result of quarter-end monkey business but I was delighted because implied volatilities dropped sharply as well. Out-of-the-money puts on stocks are much cheaper than they were just a few days ago, and I bought some late in the day.
Bonds dropped again, with 10y yields all the way up to 3.16%. Commodity indices declined, but a significant part of that decline was due to the shellacking that grains took today (on crop estimates that were revised sharply higher). Energy quotes were higher.
The Fed announced that it is suspending sales of the AIG and Maiden Lane securities after discovering – wait for it – that their unloading ten billion dollars’ worth of various sorts of bonds was actually pushing the credit market lower. Wow, really? You don’t say? Selling billions and billions will move a market? Who knew? Certainly not the people at the Fed, who declined an all-or-none bid from AIG back in March, and who continue to speak earnestly about how they will dump over a trillion dollars’ worth of Treasuries when it is time to do so, and no one the wiser. Seriously, can someone put a grown-up in charge over there?
The asset markets are, I suspect, about to get sloppy. I’m really not looking forward to the third quarter (except inasmuch as I own puts). This could begin as early as tomorrow, but I suspect it will take a few days. Still, if I’d bought a bunch of stocks for window-dressing on Thursday and faced a three-day weekend with the U.S. debt ceiling still not resolved (although Congress has canceled the holiday break to work on it. Gee, I feel lots better now) and Euro politicians still so busy back-slapping each other that anything might happen. The only major data out tomorrow is from the ISM (Consensus: 52.0 from 53.5), although auto sales will come out as well. It’s a holiday-shortened session in the bond market, and a three-day weekend.
That means I will not be writing a comment tomorrow, although I will be Tweeting if anything interesting happens. You can follow me @inflation_guy. Happy Independence Day, fellow Americans. Happy day-off-from-the-stinking-Americans, rest of the world!
Austerity We Can Believe In?
The Greeks have now spoken, or at least some of them have. This morning, in the cradle of democracy the representatives of the People defied 80% of those people and voted in favor of a more-severe (one might even call it Spartan) austerity. The outcome of the vote was not in much doubt; but it bears noting that this is only half of the deal. Tomorrow, the parliament votes on another key piece of legislation that, among other things, details some of the specific fiscal measures that were passed in principle today. And wouldn’t that be a kick in the pants if it was the second measure that didn’t pass?
However, it is expected to pass as well, and that means we will head into a partial day on Friday and a long weekend (in the U.S.) with all of the good news out and only worries remaining. Worries such as:
…whether the various banks will agree to roll over their maturing debt in sufficient amounts.
…whether there is any chance that Greece will actually implement these reforms.
…whether any person in authority will actually be so impolitic as to point out that possibility.
…whether the Troika will be sufficiently satisfied to release the current tranche.
…whether the Troika will be able to produce a follow-on tranche that is necessary.
…and whether the ratings agencies will swallow all of this baloney.
I am not saying that any of these things are going to be resolved over the weekend, but the fact that there are so many more bad things left to happen now that the good things are out of the way makes me inclined to be short (equities) headed into the weekend. But I am not the only one, and I suspect that will actually mean I won’t get the chance to do so at good prices. With liquidity due to be thin on Friday, I suspect prices will turn tomorrow afternoon if not before.
The extent of the response already has been pretty impressive, considering that no one seems to be particularly in denial about the fact that Greece is, eventually, going to default and/or leave the Euro. It is really just a matter of time, and of seeing what the best way is to contain the damage and prevent other dominos from falling. I haven’t heard anyone suggest seriously that “no, Greece can actually make it through this.” I think that is because if your math is that bad, the only job you are qualified to do is to hold elected office or work for the IMF or ECB.
Now, one of the side effects of the Greek crisis moving (fitfully and impermanently) to the back burner is that the spotlight can now be turned on the U.S. and its debt problems, and the apparent impasse in the debt ceiling talks. Our leaders have been recently “laboring” in relative obscurity, and unfortunately that means that in order to get their column-inches they’ve been drawing lines in the sand. I don’t recall reading in Getting To Yes that the strategy of drawing a line in the sand is conducive to forging a durable agreement, but it has worked for Europe. Well, it ought to be a fine Independence Day holiday weekend.
The illiquid market moves today included the 0.8% further rally in stocks, the 8bp further selloff in the 10y note (3.11% now), and a 4% rebound in gasoline prices. Happy driving!
Speaking of rising prices, that 8bp rise in the 10y yield came entirely from a rise in inflation expectations as the 10y TIPS note was unchanged on the day. In fact, the important metric of 5y, 5y forward inflation has been rising quite rapidly recently as the chart below (Source: Enduring Investments) shows.
5y5y inflation has spiked - but part of it has nothing to do with inflation expectations.
Now, ordinarily that sort of spike in the variable the Fed watches – actually, they watch an awkward one based on TIPS, which is almost always lower since breakevens are below the more-accurate swaps measure – would ordinarily be a grave concern. It isn’t as important in this case, however. There is a well-circulated story about a particular firm that finds itself unwinding a 5y-30y inflation curve flattener – which means they are selling inflation in the 5y area and buying it back in the 30y area.
Pressing down the 5y inflation point serves to increase the 5y, 5y forward if the 10y point is held constant. The 5y, 5y is calculated as:
[(1+CPI10y)10/(1+CPI5y)5]0.2 -1 = CPI5y5y
(Try it. The intuition is that if the amount of money I would have at the end of ten years remains the same, and the amount I earn for five years drops, then I need to reinvest that lower amount at a higher rate to get to that same 10-year pool of money).
Consequently, this rise in the 5y, 5y forward is less important than it might seem at first. Also, as you can see from the chart, as recently as late 2009 the 5y5y was higher, so 3.25% isn’t yet near any kind of danger zone – especially with the economy quite weak.
On Thursday, the economic releases on the docket are Initial Claims (Consensus: 420k vs 429k last) and the Chicago Purchasing Managers’ Report (Consensus: 54.0 from 56.6). But the important data (Employment) is next week anyway…and there is ample uncertainty over the weekend. Look out for increasing illiquidity as the day wears on – remember, it’s quarter end, and followed by a half-day on Friday and a three-day weekend. Risk budgets will be tight, and that might provoke bigger-than-expected moves if something breaks.
Nobody Better Blink
The Greek debate is ending tomorrow, and at 7am the vote will be taken on the new package of austerity measures. The market’s behavior – strong commodities and stocks (+1.3%), 10y Treasury yields back over 3%, and the dollar marginally weaker – suggests that the consensus bet is on “it will pass,” leaving most remaining surprises pretty much one way.
Of course, the vote is just the first step, but a great analysis by my friend (and very seasoned credit markets observer) Peter Tchir suggests that the deal is much better for banks than they are making it sound. His article is worth reading in full, but his summary of the consequences of the plan (note that the “Troika” is slang for the IMF/EU/ECB triumvirate) follows:
Working through the details as best possible shows it strengthens the positions of the banks and weakens the IMF/EU/ECB (“Troika”) and is expensive for Greece. The consequences of the rollover plan are that:
- The Troika has to provide more money up-front without being able to enforce austerity compliance.
- The Troika is more likely to continue to fund Greece longer than it would otherwise because of the additional up-front payment and the moral suasion the banks will use to encourage further use of public funds.
- Greek interest payments will go up, and with the GDP kicker, will be almost 2.5 times what they are currently scheduled to be and are in line with existing Greek long bond yields.
The rending of clothing and wailing and gnashing of teeth that we are reading daily in statements from bankers really had me going, but after reading Peter’s column I’m not sure why I wouldn’t want to do what the banks are being “asked” to do, given the likely alternatives. And, arguably, that might make it a voluntary rollover, or certainly an easier argument can be made that it may be.
By the same token, though, the terms are much worse for Greece than they appear, again if Peter is right. It becomes much less clear why Greece would want to do the deal, unless politicians think it is sufficient to kick the can down the road past the end of their terms. After all, the point of restructuring is to reduce a debt burden to make default unnecessary, not to increase the burden or to keep it the same. I suppose that all of this presupposes that Greece actually will implement the reforms they vote to approve, and that they’ll actually pay the amounts they are scheduled to pay. But who is going to make them do so, if they decide (post-receipt of the money) to renege?
In any case, there are a lot of interested parties here, and that makes it very difficult to pull off the trick. Cartels tend to fracture because there is a big incentive to be the first cheater, and a similar maxim applies here. Nobody better blink, or all of these team players are going to throw each other under the bus to reach the door.
All of this is happening with month-end and quarter-end just a couple of days away, and a long weekend to follow. As one indication, albeit anecdotal, of the thinning activity, hits to my website and commentary are already down by more than half compared to the usual Tuesday amounts. Liquidity over the next couple of days is going to be bad and risk budgets rigid, so there better not be many surprises.
On the economic-data front, Consumer Confidence came in a bit below expectations at 58.5, which is the lowest of the year and with Jobs Hard To Get essentially unchanged (up to 43.8 from 43.5). As I suspected, though, the market didn’t much care about this with the Greek vote only one day away. A 50.0 might have gotten folks excited; a 2-point miss isn’t going to do it.
There is no doubt that the technical condition of the market is vastly better today than it was just a week or two ago. Stocks have bounced multiple times off the 200-day moving average and remained above the year’s lows set in March. The S&P is threatening to break above last week’s high, which would yell ‘double bottom’ to techies and would certainly be an upbeat development. The dollar index never broke appreciably above 76.00, which represented last year’s lows. The 10y note tried to put the screws to Mr. Gross, but is falling back and the 3-month downtrend in yields is surely exhausted.
But all of these markets are in ‘neutral.’ Only bonds have recently been in any kind of significant trend, which makes further rally less likely, but the other markets I mentioned could very easily set significant reversals or extend their most-recent moves. While I don’t think that the Greek vote is going to turn out to be the most important point of this crisis (unless, of course, the austerity package is actually defeated), the combination of neutrally-situated markets and likely thin market conditions means that it could well be an important technical moment we are approaching. I wouldn’t feel comfortable at this moment with a long or short position in any market except for the possible exception of being slightly short bonds further out the U.S. curve…but if a real crisis hits, those bonds will be hard to buy back.
Heads I Lose, Tails I Flip Again
Another week of Greekwatch begins with everyone seemingly convinced that the inevitable is simply too awful to contemplate and therefore will not happen. It is a happy thought, a faithful thought; wouldn’t it be wonderful if disasters never happened because it would be so bad if they did?
And so investors were cheered by the work over the weekend by French banks and the French government, who have developed a plan under which French banks would agree to roll over some part of their Greek debt into longer-dated bonds. This is another necessary condition –among many – for the Greek crisis to be temporarily defused again. The plan, according to reports, would involve banks reinvesting half of the Greek debt they have that is maturing in the next three years (note: these will be the ones with the prices closest to par!) into new 30-year Greek bonds yielding 5.5% plus a ‘kicker’ of up to 2.5% if the Greek economy expands.
Clearly, this is not a ‘voluntary’ conversion in any normal sense of the word. With Greek 30-year rates at 11.35% in the market (according to Bloomberg), a 5.5% coupon should trade at a price around 50.50, implying that a par bond being exchanged would involve an economic loss of about 50%. If the maximum ‘kicker’ is achieved, the 8% coupon would be worth 71.65. Aside from the numbers, just contemplate whether it is reasonable to imagine that a bank would voluntarily exchange 1-year securities, trading at 98.00, for 30-year bonds, issued by an entity the market believes has an 80% chance of defaulting in the next 5 years (judging from CDS), trading at 50.50 or 71.65. If any bank would “voluntarily” take that large a hit to a position, I want to deal with them – as a counterparty, not as a client! There are some other parts of the plan but you can stop reading it at that point.
The French plan has been warmly received as the German banks are also looking at it and carefully considering it while most of us scratch our heads, look at our neighbors, and say, “really?”
Meanwhile, in Greece, the next couple of days will be filled with debate in parliament while riots rumble outside. The debate will culminate in a vote on whether to accept the new austerity measures that Prime Minister Papandreou agreed to after his recent jeopardy in the government confidence vote. Remember how keyed up the market was about that dramatic confidence vote? Well, it turns out that a loss would have been devastating, while the win turns into just another opportunity for a loss. That’s a serial game that I wouldn’t want to play since the outcome seems fairly obvious (“heads I lose, tails I flip again”) but Papandreou seems to enjoy. Anyway, after three days or so the parliament will vote on the new austerity measures. The Papandreou government enjoys a five-seat majority with four of those legislators already declared opposed to the plan. It ought to be an interesting week.
So there are multiple chances to lose. Papandreou can lose his vote, which would probably clarify things rather quickly. No one seems to think this is possible because it is just unthinkable. Or the measure could pass, and the EU could falter because it can’t agree to the rollover plan. Everyone regards this as absurd: how could the EU fail to meet such an easy test once Greece has done her part? Or, the EU rollover plan could be agreed on, and the rating agencies could reasonably state that Greece is in default anyway, triggering CDS and forcing the ECB’s hand on their prior position to refuse to take defaulted securities as collateral. “Surely,” the thought process seems to go, “the rating agencies wouldn’t destroy the concept of a united Europe simply because their rule says that ‘voluntary’ means this-and-so? Surely they will make an exception?”
All of these steps may be plausible, but collectively sums to a long shot in my mind. And so I look askance at the level of equities and of implied volatilities (especially!). And I wait for the first time “heads” comes up.
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One of the topics that has been drawing a lot of attention has been the question of whether a Greek default would be a good idea for Greece, or not. We all think we know that it is bad for Europe, and certainly for the other PIIGS, but there seems to be a concerted effort to persuade the consensus to come around to “a Greek default is bad for Greece, too!” This is akin to the campaign to persuade deeply-under-water mortgagees to eschew “strategic default,” even though for many of them there aren’t any alternatives to default, whether today or in the future. And so it is with Greece.
The Economist had an article recently (“If Greece goes…”, June 23, 2011) in which this argument was made:
“While the EU’s leaders are trying to deny the need for default, a rising chorus is taking the opposite line. Greece should embrace default, walk away from its debts, abandon the euro and bring back the drachma (in a similar way to Britain leaving the gold standard in 1931 or Argentina dumping its currency board in 2001).
“That option would be ruinous, both for Greece and for the EU. Even if capital controls were brought in, some Greek banks would go bust. The new drachma would plummet, making Greece’s debt burden even more onerous. Inflation would take off as import prices shot up and Greece had to print money to finance its deficit. The benefit from a weaker currency would be small: Greece’s exports make up a small slice of GDP. The country would still need external finance, but who would lend to it?”
But the argument is flawed. If Greece defaults, how would the plunge of the drachma make its debt burden more onerous? There wouldn’t be a debt burden! The budget would be in balance, or at least dramatically closer to it without the overwhelming interest costs, and so it isn’t clear why the country would need external finance. Anyway, they wouldn’t need much. There would undoubtedly be some inflation, perhaps even a lot, but there is an upside to that in the case of Greece. One of the nation’s big problems is that many Greeks refuse to pay their share of taxes, so taxes need to be raised much more dramatically on those who actually pay.[1] But inflation – also known as the ‘stealth tax,’ means that all Greeks would bear the burden without any need to file a tax form. Arguably, this single fact makes a departure from the Euro and an outright default not only a bearable outcome but perhaps even a fair outcome. At least, from the perspective of Greece.
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With that drama unfolding slowly overseas, and a vacation weekend coming up, tomorrow’s release of Consumer Confidence for June (Consensus: 61.0 vs 60.8) is not likely to be as big a market-mover as it can occasionally be. But the consensus seems very rosy to me. I think it is based on the recent decline in gasoline prices, which some economists think has an important effect on consumer confidence. It does, but the labor market situation and equity prices also have an impact (and probably home prices, although that is harder to track). A very simple regression I ran with those three variables since 1983 suggests that the ‘historical’ relationships argue that Confidence probably ought to fall by around 5 points. That’s not an economist’s forecast but a trader’s forecast: that is, I am trying to look at the risks for the number, and to me the risk appears to be that we see a lower number than the consensus estimate.
[1] One might make a reasonable observation that a similar situation exists in this country, although it isn’t because taxpayers evade taxes but because the tax code requires only the top quarter of Americans to pay very much tax at all. Therefore, raising taxes “on the rich” simply cannot balance the budget without huge increases and the concomitant dramatic effect on the economy.
‘Boing’ Or ‘Splat’?
Well, from an investment perspective it really all comes down to this. With the stock market dropping, oil plunging, and the economy softening, are we going to get a ‘boing’ sound when the ball bounces off the pavement, or are we going to hear ‘splat’ as the ball hits the pavement and breaks open?
The current signs are not promising.
Initial Claims was the first disappointment of the day, rising to 429k with an upward revision to 420k. The expectations were for 415k, so with revisions the miss was about 20k. That’s fairly large for this time of year, and while the fact that the chart of Claims looks suddenly less promising (see Chart) is mostly an illusion – as one wag observed, ‘where did the slow downtrend go?’ – many economists are influenced by just such pictures and will begin to change their assumptions about the trajectory of the economy from ‘boing’ to ‘splat.’
Initial Claims - doing nothing good.
Other things are splatting as well. Oil prices, for one; the International Energy Agency (IEA) announced today a determination to release 60 million barrels from its stockpile and the U.S. said it would also flush some 30 million barrels from the Strategic Petroleum Reserve. This happens as oil was already trading closer to the lows of the year than to the highs, well under $100/bbl. The IEA has only released oil two other times: during the first Gulf War in 1991 and following the destruction of Gulf of Mexico oil rigs by Katrina in 2005. The current release is supposedly triggered by the lack of Libyan oil, but since market prices weren’t suggesting any scarcity from that reason the reason rings hollow. Interestingly, after the IEA announcement oil futures only fell another $1-2 so it seems pretty plain that some players already had the information. NYMEX Crude ended the day -3.9% at $91.85, off the day’s low.
Nevertheless, the drop in energy quotes along with the drop in precious metals occasioned by the dollar’s strength today caused major commodity indices to gap through important support points. The chart below, of the DJ-UBS commodity index, is one example. Chartists will have a field day with that picture, and it’s not pleasing to those of us (myself included) who are overweight commodity indices in preference to stocks. It is looking very ‘splatty’, although I continue to believe that the long-tail potential gains if central banks start to monetize again are worth the risk of setbacks based on nominal supply/nominal demand analysis. In an inflationary environment, it won’t matter whether stockpiles of oil are being sold; the commodity will exchange for a higher number of more-plentiful dollars.
Technically speaking, commodity index charts look ugly.
There was one bouncy market today, although until 3:00ET stocks didn’t look bouncy at all as the S&P was flirting with last week’s lows (and the lows for the year not far beyond that). At that hour, however, a pair of Bloomberg headlines suggested that there may be a deal between Greece and the IMF and Europe on an austerity deal. Now, you may recall that the Greek Prime Minister just survived a confidence vote based on the old austerity plan; external parties then decided that the plan in question wasn’t quite austere enough. But since all of the parties who voted their confidence earlier this week were not party to the ‘new deal,’ it isn’t clear why that’s particularly good news. Indeed, one would expect the folks who just voted their support for the PM based on one deal would be pretty miffed and if anything perhaps less likely to vote for a new deal. But the news was enough to scare gutless shorts to cover. Really, the only stock I want to own right now is one for a company that makes underwear, because it seems investors are soiling themselves exceptionally easily these days.
I will say that having commodities go down and equities tread water strikes me as an unlikely combination in time frame other than the short term. If Greece is saved then the dollar will not likely continue to rally, and equities have the added handicap of being expensively valued.
And speaking of the dollar, while it rallied today I wonder how long that is likely to last if the talks about raising the U.S. debt ceiling stay stalled for very long. Today, a couple of Republicans abandoned the “Biden talks” about debt reduction (if you want to inspire bipartisan sacrifice, calling them the “Biden talks” is probably not a good start) and supposedly President Obama is going to add his leadership to help “break the impasse.” Oh, great. See what I mean about the demand for underwear?
The TIPS auction went very well today, clearing at 1.744% with a 3.02 bid:cover ratio and 26% going to direct bidders. What that means is that there is a great demand for long-dated inflation protection, which given the yields we’re talking about is pretty discouraging about the perception of the long-term growth outlook (since real yields and real growth are closely related).
The real interest rate curve crashed flatter, with 2-year real yields up about 7bps and 30-year real yields down 12bps to 1.70% by the end of the day. A 19bp flattening from 2s to 30s is a pretty impressive move. Since the nominal yield curve rallied mostly in parallel today, the implication is that 2-year inflation dropped about 10bps and 30-year inflation rose about 8bps. This suggests that market views are evolving to expect a sharper escalation of inflation coming a bit further in the future, and reaching a higher level. The chart below (Source: Enduring Investments) illustrates the spot inflation swap curve and the curve of 1-year forward inflation rates (without convexity adjustment) it implies. You can see that the market is now pricing in a period of time with inflation significantly above 3%. The 5y, 5y forward, in fact, is at 3.12%, higher than it has been in several months.
Inflation curves derived from US CPI swap rates.
It is hard to imagine that the fact the most powerful central banker in the world admitted he’s “clueless” in the words of one blogger had nothing to do with the marking-down of long-term growth prospects, as reflected in long-term real yields.
So, overall, decidedly splatty. Which means, sadly, that the race may not be to the bold but to those with the best underwear.
What Were You Expecting?
The Federal Reserve today did almost exactly what its members have been telegraphing they would do for a long time: nothing. As QE2 winds down as planned, some observers were assuming that QE3 would be right on its heels. But over and over during the past few months, Fed officials have shown much more concern about the exit, and about the potential for future inflation, than they have shown about the tepid pace of growth. This is appropriate, since monetary policy has very little effect on growth (although there are plenty of people, including people at the Fed, who believe that it does despite the experiment just completed) and mainly works to raise the price level.
In August, the Fed had every reason to pursue quantitative easing. The two elements of the Fed’s mandate – sustainable growth and stable prices – usually suggest opposite policies; late last year, however, with core inflation too low and growth also weak, both mandates argued for more stimulus. Even if the Fed only cared about averting the risk of deflation, it would have been defensible to institute the LSAP (large-scale asset purchase program). However, this is no longer true. The variable that the Fed can affect most directly, the price level or rate of inflation, is rising and core inflation is near the level the Fed considers neutral and the lags inherent in monetary stimulus imply that policy will still be pushing prices higher for some time. Growth is weak, but $600bln didn’t change that and there is no reason to think that another $600bln would – but even if there was a reason to think so, the tradeoff is now more difficult.
Perhaps surprisingly, the Committee seems to realize that and the Chairman said as much in his post-meeting coffee talk.
This surprised a lot of observers, evidently, as did his suggestion that the failure of Greece would bring instability and threaten the European system. You don’t say? You know, I don’t think he should be speaking so bluntly about it either, but I have consistently said the Fed could better pursue its function if it kept its mouth shut. Some of the people who seem surprised are the folks who wanted the Chairman to hold these conferences in the first place. Look, if you hand the microphone to Andrew Dice Clay you shouldn’t be shocked at what comes out. Extemporaneous speaking is a great medium for comedy, but an awful one for policy-making. We are very lucky that he said nothing sillier than that the “securities purchases were successful” in fighting deflation, which is a hard argument to make seriously when core inflation – ex-housing – bottomed in late 2003 (see Chart).
I ran this last week, but this time focus on the bottoming in core ex-housing...in 2003. That was well before QEx.
Neither bonds nor equities cared much for the not-as-dovish (it is hard to call it ‘hawkish’ when there is no hint of a tightening in the future) meeting result. Bonds ended up roughly flat at 3% on the 10y note (10y TIPS up to 0.77% real) but stocks fell 0.7%.
Modest pressure on TIPS came from two fronts today. The first was from a very poorly-reported article entitled “Change To Inflation Measurement On Table As Part Of Budget Talks – Aides.” The article noted said that “Lawmakers are considering changing how the Consumer Price Index is calculated, a move that could save perhaps $220 billion and represent significant progress in the ongoing federal debt ceiling and deficit reduction talks.”
For those who aren’t aware of it, Congress doesn’t calculate the CPI. Moreover, Congress has really nothing to say about how the CPI is calculated; the Bureau of Labor Statistics is part of the Administrative branch. The best that Congress could do is threaten to de-fund the entire BLS if it didn’t calculate CPI the way that Congress wanted. But this isn’t a Constitutional crisis. It is bad reporting. What Congress is considering is whether to use a different CPI index, incorporating chain-weighting methods that would tend to reduce the tendency of the CPI to overestimate inflation in one very technical way. The BLS already calculates such an index, called the Chained CPI-U, and it is readily available on the BLS website.
Congress also does not set the terms of the bonds that are issued by the U.S. government. Those terms are set by the Treasury, which is a department of the Administrative branch, and moreover they are governed by a bond indenture. While I can imagine a circumstance where the Treasury would simply change the rules on which TIPS would pay out, changing to follow a different index in violation of the bond indenture would probably constitute a default. They’re not going to do that to save a few tenths of a percent on 7% of their outstanding debt.
So here is what this change, if it happens, will not do: it will not affect how TIPS are paid. It will not affect monetary policy (since the Fed focuses on the PCE deflator anyway). It will not affect the inflation swaps market, which will continue to track the same index that TIPS do until there is more creativity on Wall Street.
What it will do is to transfer wealth from young Americans to old Americans. It would seem that the effect would go the other way, wouldn’t it, since it will affect the future benefits of the retired? True, but it will affect the future benefits of the non-retired by much, much more. (You didn’t really need to know that; you could simply have observed that older people vote more than younger people and you would know which way the money is likely to flow).
So whatever distress was caused among holders of TIPS today by this report can be blamed on bad reporting. Move along, there’s nothing to see here.
TIPS also experienced a little bit of pressure from the fact that there is a TIPS bond auction tomorrow. The Treasury will sell $7bln more of the current TIPS long bond, bringing to $16bln the total outstanding in that issue. Selling $7bln of the Feb 41s at a real yield of 1.84%, when the Fed is done buying, will be challenging. Ordinarily, long TIPS auctions go reasonably well or at least clean upreasonably well because inflation is a long-wave problem. If you need inflation protection, you most likely don’t need it for 5 years but for 10, 20, or 30 years (and for years, I have been arguing that some company should issue an inflation-linked perpetual bond or the government an inflation-linked ‘consul’). At 1.84%, or a little higher, the auction will probably be a little sloppy but passable because while these yields are low by 30-year TIPS standards (see Chart, source Bloomberg), that real yield compares reasonably favorably with other investments available right now. For example, stocks are priced to deliver a real yield around 2.1% over the next ten years.
Real yields of 30y TIPS are very low by historical standards.
Also tomorrow, although less-exciting for my tastes, we’ll get Initial Claims (Consensus: 415k vs 414k last), the Chicago Fed National Activity Index (Consensus: -0.05 vs -0.45), and New Home Sales (Consensus: 310k vs 323k). Expect equities’ performance to remain muted and for bonds to also struggle to do much positive until the market has come to grips with the –unsurprising – end to QE2.
Greece Is Not Lehman
Stock market bulls bellowed today as bourses around the globe rocketed higher. Several major European markets were up more than 2%, and the S&P vaulted 1.3% higher on the day. Unusually, bonds did not sell off with comparable ferocity, nor did commodities shoot drastically higher – indeed, gasoline fell more than 1% on the day.
The cause of this moon shot was the fact that Greece was preparing for a vote of confidence/no confidence on the government of Prime Minister Papandreou. Observers believed that the pro-Papandreou forces would win a narrow but important victory, because it would signal acquiescence to the Prime Minister’s proposed budget cuts, which are needed to qualify for the next draught of that crucial elixir of life: credit.
The outcome of the vote should not ever have been in much doubt. After all, the vote concerns the question of who will get the blame for the austerity measures. All legislators can naturally agree that the answer should be “someone other than me,” and Papandreou qualifies. Adding more cynicism to that observation, let me point out that getting someone to take money is rarely the problem in a negotiation. The main problems are usually (1) persuading someone to give the money, and (2) getting the recipient to pay it back. It seems to me that even though Greece has agreed to take the money if it is offered, the hard parts are still ahead of us.
Still, as I pointed out yesterday the equity markets since late last week have clearly been looking for reasons to rally. Delaying the inevitable on Greece seems to be a decent excuse to do so.
How far could such a bounce extend? It should not go very far, since the stock market was not down over the last two months because of fear about Greece but rather because softer economic data collided with a market priced at 22x cyclically-adjusted earnings. The high valuation and soft data have not changed; as a reminder of that, we learned today that Existing Home Sales slumped to 4.81mm units in May and the inventory of unsold homes remains above 3.7mm units.
Now, assessing what bounce is “reasonable” doesn’t always work. Bulls are adept at selecting scapegoats and attributing all of the bad things that are happening at the moment to the single scapegoat. In 2000 it was the “NASDAQ Bubble” even though the S&P was also extremely overvalued. In 2002 it was “governance” after Enron and Worldcom collapsed. It was LTCM. It was program trading. In each case the scapegoat was advanced, dealt with, and then bulls (led by the cheery fools on financial TV) declared that the reason to be bearish was over and the market could rally again.
Can “Greece” be the scapegoat for this market? I don’t think so, if only because scapegoats are most successful at the bottoms of markets and not at the ends of brief corrections of long uptrends. Maybe “European sovereigns” could be the scapegoat, and that’s closer to the truth anyway – but the fact that the problem is far from solved means that it makes a poor scapegoat. So I don’t think the current exuberance is going to last very long unless there comes other good news. The related markets are echoing my skepticism. Treasury yields rose only 2bps, which isn’t much of an unwind of any ‘flight to quality’ bid!
And Greece, vote or no vote, remains a problem – perhaps deferred a couple of months at best if they get the current tranche due from the EU. How a big a problem it is remains a matter of debate.
Because it is recent, the Lehman collapse is often cited as a model for how bad a default by Greece could be. It is a bad comparison. In most ways, a Greek failure would be worse although in one or two ways it compares favorably.
First, let’s think about the ways that Greece is a bigger problem than Lehman. While Lehman had enormous amounts of derivatives outstanding, most of the money lost in the collapse had nothing to do with the derivatives. That is because the derivative positions were mostly hedged – for every long Lehman had, there was an offsetting short also in the book. The two counterparties each did not know who the other was, but it was pretty certain that if Lehman was receiving fixed on $200bln in 10-year swaps in aggregate, they must have been paying fixed on roughly the same amount. Dealers did lose money in search costs, trying to find the other side, and in panicky hedging maneuvers that were ineffective, but the aggregate loss on market positions was small – perhaps a couple of billion (remember also that derivatives positions are subject to a mutual exchange of collateral. The ‘gap risk’ from suddenly losing a hedge turned out to be far more damaging than the credit exposure).
However, Lehman also had in the neighborhood of $100bln in bonds outstanding. That is the only major position that was essentially unhedged – as an issuer, Lehman was “short” its bonds to the world, and they weren’t long anything against that. Most of the money lost on Lehman was lost by equity investors and by lenders who owned Lehman bonds, and that wasn’t generally the other banks/dealers.
Greece, by contrast, has over €340bln, or nearly $500bln, in outstanding bonds. Now, Greece is also not as leveraged as Lehman was, so while Lehman bondholders recovered around 16%[1] of the notional amount of the debts, meaning that they lost some $84bln-ish, a 40% recovery assumption on Greece would imply that the losses by bondholders would be around $300bln, about three-and-a-half times worse than Lehman’s collapse. My point here isn’t to make precise calculations but to illustrate the size of the problem.
On the other hand, whether a Greek default would lead to a seizing up of the credit markets is less certain even though the amounts involved are much larger. What caused the credit markets to seize after Lehman was not the size of the event, which wasn’t actually all that large when you consider banks’ exposures, but the fact that no one knew who was holding the bag. Should I lend unsecured money to Citigroup, or Goldman, or Morgan Stanley, if I don’t know what their derivatives exposure to Lehman was? It is best to husband one’s resources until we know who the zombie banks are. But with Greece, the exposures are conveyed through ownership of the sovereign bonds, and so it is easier to know where the bodies are buried. If Greece defaults, the regulators will have a very good idea of which banks are in the most trouble. Very quickly, the capital will flow around the dead banks and to the living banks and it will be fairly easy to tell which institutions are in those two sets because regulators will want to cordon off the bad banks. In fact, with the current uncertainty gone, it might actually improve capital market functioning.
Oh, but here’s another way that Greece is different from Lehman. The Federal Reserve did not have meaningful direct exposure to Lehman, while the ECB owns a large slug of Greek bonds that it has bought in misguided price-keeping operations over the last year.[2] I have no idea how the system will function if the ECB is effectively insolvent. I assume that the central bank would take the route out of the problem that only a central bank can, and print itself back to solvency, but the people in charge of the ECB are somewhat crazy – after all, let’s remember that they are tightening policy at the moment, into a sovereign crisis.
One final way that Greece is unlike Lehman is that default doesn’t end the game for Greece. Once Lehman shuttered, there wasn’t much else to do besides prepare for the lawsuits and help counterparties find each other. The entity was finished, kaput. But if Greece defaults, it opens up a whole can of worms with respect to membership in the EU and the Euro. Both entities threatened contagion: Lehman to other banks and Greece to other PIIGS. But Greece creates a constitutional crisis in the Eurozone as well. There is no mechanism to explain how a country exits the EZ, how the egg ‘unscrambles’ as the analogy goes. It is sure to be messy. And in that sense, a Greek default will be just the beginning.
It is a beginning that European politicos don’t want to have to deal with any sooner than they have to, but the day is rapidly approaching when there won’t be a choice.
In the middle of this maelstrom, the Federal Reserve is meeting tomorrow and will make an announcement in the afternoon that will presumably not stray far from the expected text. The FOMC will note weakening data, which it will categorize as “likely temporary,” and will somehow acknowledge that QE2 officially ends this month. They are not likely to make important changes to the wording, or to their approach, at this meeting, because the Committee will want to see how the end of quantitative easing affects markets before taking another step. After the statement, Bernanke steps into the klieg lights for his close-up, with equal probabilities of him saying something really dumb or nothing useful at all.
‘Change’ Is the Status Quo
Going into the weekend, markets were recovering somewhat on optimism as German Chancellor Merkel had signaled in a meeting with French President Sarkozy a “compromise” on the role of bondholders in the rescue of Greece. However, the ECB had not indicated any compromise, so unless Merkel was prepared to cave in and hand over German taxpayer money – which would probably mean the end of her tenure – it wasn’t exactly the same as a resolution. The ‘rollover’ strategy she was said to favor was what the ECB specifically had said they would not participate in and the ratings agencies had already said would constitute a default, so it didn’t really seem like a resolution except to true optimists.
From a trading perspective, the market reaction on Friday indicated that investors are looking for good news or anything they can characterize that way. A fear of being short or not long enough was starting to outweigh a fear of being too long and exposed to risk assets.
Over the weekend, the “deal” came unraveled a little bit when the Euro-area finance ministers (including those from the other pesky countries that have to unanimously approve any further disbursement) failed to decide in favor of releasing the July tranche (some $17bln) to Greece.
And yet, the positive vibes continued on Monday. This is worrisome, because it seems that investors almost want to be surprised by what is the increasingly-likely outcome of a Greek default (although not necessarily in July!). By trying to catch the zig-zags, I fear that investors are setting themselves up to be bag-holders once the exit door grows small once again.
Example: “Looking at the consequences of not funding Greece, they will do it”…said someone who helps manage $15bln or so at a big money management firm, according to a Bloomberg story. This is a naïve view, and represents what has passed for analysis for a long time. You were safe investing in Citi during the crisis, because “surely they won’t let Citi fail.” They’ll save Greece because the consequences of not saving Greece are too terrible to contemplate…or so the reasoning goes.
But that’s the wrong question. Surely if saving Greece was costless, everyone would agree to do it. There are costs, though, and so the better question is “are the costs of saving Greece worth it, not to the wealthy managers of $15bln but to the people who actually have to bear those costs, the taxpayers and shareholders of banks and citizens of wealthy countries?” This is where the process is breaking down a little bit, because some groups are starting to question whether saving the grasshoppers is really in the ant’s best-interest. Of course, the ultimate question is, “is it possible to save Greece?” As much as we would love to save everyone who ever had any financial difficulty, it simply isn’t possible. Long-time readers know that I am loathe to discount the survival meme among institutions and political systems, but these are the more-interesting questions right now.
John Mauldin’s newsletter last week raised the question “Could the Eurozone Break Up?” Again, it’s the wrong question and reflects a status quo bias. A fairer question is whether the Eurozone can possibly stay together!
By the way, I want to raise a logical inconsistency in the whole Greek deal that began to bother me on Friday. The discussants in the “bailout” talks are intent on making sure that any resolution that involves extending or rolling the Greek debt will not “count” as a restructuring or default event. This is now completely necessary since the ECB has drawn a line in the sand with respect to defaulted securities. That line can be erased, if the ECB is willing to lose face; and if the EU is willing to change the rules again so that all sovereign bonds even if in default can be carried at par that can be done as well. Sure, that would make a mockery of bank capitalizations but it isn’t without precedent (except at this scale).
But let’s suppose all of those hurdles are crossed. The question is, why would a creditor to Greece agree to take an economic loss in a way (via a ‘voluntary roll’) that prevented his hedge from being triggered? After all, while it is popular to think of credit default swaps as being evil tools of speculators and bear-raiders, in reality they are very useful hedging tools that are widely used by legitimate investors. Causing a non-default default would punish those investors who held onto their Greek positions, but hedged them. For those investors, the worst possible case is that Greece effectively defaults – that is, they experience a big economic loss through a restructuring or ‘voluntary roll’ – but the value of the hedge goes to zero. Why would those investors, which will include some banks, pensions, and investment managers, ever agree to a roll? Such a resolution is not “better than the alternative,” but actually worse than a default which is actually called a default.
It isn’t clear to me that the desires – and the votes – of this constituency have been considered. How can any ‘roll’ be considered voluntary if some class of investors is screaming about the injustice of the outcome?
In my view, the most-likely case continues to be that this all ends up with monetization by the central banks. I don’t see any reasonable outcome from the Greek (and to a lesser extent, the Irish and Portuguese) situations that keeps these countries from defaulting. And I don’t see any way for Greece to default – whether or not it is called a default – that doesn’t result in massive trauma to the international banking system – whether or not the bonds are carried at par or not. And I don’t see any way that massive trauma to the banking system can result in anything other than another credit crunch and an eventual monetary response. While calling a triple-combination is no less challenging in economic forecasting than in billiards, this seems inexorable to me and only the timing in question.
Interestingly, the inflation markets are also acting optimistic on the general pricing environment. While both real and nominal interest rates continue to drift to ever-lower levels (generally, although not today), the implied core inflation has remained surprisingly static as well as high compared to the current level of core. The chart below is an updated version of a chart I have run before. It illustrates that the sharp decline in 1-year inflation swap quotes is mostly explained by the drop in forward energy prices. The red line is the 1y inflation swap; the other line is the residual after subtracting out the movement implied by energy futures.
Plummeting inflation swaps quotes does not imply a change in the view on core inflation
If investors were seeing a disinflationary impulse in our future, surely this would show up someplace other than in energy prices only.
Still, inflation swaps are getting more attractive because as energy prices drop it creates another way to make money on a long position in swaps or breakevens. At $120 oil, you could be long core inflation but were very exposed to a growth-related drop in energy quotes. At $93.50, this is a smaller risk.
The Arrow Of Fate Is Aloft
Thursday’s markets weren’t as thrilling, enthralling, or scary as Wednesday’s action, but make no mistake: history is moving forward. There are some bad parts of that history in our future, so that’s not necessarily encouraging…
Initial Claims fell to 414k, with a small upward revision to last week causing it to be viewed as just about on-target but with a better-looking trajectory. There was not a lot of question that the initial spike to 480k or so would be retraced; the real question is how much of the gap wider was Japan-tsunami-related and how much was not. Not all of the weakening manufacturing surveys occurred in areas where there is a lot of auto or auto parts manufacturing. Will claims improve to 375k or only 414k? What is the new underlying rate? Those are the questions we have yet to answer. It does appear that the new underlying rate is higher than the 490k or so that prevailed before March, but we don’t know if the impulse is dying out yet or not.
Housing Starts also improved, to 560k with an upward revision to the prior month. This is good news, maybe, but it’s probably fairer to call it irrelevant news…560k is right in the middle of the range that has prevailed since 2009, and considerably off the 2mm+ pace of early 2006.
The Philly Fed index (see Chart) was pretty bad. It printed -7.7 versus expectations for +7.0. The level is the worst reading since 2009. It’s a relative index, which means that technically business conditions in the Philly area actually deteriorated in May. They didn’t merely decelerate, as would be the case if the index fell from say +30 to +10, but actually got worse on the month. The Number of Employees subindex went from +22.1 to a veritable standstill at +4.1; New Orders went from +5.4 to -7.6. It’s looking like a hot summer in Philly.
Philly Fed is not encouraging.
The bond market was extending its rally, but stocks were bouncing when a story came out saying that “the Basel Committee on Banking Supervision is considering proposed capital surcharges of as much as 3.5 percentage points that the largest banks may face if they grow any bigger.” Equity investors don’t like it when policymakers lean on their companies, and stocks turned south at that point.
The idea is not particularly unique – after all, Major League Baseball has been applying a similar sort of ‘luxury tax’ idea on the Yankees and other big “firms” for a while now. Indeed, I made a similar point in November 2009 in an article called “Sauropods With Thermal Underwear” and also in one called ‘Too Big To Fail’ And The One-Way Arrow Of Antitrust’ (this latter is only available at the moment to registered customers of Enduring Investments). It is a reasonable concept – charge banks for the “Too Big To Fail” insurance. Small banks shouldn’t have to pay for that insurance, because they’re allowed to fail. This makes sense to me.
Stocks recovered late in the day, with the S&P bouncing off the 200-day moving average (at 1257.90, in case you’re watching it too), but the outlook remains poor. Bonds managed to rally a little bit as well. To call the situation delicate is perhaps an understatement.
There is no data of note that is due on Friday, but there will be an increased preoccupation with examining the headlines on Greece to divine whether something important will happen over the week. This afternoon Alan Greenspan said to Charlie Rose that a Greek default is “almost certain,” and joined Bob Shiller as noted economists who have recently raised the specter of a return to recession. If even Greenspan has figured out that a Greek default is just a matter of time, how long can it be before it becomes actuality?
The Bloom Is Off All Roses
It is always so gratifying when the most-exciting day of the month is CPI day. It makes me feel like I picked the right niche.
On the other hand, when the reason for that excitement is only somewhat related to CPI, and when that day produces a sharp rally and higher inflation right after I had suggested it may be time to short TIPS, it does tend to take some of the bloom off the rose.
But then, the bloom appears to be off roses everywhere. Wednesday’s data will conjure up many headlines and articles containing the word “stagflation,” many of them written by twenty-somethings who have never seen odd-even rationing (I have nothing against the young. I hope to be one again someday).
The inflation data were surprising, but that wasn’t the only surprise. The Empire Manufacturing index was not a surprise but rather a shock, printing -7.79 when +12.00 was expected. While the Empire is a volatile index, that’s a rather big miss.
The morose growth message was compounded by the significant weakness in the NAHB Housing Market Index, which is not normally a market-mover but which dropped to 13 from 16 (expected to be unchanged), matching last year’s low print.
The main data event was CPI, though, and it surprised on the high side. Both headline and core came in 0.1% higher-than-expected, but the +0.287% rise in core inflation is the real story. The year-on-year rise in core is up to 1.51%, approaching the full-year projections of many economists half a year early.
This rise is starting to be flattered (and flattened) once again by the slower rise in Housing inflation. Core ex-housing (see Chart) is up to +1.83% from 1.08% back in December. While it had been up to almost 3% in late 2009, the upward direction has been re-established fairly clearly.
Core ex-housing turning higher again.
It’s important to realize why it makes sense to look at ex-housing core inflation. In most cases, taking ex-this and ex-that is dangerous because you risk removing important information from the data. If you’re removing something that is rising slowly, you’re after all biasing the number higher. If you’re concerned about outliers, you can merely turn to Median CPI (+1.5% y/y in May), 16% Trimmed-Mean CPI (+1.9% y/y in May) or some other measures of inflation’s central tendency and leave everything in.
However, Housing is different because Housing is coming off an asset-price bubble, and as a result prices are going to be less-sensitive to monetary policy simply because the bubble is deflating (although a fair case can be made that prices are back roughly to fair, in which case ex-housing is less compelling). A policymaker doesn’t want to focus on parts of the economy that are temporarily insensitive to policy, in order to calibrate policy. If core inflation is rising at 2%, while core ex-housing is rising at 5%, and the central bank obsesses on the former, then it is committing a policy error (even though 2% in that case would be a fairer measure of the price changes consumers are actually experiencing).
There are other things to consider that inform the question of whether this month’s 0.3% is a one-off or whether it augurs a further acceleration in inflation. Breaking down the CPI into the eight major groups is an instructive exercise. In May, the only group that did not see inflation accelerate on a year-on-year basis was “Other Goods and Services,” which is a mere 3.5% of the overall basket. The chart below shows the change in the y/y readings.
| Weights | y/y change | prev y/y change | |
| All items |
100.0% |
3.569% |
3.164% |
| Food and beverages |
14.8% |
3.363% |
3.057% |
| Housing |
41.5% |
1.159% |
0.975% |
| Apparel |
3.6% |
1.045% |
0.068% |
| Transportation |
17.3% |
13.098% |
11.791% |
| Medical care |
6.6% |
2.995% |
2.866% |
| Recreation |
6.3% |
-0.022% |
-0.363% |
| Education and communication |
6.4% |
1.029% |
1.004% |
| Other goods and services |
3.5% |
1.517% |
1.931% |
One year ago Housing, Apparel, and Recreation were all contracting; only Recreation is still doing so and only just. The smaller groups are more volatile, and less “sticky” in general, but when they are all going the same way it has potential significance in the same way that the sudden co-movement of all the different commodity markets last September carried significance. It increases the possibility that there is a common tide – inflation – that is lifting all boats. It doesn’t guarantee that is the case, but it increases the odds.
So with the signs of price inflation, one would expect the bond market to sell off (and, with weaker growth as well, you would expect stocks to do poorly). But the reality was quite contrariwise. Bonds shot higher, because of another little detail that was unrelated to the data today.
The bailout package for Greece (I should say the ‘next’ bailout package) appears increasingly unlikely to happen. This shouldn’t be a big surprise since all of the participants have previously staked out positions that are not easily compromised (especially since those positions were made very public). The BBC took it a step further, reporting that Commissioners “fear future of eurozone.”
On the plus side, the first step to recovery is admitting that you have a problem.
So Greek 10y yields reached 17.44% today, a new high, and the Euro (bless its poor misbegotten heart) was hammered as if the market wanted to break it into its constituent pieces through brute force. The kneejerk response is to buy U.S. bonds for the flight-to-quality, sell commodities because a stronger dollar tends to weaken demand for commodities denominated in dollars, and sell stocks. I can’t say I disagree with any part of this formulation in the short run, although it bears noting that any effect of FX movements on consumer inflation is relatively small and operates at a long – multiple years – lag.
On the day the S&P fell -1.8%, the yield of the 10y Treasury dropped 13bps to 2.97%, and the 10y TIPS yield fell 8bps to 0.69% (real yield). NYMEX Crude dropped 4% to 95.32, grains were -2%, softs were -2.2%, and industrial metals -1.2%.
.
Lost in the chaos of the day was the headline overnight that Fed officials are “said to discuss” adopting an inflation target. This is not exactly man-bites-dog since the Fed has been discussing it for at least a couple of years. The real question is not whether they do inflation targeting at some point – they will – but whether they do inflation rate targeting or price level targeting. Kahn wrote an important paper on the subject a couple of years ago, and if you’re curious about the topic I discussed it here. To summarize, price-level targeting makes much more sense than pursuing a short-term inflation rate target but regardless of what they do it will take a long time for them to figure out what approach to take even if they’re sure they want to do it. The lay person thinks it sounds very easy to institute an inflation target, but in fact it is a complex multi-faceted decision which requires a lot of discussion. From a market standpoint, we haven’t heard enough speeches yet about the different types of inflation targeting for me to think it’s very close. Before the Fed announces any such thing, we will all know it is coming.
I don’t think that having an inflation target is a good idea. The Fed already has
an implicit one, so an explicit one just means that if they miss the target they lose explicit credibility (see “Bank of England”). But anyone waiting around for Bernanke to make a clever move had better be talking about chess because he has manos de piedras when it comes to making good long-term policy decisions.
Is this week over yet? Not yet. On Thursday we’ll be treated to Initial Claims (Consensus: 420k vs 427k last), Housing Starts (Consensus: 545k vs 523k last) and the Philly Fed index (Consensus: 7.0 vs 3.9 last). After today’s data, some economists might want to tweak those figures, but “no backsies.”
Stocks are in a bad place, and for Treasuries the view appears glorious. It is much easier for the former situation to persist than for the latter. Commodities took another bruising today but it was mostly in the energy group; the commodity indices still haven’t done enough damage to the technical picture to be sure of another leg down. Similarly, the dollar is gravitating toward the 76 level on the dollar index again, but there is a bit of wood to chop before it breaks free into a bull move.
