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Deal, Or No Deal?
Investors on Friday felt a bit betrayed, while the man on the street said “See? I told you so!” as the Bureau of Economic Analysis (BEA) reported revised figures for the last several years of GDP growth. The BEA revised the last three years (plus 2011Q1) in the regular series of revisions, and also made some lesser revisions back to 2003. These revisions show the 2008/09 recession to be deeper and the recovery less strong, and help explain the strange phenomenon of an economy growing without adding new jobs. It isn’t that productivity was jumping; actually, the economy just wasn’t growing as fast as we thought. In other words, the job growth makes more sense now.
The economy is smaller than we thought it was – and Q2 was weaker-than-expected as well. Headline GDP was +1.3% versus expectations for +1.8%, and Personal Consumption was only +0.1% (economists expected +0.8%).
Incidentally, the revisions have generally been to lower figures from the original releases to the final releases, as well. Counting from the original GDP release in each quarter, the new revised quarter-on-quarter growth rate ended up lower in 22 of the last 29 quarters, and higher in only 6. In other words, don’t be too confident in the +1.3% that was announced for Q2!
Revising level of GDP lower, of course, raises the market-to-GDP ratio, and the ratio of profits to GDP, which is now at the highest level (biggest margins) in 60 years. The market, in other words, is even more over valued than it was on dependable long-term metrics like the Q ratio. (This doesn’t mean that the next 100 Dow points is lower. The question I am more concerned with is what the next 5-10 years looks like. If I can be consistently right on that, I’ll be consistently overweight when stocks are generally cheap and underweight when they are generally rich, and that ought to be good enough to do quite well over time. I feel the need to mention this because I think some people read this commentary as if I am writing about day trades. In general, I focus more on strategic positioning than tactical trading, although I try for a few good hit-and-run tactical trades per year).
Less-noticed was the Employment Cost Index, which rose +0.7% after +0.6% last quarter. This performance will worry some people who fret about wage-push inflation, even though the evidence that there is such an animal is sparse (wages typically follow inflation, rather than lead it). The ECI broke down as +0.4% on the wages portion (right on the trend of the last couple of years), but the +1.3% rise in benefits was the largest quarterly increase since 2005.
Noticed even less than ECI was the rise in M2 that printed on Thursday evening and put the 52-week rise in M2 at +7.9%. I had expected this rise to pause, flatten out a little bit, as the sudden acceleration is very unusual. But at least so far, there are few signs that this surge is a temporary phenomenon (see Chart). It also bears observing that since real GDP was revised lower, it implies that velocity slowed more than we thought as well (since MV=PQ, where M is the money stock, V is velocity, P is the price level, and Q is real output).
The multi-week acceleration in M2 is now noticeable even on a chart of the level of M2.
All of this news led stocks to open up weak, and bonds to continue their recent rally with 10-year yields falling to 2.80%. Equities rallied mid-morning when President Obama went on TV again to waggle his finger menacingly at the Congress. Soon, stock prices fell back and the S&P index ended the day -0.7%. As I said, bonds had a big rally, with yields falling 15bps on the 10y note. Real yields accounted for almost all of that, as the 10y TIPS yield fell 13bps to 0.36% – tying all-time lows from last October (see Chart). The reaction of real bonds implies that the bond rally is not due to a decline in inflation expectations, but rather to a decline in investors’ expectations of the long-run growth rate of the economy. At least, that’s philosophically the case; right now there are obviously a lot of other crosscurrents with the potential for the government to briefly stop spending money if a debt ceiling deal is not reached. Disappointment on Friday that a deal had notbeen reached also led the VIX index to reach its highest level since the Japanese tsunami.
10-year TIPS yields tie all-time lows.
Because the nominal bond rally occurred through the medium of real rates rather than inflation expectations, it seems that the rally was less due to flight-to-quality than it was a reaction to the GDP report and the revisions, which suggest that the resurgent economy was less resurgent than had been thought (and the return to monetary and fiscal policy even less than had been thought).
The reason that may matter is that, as I am writing this on Sunday night, there is talk that there may be an agreement to raise the debt ceiling that has been approved by Republican and Democratic leaders and by the White House. So far, it appears to be just the leadership that has agreed to the deal, but since both sides of the aisle have already had their cover vote (that is, they have each voted on the plan they wanted but that was doomed in the other chamber, so they can say to their constituents “I really tried”) there is a decent chance that this gets approved and we can again spend like drunken sailors. Yayyy!
The deal only cuts spending by $1 trillion over the planning horizon from the previous baseline, which means a drop in the bucket compared not only to spending (which would be something like $40-50 trillion over the next 10 years, so this is a 2.0%-2.5% cut) but to the deficit itself. It would be a down-payment on another $1.5 trillion cut that Congress would need to decide on by year-end, or that would in the alternative happen through automatic cuts to all government areas.
If the deal is real, and is passed by Congress and signed by the President, then the stock market will breathe a sigh of relief. At this hour, S&P futures are up 15 points in Sunday evening trading. But it certainly isn’t nearly enough to avert the downgrade that the ratings agencies have threatened, and fairly soon I imagine we will hear them say so. There was never a chance of default, unless the Administration had chosen petulantly to not pay the interest on the bonds with the trillions in revenue it continues to take in, and the deal doesn’t seem to avert the downgrade, which was the real threat all along…so I suspect this is a sucker’s rally in stocks.
Now, notwithstanding the foregoing I still don’t think a downgrade is a big deal either. Indeed, since I wasn’t worried about a default and I don’t think a downgrade to the sovereign credit is a big deal, the main reason I have been watching the monkey business on Capitol Hill is because of my love for country and my fear for its future and the future of my children. Nothing I have seen recently makes me feel much better about that, except for the fact that the citizens themselves seem finally to be getting moved to action. And in the U.S., that’s a mean feat.
Now, I did think of another negative possibility that could follow a US downgrade. A downgrade would also result in the downgrade of Fannie Mae (FNM) and Freddie Mac (FRE), which are under U.S. conservatorship and which only survive in their forms because of the extraordinary funding that U.S. backing affords. Without a AAA, it is much less clear that these entities will survive (although it has long been unclear whether they should survive). And that raises the specter of volatility in mortgage markets. It also might help explain the bid to Treasuries, because while there are few investors whose mandates will require them to sell sovereign bonds that are downgraded from AAA to AA, there are many more investors who hold agency securities who may have such mandates. Where does an investor who needs to sell Fannie Mae agency bonds turn to invest that money? Well, turning to the sovereign herself makes some sense.
In my current job I don’t see those flows, as I might have if I was still on the sell side, but I wouldn’t be surprised to hear that Asian accounts have been sellers of agencies for Treasuries.
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One or two clean-up items from last week: on Thursday, Richmond Fed President Lacker said:
“The additional monetary stimulus initiated last November raised inflation and did little to improve real growth… Given current inflation trends, additional monetary stimulus at this juncture seems likely to raise inflation to undesirably high levels and do little to spur real growth.”
I missed this when I wrote Thursday’s comment but it is worth noting. So much for the new, tighter communications policy! This is just what I have argued for some time, but it is very surprising to see coming out of the mouth of someone in policy circles.
On Friday, St. Louis Fed President Bullard commented that the Fed’s large balance sheet could cause an inflation concern if it isn’t shrunk when it is time to shrink it. Hey, news here: see the M2 chart above. It’s entirely possible that ship has already sailed! Bullard also said that the Fed is unlikely to add any more stimulus, because inflation is now rising. I’ve said this in the past as well. Last year, core inflation was declining, so the Fed’s two mandates were not in conflict – adding more money helped avoid deflation and helped growth (well, anyway, that was their theory). That is no longer the case; the twin mandates are in opposition now so there is a much bigger hurdle for outright stimulus. Another bank crisis might do it, though.
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The Wall Street Journal had an interesting story on Friday, entitled “Lending Markets Feeling the Strain.” The story details how investors have been pulling lots of money out of money-market funds, supposedly because individuals are afraid of default on the government securities that are held in large quantities by those funds. This is the second explanation I’ve seen of the money leaving money funds, and this makes more sense than the “elimination of Reg Q” theory. In this case, we’ll soon know if it’s accurate because once a deal is reached and there is no default coming, the money should flow back in, right? But that isn’t the reason I point this out. I want to make a different point.
Money flowing out of money funds affects the funding markets, but most individual investors never really see that dynamic. It isn’t very important right now, anyway, since banks are dramatically over-funded thanks to the Fed. But moving money from money market accounts into transactional accounts – checking accounts, cash, brokerage accounts, etc – is a threat to inflation in assets or goods and services.
When transactional money increases, prices of goods tend to increase; asset markets, however, sometimes act as a ‘relief valve’ for inflationary pressures, which end up spawning bubbles rather than triggering inflation in goods and services. People who have extra cash, courtesy of the extra amount sloshing around in the system, can either spend that cash or invest it. If they invest it at increasing market valuations, it drains some of the inflationary pressure (I need to stipulate “increasing market valuations” in the argument, because obviously every dollar I spend buying equities is just transferred to the person selling me his shares) that would otherwise bid up goods.
But what happens when the markets start looking expensive and/or dangerous for everyone, across a great many asset classes? Then investors hold more cash – and that’s exactly what they are doing. And that is fine as long as those cash balances sit there in those checking accounts or in cash. What happens, though, if investors fear those cash balances are going to be taken, either by government fiat or by inflation? Then the money gets spent instead, and moves from asset markets to goods markets.
We don’t really know how this dynamic works. We don’t know how fast money moves in these circumstances. We have never observed this sort of situation before, and we can’t recreate it in the lab. I raise it as a point of curiosity, and a matter for discussion and debate, and as a warning. It is just another risk to watch, as if we didn’t already have plenty of them. It is not today’s trade.
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On Monday, we’ll react to the weekend edition of Deal-Or-No-Deal. The ISM will be released, and is expected to be approximately unchanged (Consensus: 55.0 from 55.3), but unless there is a real shock that will be largely ignored while investors watch the votes on Capitol Hill. Passage of a deal will mean an equity rally that many of us will look to sell into if we have a chance. Failure…well, let’s not even think about that.
Of Haircuts and Helicopters
Bonds shrugged off somewhat-upbeat economic news and stocks managed to fade late in the day. As bullishly as the equity market was behaving two weeks ago on bad news, it’s now behaving bearishly on good news.
Initial Claims came in nearly 20k better than consensus (although there was a slight upward revision to last week’s figure), tossing a 398k figure onto the screens at 8:30ET. Two out of the last 3 weeks have been below the 420k line, and it’s probably the case that the underlying trend is improving modestly. Whether 380k or 400k or 420k, though, it isn’t anything to write home about and other measures of labor market health – notably the “Jobs Hard to Get” subindex of the Consumer Confidence survey – continue to look poor. Labor is a lagging indicator, sure – but it is unusual for it to lag this much, this far into what most economists would call a recovery.
The Administration made a play late in the day to get an equity rally going, by leaking the news that “The U.S. Treasury will give priority to making interest payments to holders of government bonds when due if lawmakers fail to reach an agreement to raise the debt ceiling.” Well, duh. Anyone with a sharp pencil can see that there’s enough revenue to pay the interest on the bonds, and the military, and social security, and a few other things as well. I haven’t yet seen an apology from anyone for the scare tactic of threatening to not send Grandma her Social Security check, which I presume is prioritized over, say, the National Endowment for the Arts.
It is somewhat scary that the Administration felt the need to leak such “news;” it implies that they are starting to think there is a pretty good chance that a debt ceiling deal doesn’t get done, or at least doesn’t get done before the markets melt down. Tomorrow is the next-to-last trading day before the August 2nd deadline, so prepare to go into the weekend not knowing. Will investors on Friday bet that there will be a deal announced over the weekend, and so go home long? Or will they bet that there will not be a deal announced, and so go home short? Or will they have some common sense and go home flat? (Don’t put money on the “flat” bet.)
It also seems increasingly likely that Treasury debt will be downgraded by one or more of the agencies. I have noted a number of times here why that’s nonsense: the Treasury can always replace interest-bearing notes with non-interest-bearing notes called dollar bills, regardless of the debt ceiling. Therefore, the only reason the U.S. would ever default is because it just doesn’t want to pay. But no issuer is creditworthy if it simply chooses not to pay – the rating is supposed to evaluate only the ability to pay and as long as the U.S. controls its own printing press there will always be a 100% ability to pay.
I find the gnashing of teeth over the downgrade in the ‘borderline humorous’ category. I think it mainly affects Americans in the ego department. The Wall Street Journal today said “Still, it’s hard to grasp a world in which the one security regarded as ‘risk-free’ is rated lower than the government debt of Austria, Denmark, Finland, the Netherlands and Hong Kong (all AAA.)” Really? Is it that hard to grasp that people incorrectly regarded something as risk free that isn’t? It isn’t like that hasn’t happened in a while. Home-ownership and ‘stocks for the long run’ spring immediately to mind. Besides, nominal debt is never risk-free, because it is exposed to inflation, so it’s the “regarded as” that is the error here. TIPS are the true risk-free instrument (or as close as one can get) in the U.S., and TIPS do not have competition from Austria, Denmark, Finland, the Netherlands, or Hong Kong. Maybe we can finally dispense with the idea of nominal Treasuries as the risk-free instrument, which is a Ptolemaic view of the fixed-income heavens anyway. Let’s start calling them Treasury Inflation-Exposed Securities, which is after all what they are.
Now, fortunately most of Wall Street (the people who should know because they talk to all of the investors) finally seems to agree that a downgrade from AAA to AA (which, by the way, would be a large single-downgrade move – be prepared for a rally if it’s just AAA to AAA- or AA+) would not cause most investors to sell Treasuries. Double-A is still very good and it is very rare to have a mandate that distinguishes between really-good credit and really-good (but not quite as good) credit.
One place where people worry is that in principle, a downgrade could cause dealers to require larger “haircuts” on Treasuries used as collateral. For the non-initiated, a “haircut” is when your dealer says you can only borrow, say, 95 cents against an asset that is worth one dollar. In general, a haircut is larger the higher (a) the volatility of the collateral’s price; (b) the illiquidity of the market the collateral trades in; and (c) the difficulty of assessing the value of the collateral. A dollar bill receives no haircut. A T-Bill receives very little haircut, maybe 1% or less, because its price is highly stable, the market is very liquid, and it is very clear what the value of the collateral is. A long Treasury bond receives a larger haircut, because its price is more variable even though the market is liquid and the price clear. A corporate bond gets a bigger haircut still, because it is more variable, the market for any particular credit is less liquid, and a structured corporate bond on the same name, compared to a bullet bond, gets an even bigger haircut (at least in principle) because it is less clear what the price really is.
So will haircuts change on U.S. Treasuries? I don’t see why they would, since (a) the market shouldn’t be any more volatile (in the medium-term, anyway), (b) the market will be just as liquid and (c) just as transparent. Remember, the question for a haircut is “how fast can I sell it at receive something close to the marked price?” If the price changes, then the collateral may be worth less, or more…but the haircut percentage shouldn’t change just for that reason.
Now, there is one ex-theoretical reason that haircuts might change, and that’s because a downgrade would give dealers an excuse to change haircuts on their clients. This is a dangerous game, because it would decrease the leverage available to hedge funds and would force some position unwinds – not just in Treasuries, but in all kinds of asset classes where risk positions are collateralized by Treasuries (that is, all of them); moreover, if the customer repo haircut changes then there will be pressure on the interbank haircut to change. Since dealers rely on the leverage afforded by being able to use their bond inventory as collateral, this would force dealer leverage to decline, causing some unwinds and by-the-way reducing further the future ROE (one element of which is the financial leverage used).
In the worst case, a change in repo haircuts could cause a significant unwind of long Treasury positions, driving interest rates higher and – as a side note – leaving dealers with lots of cash and lots of reserves rather than lots of bonds and lots of reserves. The latter configuration is positive carry; the former is flat carry and increases the incentive to lend these funds (especially as rates would be rising). Perversely, then, we could get higher rates but also an expansion of credit and the attendant inflation pressures, simply because Treasuries are less valuable as collateral. This would be good for an inflation consultant/trader/advisor (ahem) and good for the small business that can finally get credit, but bad for everyone else.
Let me highlight that that’s the “worst case.” I doubt that haircuts on Treasuries will change, even with a downgrade, unless dealers are just looking for an excuse to squeeze more collateral out of clients.
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A good friend who writes a daily note I’m lucky enough to receive made a very insightful point tonight. He said, and I echo him, that it’s important to remember that the market can only be preoccupied on one point at a time; as soon as the debt ceiling deal is sealed, the markets will start focusing again on the European mess. Or, I would add, on the CMBS mess.
The Commercial Mortgage-Backed Securities (CMBS) market has been tagged as the ‘next disaster’ by many observers for quite some time. We have become all-too-familiar with the risks of issuing high loan-to-value mortgages to unqualified homeowners in a real estate market downturn. Well, the same thing happens in the commercial world, although there aren’t really any ‘no-doc’ or ‘liar’ loans. The problem is still that high LTV mortgages were made on properties that are now worth much less.
This is one reason, I think, that CMBS issuance has been so heavy recently – dealers have been trying hard to limit their direct exposures as much as possible. The hammer has not yet come down, but there are some signs that it is hovering. Today Citigroup and Goldman withdrew a $1.5bln CMBS offering after S&P said the transaction would not get the rating that Citi and Goldman expected. Now, the firms could have added some more credit enhancements and gotten the deal to the rating needed, or raised the interest rate it was packaged to, but then investors in other CMBS deals would start (and probably already are starting) to question why their CMBS deal doesn’t have that yield. Pulling the deal is a curious move that either says the rating was way off or, possibly, that some investor group was willing to buy the whole thing without the rating.
But if it was for the latter reason, I don’t think the head of Citigroup’s CMBS group and the head of Goldman’s CMBS group would have both resigned this week. Indeed, if there is a lot of money still to be made there, it would be weird to see either guy resign, much less both of them. Keep a watchful eye on CMBS headlines in the near future! This would be a surprise that isn’t, really, a surprise except for the timing.
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Tomorrow, we get a slew of economic data. The 2nd quarter ECI (Consensus: +0.5% versus +0.6% in Q1), and GDP (Consensus: +1.8%, +0.8% personal consumption) will be released at 8:30ET. The Chicago Purchasing Managers’ Report (Consensus: 60.0 vs 61.1) and NAPM Milwaukee (Consensus: 56.9 from 59.3) will come out at 9:45ET and 10:00ET, respectively. There is also the revision to the month’s Michigan Confidence figure. But the real point of the trading day is what happens going into the weekend (which is also the month end). I have no real feel for what is going to happen, so I will maintain my current, conservative, stance.
Now That’s European Unity For You
It seemingly dawned on investors today that something smells bad and it isn’t clear whether it is something that is already in the trash (say, Greece) or something that should be put there (say, the U.S.). Faced with this dilemma, investors did the only reasonable thing: they took everything that smelled even slightly funky, threw it out, and took it to the curb.
Of the 27 countries in the EU, 23 of them saw their equity markets decline. In Germany, the UK, France, Spain, Italy, Portugal, Ireland, Finland, the Netherlands, Belgium, Sweden, Luxembourg, Denmark, Austria, Poland, the Czech Republic, Hungary, Romania, Cyprus, Malta, Slovakia, and Slovenia, every single equity index listed on Bloomberg declined; in Greece three out of four fell (Greek midcaps are clearly the place to be, baby! Well, maybe not.). The only ones that rallied? I hope you had your money in Bulgaria, Latvia, Lithuania, or Estonia. Being outside of the EU was no proof against an equity decline either; Russia, Switzerland, Turkey, and Norway sported falling bourses. European solidarity is at last a reality!
The weakness in Europe was fairly easy to trace. German Finance Minister Schäuble (spelled Schaeuble if you eschew umlauts in your daily life) wrote a letter to Bundestag colleagues clarifying some of the murkier elements of the grand plan that emerged last week. For example, he pointed out that the EFSF, which is the entity which is theoretically going to buy bonds to support the market, only can do so when the ECB does an analysis and recognizes “exceptional financial market circumstances,” or if there is a “mutual agreement of the EFSF/ESM member states.” (Be flexible on the precision of the quotation: this is obviously a translation from the German).
Schäuble also noted offhandedly that the IMF and the ECB expect a primary surplus from Greece in 2012, which is so outrageously implausible that some ministers must have thought they were at a comedy club. He described the €159bln (back to that number again!) bailout of Greece as a ‘one off’ thing, implying that the ‘ring fence’ attempt to prevent contagion wasn’t really very serious. And he said the crisis is not over yet, which we kinda already knew but scares people when a politician admits it: “it would be a mistake to think that the crisis of trust in the euro area can be solved by a single summit.”
Then, of course, we have the U.S. train wreck. The supposed engine of the global economic train may be slipping off the rails again, before we even get to the debt ceiling debate. Durable Goods Orders were weak, turning in a +0.1% ex-transportation versus +0.5% expected. Nondefense capital goods orders ex-aircraft, considered by some economists as a proxy for future business investment, fell -0.4% compared with an expectation for a +1.0% rise. Durable Goods is a volatile number, and one month does not a trend make, but the market needed a break and didn’t get it. Later in the day, the Fed’s Beige Book also showed that growth anecdotally “moderated” (that is, slowed) in two-thirds of the country.
The S&P ended the day -2%, and never really made any indication that it wanted to try and recover.
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And now, the self-adulatory portion of our broadcast:
“It has now happened twice in the last few weeks that equities have blasted off, seemingly on nothing or next-to-nothing, before trading sideways for a couple of days in a moderately disinterested fashion. After the last episode, earlier this month, a final spike was followed by a series of somewhat-alarming slumps to erase most of the surge.” – Me, “Readying the Next Bumper Crop of Money,” July 20, 2011
I don’t usually toot my own horn too loudly, because I don’t like it blown in my face when I am wrong, but you have to admit: that was a prescient observation! Every now and then I get lucky.
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The headline on Bloomberg throughout the day screamed “STOCKS, COMMODITIES SLIDE ON DEFAULT CONCERN AS DOLLAR GAINS, OIL DECLINES.” Well…it is true that stocks slid, anyway. Commodity indices were only down 0.5% or so. I have some sympathy for the journalists; I know it seems like commodities should have slid. But as I keep pointing out, commodities aren’t going up because of supply and demand of commodities – in which case, news of slow growth should kick the legs out of the commodity price rally – but because there is an extraordinary supply of money, which keeps rising, and that dynamic keeps the price of dollars (in commodity terms) on the defensive (or, conversely, keeps the price of commodities, in dollars, on the offensive). Actually, crude oil declined today because of large, surprising builds in the weekly inventory numbers that were released, and without the energy complex (-0.9%), commodities were basically flat overall.
As an aside, a number of “inflation protection” funds these days own equities of commodities producers, supposing these to provide protection in the event of inflation. I think these are acceptable investments if inflation stays low and stable, but if inflation rises then these equities will get marked to a lower multiple just like the rest of the market – moreover, since mining expenses will rise with a general increase in prices, it is not entirely clear that commodity producers will capture the lion’s share of commodity market gains. With equities generally quite rich, I would be careful about my holdings of commodity producers or ETFs and funds which invest in them. These stocks and funds may well outperform the equity market in an inflationary debacle, but they will very likely underperform commodities and inflation generally, and not provide the protection they are expected to.
Bonds sold off modestly, and 10-year yields are back at 3% even. TIPS outperformed and were roughly unchanged (10y TIPS yield 0.55%). Bonds are perversely doing comparatively well because the chaos that would follow a U.S. default would supposedly lead to …buying of Treasuries as a safe-haven. Now that is perverse, if even defaulting on your debt doesn’t get investors to sell it! It isn’t crazy, though, since investors understand (even if politicians and journalists don’t) that a U.S. default would be merely technical in nature and a downgrade signifies less for the bonds than it does for the state of the economy (that is, a AAA country has a very rosy outlook while a BBB country faces only painful choices. Frankly, I think we’re closer to the latter than the former, but it doesn’t mean anything for the bonds, which can always be paid with paper).
Now, trading gets harder. The VIX ended today at the highest closing level since March, so options are no longer a cheap way to play what’s going to happen (I still own my puts, though I’m now nervous about my vega exposure). But if equities are going to decline because the European situation isn’t as resolved as it was and because there’s a possibility of a technical default, then we can no longer necessarily sit and wait for the inevitable pop higher to sell into once the debt ceiling deal is reached. That could happen tomorrow, or it could happen 10% lower from here. When we were hoping and expecting a clean – if unimpressive – resolution to the standoff, we could just sit and wait for the pop. That is no longer an attractive strategy.
So what to do? If the equity pop happens today, I’ll still sell it. And bonds are still expensive to virtually any likely medium-term outcome (deflation is just not happening, folks), so I’m more comfortable selling those or putting on curve steepeners even though I know I run the risk of getting stopped out on an equity market flush or a European headline that causes the same. Of course, I remain long commodity indices, and I hold a reasonable amount of cash. Actually, come to think of it I am not sure what would constitute an unreasonable amount of cash!
Rating For Godot
I have said several times that I expect the debt ceiling debate, as heated as it has become, will be resolved “just in time” and will be followed by loud back-slapping about the glorious bipartisanship that has been displayed by avoiding this disaster of our own making.
However, I must say that as this debate gets more and more surreal, it does make me scratch my head a bit. President Obama took to the airwaves last night to sternly remind us…what? That the two sides in Congress might have to accept something that doesn’t fully satisfy either side? He had no new suggestions for reaching agreement – in fact, he muddied the waters by proposing something (tax increases! We don’t have enough of your money to make ends meet!) that both sides have stopped discussing as part of a solution. To add to the sense of unreality, he urged people to contact their legislators…and most of the websites of Members of Congress promptly crashed. Well, that’s one way to avoid hearing from the People!
It seems like the Reid plan is in the lead, and though it uses some gimmicks (like counting savings from “winding down the wars in Iraq and Afghanistan,” which isn’t really up to Congress although I suppose funding our soldiers is) those gimmicks are similar to ones Republicans have used in the past. I am most skeptical of the “$400bln in interest savings” in that plan, when interest rates are very likely to rise; my guess is that he takes the projected future rise in interest rates that is in the budget and lowers the projection to get a “savings.” Heck, if it was that easy we should just lower that assumption a lot further and get the whole $2.7 billion! It sounds like he has been studying pension accounting.
Still, a budget agreement, even one with gimmicks, that makes real spending cuts and doesn’t raise taxes much or at all is a huge win for the country. Smaller government (let’s not, however, call it “small” government) leaves more for everyone else. In reducing a deficit, it is the method that causes the lowest negative impact immediately (since tax increases have a larger multiplier than spending cuts) and in the medium term actually bears a dividend in terms of faster overall growth as the private sector uses those resources more effectively.
Clearly, even with a huge deficit-reduction plan (and the plans being discussed don’t qualify; the $2.7 trillion or whatever is spread over a decade and involves a lot of questionable assumptions anyway) the country faces enormous challenges, and growth will be tepid at best for a while – and, if there are real cuts to government spending, temporarily negative in the near future. This is not encouraging with the job market still flatlining – the “Jobs Hard to Get” subindex in the Consumer Confidence report rose again, to 44.1 (the overall index surprised on the high side but remains very low at 59.5).
So…what about a downgrade of the U.S. credit rating? Let me rephrase: so what about a downgrade? Anyone who evaluates the US market on the basis of rating agency markings, and avoids a AA+ or AAA- instead of a AAA+, is seriously confused. It makes some sense to rely on ratings agencies when they downgrade a country to less-than-investment-grade (simply because investment managers need to have a bright line somewhere in the investment mandate that tells them what they can and cannot invest in), but the list of AAA companies that ended up failing – the most notable being Enron – should make any investor skeptical of the ratings in the first place. Oh, and any investor who is worried about the debt ceiling should be aware that Fannie Mae and Freddie Mac debt, about $1.5 trillion of it, is not included even though these are now under conservatorship. Neither are any of the government guarantees of mortgages and money funds and banks that were put into place in the crisis. Nor are unfunded Medicare and Social Security liabilities. All of these are debt as well, especially the FNM and FRE debt – suggesting that one way to resolve the impasse is to simply re-class obligations so they aren’t under the definition of the cap. I would not be the slightest bit surprised if that ended up being part of the final deal.
But, as I have pointed out a-plenty, a downgrade is not the issue here. Any ‘default’ for a sovereign issuer of currency can only be a technical or political situation, because the Treasury can always simply print currency to pay the bills: physical currency is not included in the “public debt subject to limit.” For that matter, neither is it subject to limit if the Fed ‘pays’ for Treasury expenditures or interest by simply crediting the appropriate accounts with electronic money. Now, in both cases it would be practically hard to print the amount of money needed to avoid default quickly enough, because we chew through an amazing pile of money every day just in interest and principal payments – but that’s an engineering challenge, not a financial challenge. Any sovereign issuer of its own currency (which leaves out Europe) is able to be AAA until it decides it doesn’t want to pay. So the ratings agencies aren’t measuring financial stress, but the I.Q. of its politicians. On that basis, we should have been BBB long ago.
Frankly, I don’t think the market goes particularly crazy if a deal is not struck by the “deadline” – and that possibility is probably the scariest thing a Congressman could think of right now. Irrelevance of the political circus? What if the U.S. rating fell in a forest and it made no sound?! Like I say, we already know these clowns are doing their act; do we really care if the funny car breaks into pieces when they try to stuff it too full? I’m butchering metaphors here but I think you get the point.
But the scary brinkmanship in debt ceiling negotiations is starting to have an effect on markets. As I have said, we’re all waiting for the debt ceiling to pass so we can sell the pop in stocks and/or in bonds, but … at least occasionally we are asking the question whether it’s possible that the deadlock may not be broken any time soon. As a result, stocks are having trouble making headway (the S&P fell -0.4% today) and the dollar index is the lowest it has been since May…which in turn was the lowest since 2008. The dollar index never broke and held above 76.00, and now is approaching the May lows; this is pretty negative. Bonds are doing okay, because one effect of an impasse would be a significant decrease in the pace of the government bond auctions (presumably, however, they would continue to have auctions since maturing issues would lower the debt subject to limit, allowing a similar amount of debt to be auctioned without violating the cap). But I don’t think I’d play the ‘Treasury scarcity’ card when there is ~$9.3 trillion in marketable Treasury debt out there. Again, we’re all just waiting to sell the pop when there’s a deal done (although it is less clear in Treasuries than in equities, I think).
On Wednesday, Durable Goods Orders (Consensus: +0.3%/+0.5% ex-transportation) and the Beige Book will be released; we all know by now, however, that eyes will be turned towards Capitol Hill – expectantly, resignedly, but turned in that direction nonetheless.
A Billion Screaming Benjamins
Can one billion Benjamins be wrong? Actually, it’s more like 1.57 billion hundred-dollar-bills (aka “Benjamins”) that the EU and private bondholders are committing to the defense of Greece – inexplicably, the number in articles today was €109 billion, rather than the €160 billion mentioned in articles last week. Despite that band-aid, today Moody’s cut Greece another three notches and declared the bond exchange equivalent to a default. Said the agency: “While the rating agency believes that the overall package carries a number of benefits for Greece – a slightly reduced debt trajectory, lower debt-servicing costs, as well as reduced reliance on financial markets for years to come – the impact on Greece’s debt burden is limited.” So, kudos to the EU, which managed to spend a deci-trillion (we might as well use the units we’re going to be seeing more and more) and still not do much for the problem!
Greek 10-year yields rose 25bps today – along with Spanish and Italian and Portuguese yields – reversing only a small part of Friday’s plunge but keeping 10-year yields for the saved country still around 14%. Irish 2-year yields rose 77bps, despite the fact that the EU pledge for Greece also promised a break on interest for Ireland.
The S&P index started the day very weak, after trading down as much as 19 points overnight. Bloomberg claimed that U.S. equities were falling because there was no debt ceiling deal over the weekend – I am not sure who was expecting one, but they seemed to think our legislators will try to get things done before the eleventh hour. The explanation seems weak to me, because it doesn’t explain why European equity markets were falling (the Euro Stoxx 50 fell 1.1%). The main reason for weak markets is that (as Moody’s pointed out) the grand plan out of the EU last week really did very little to (a) ensure Greece won’t really default a little down the line, (b) ring-fence the other countries with bad fiscal issues, or (c) give us any confidence that they’re capable of handling the next problem.
To be sure, timing is everything. We are all fairly confident that there will eventually be a debt ceiling deal. We all know that stocks will jump on the news of the deal, no matter how much they have rallied in anticipation of the news or on prior rumors of the deal. We all know that bonds will probably rally on the news. And so we’re all waiting to sell into that pop, which consequently may not end up being very much of a pop. So volumes continue to slide since no one really wants to sell right now, and buyers also figure that if they wait there may be lower prices after the post-deal correction.
After the weak overnight session, stock prices did drift higher before fading into the close. Bonds didn’t do much of anything although yields slipped a couple of basis points higher. Gold set a new all-time high, but grains and softs pulled commodity indices slightly lower on the day.
The only economic data were a couple of lesser manufacturing indices, with Dallas a little stronger than expected (and showing a big bounce from last month) and Chicago a little weaker than expected.
Inflation swaps rallied again. The 10-year inflation swap rate is now at 2.85%, only a whisker away from the year’s high around 2.90%. 10-year inflation expectations haven’t been higher since before the crisis…and at the time, crude oil prices had just doubled over the prior year so some amount of nervousness was evident and understandable. Over the last 52 weeks, oil has only risen 25%, and core inflation is much lower now than it was in 2008.
You can think of a future inflation measure like this as being something like the median expected inflation plus an option premium to account for the value of the tail, which is much longer to higher inflation rates. In that context, you could say that in 2008, with core inflation at 2.4% and 10-year inflation expectations at 3.0%, you were paying 2-2.5% for the expectation that the average would be slightly above the Fed target over the next decade, plus 0.6% or 0.7% as an option premium. Right now, with core inflation around 1.6% and many people still believing that deflation is a not-unlikely outcome (to be clear, however, I myself view that as a very remote possibility), you could argue that you’re paying 1.75% or 2.0% for the expectation of the average and more than 1% as an ‘option premium.’
In other words, people aren’t paying 2.85% on 10-year inflation swaps because they expect inflation to be so high; they are paying 2.85% because they think there’s a good chance they lose 100bps but there’s some chance they make 500bps or 1000 bps. Moreover, in the case where the investor loses 100bps on his inflation swap, the rest of his stock and bond investments are likely to do comparatively well, but the “tail” case of higher inflation will splatter both stocks and bonds, so it’s the right option to buy.
The reason that “option premium” is so well-bid is for the reasons you might naturally think of: a deterioration in the credibility of central banks, the narrowing list of plausible escapes from our current fiscal predicament. More recently, too, there is the observation that money metrics are no longer comatose. The chart below is worth taking administrative note of. It shows commercial bank loan growth over the last 52 weeks.
Bank Credit just went positive on a year-over-year basis!
Simply put, commercial loan growth has finally stopped shrinking. Some people will say that means that loan demand is picking up; I believe this means that loans are now more available than they were – it is a supply-side phenomenon. In either case, it is a sign that more-normal functioning of the banking system is returning. I happen to think the timing of such a phenomenon is exquisitely poor considering what is likely to be happening in Europe, but the numbers are clear. In just the last month, commercial loans have expanded at a 10% annualized pace.
So let the good times roll, except for the nagging issue that if the economy’s lending organs are no longer impaired, it increases the risk that the money multiplier might make a comeback sooner rather than later.
Tomorrow, the Consumer Confidence (Consensus: 56.0 from 58.5) figure is due to be released with the consensus expecting a decline to new 2011 lows. As usual, look for the “Jobs Hard To Get” subindex, which last rose to 43.8. New Home Sales (Consensus: 320k from 319k) is a number that is simply not very important as long as it is under 400k or 500k, but be alert to a knee-jerk reaction if there happens to be a significant month-on-month percentage gain. It’s meaningless but the market got all hot and bothered about housing starts, after all.
As a final note, be aware that Kansas City Fed President Hoenig is due to testify on monetary policy before Ron Paul’s House Financial Services Committee at 2:00ET. Although the Fed Chairman has worked very hard to get Hoenig back on the reservation and reined in with the new communications policy, Congressman Paul is sure to try and elicit some hawkish comments at the hearing entitled “”Impact of Monetary Policy on the Economy: a Regional Fed Perspective on Inflation, Unemployment and QE3.”
€160 Billion Later, Not Much Closer To Resolution
If €160 billion could somehow be an unimportant amount, today it was. But before we get to the latest discouraging result from the EU, let’s do a quick survey of the prior news first.
We’ll start with last night’s speech by the head of the Fed’s SOMA account, Brian Sack. Now, I know that isn’t what readers want to know about, so I’ll just include a little snippet. Sack, talking about how QE2 went over, said:
“Despite its limits, the expansion of the balance sheet was seen by the FOMC as the best policy tool available at the time, given the constraint on traditional monetary policy easing from the zero bound on interest rates. The willingness of the FOMC to use this tool is indicative of a central bank that takes its dual mandate seriously and does what it can to deliver on it. The disappointing pace of recovery that has been realized since then suggests that the additional policy accommodation provided by the LSAP2 program was appropriate.”
Wait, what? Where is Tivo when you need it? Did he say that the decision to deploy QE2 (LSAP2) was proven to be justified because it didn’t work?
Keep in mind that speeches by senior Fed officials are ordinarily proofread and vetted a number of times. So it seems that everyone who proofread Dr. Sack’s speech felt vindicated by the fact that growth slowed between the time QE2 was instituted and when it ended. I wonder what failure would have looked like!
This morning started with Initial Claims, printing weaker-than-expectations at 418k. Leading Indicators came in at 0.3%, near expectations. Surprisingly, the Philly Fed index did bounce to 3.2, which was even a little bit more of a bounce than economists were expecting. That behavior stands in contrast to the weak Empire figure and therefore clarifies neither.
The TIPS auction went rather well. (Incidentally, an erratum is due here. Yesterday I quoted the WI 10y TIPS based on Bloomberg’s numbers, which were completely off. Instead of 0.48%, it was around 0.63%. I should have known better, since I knew the roll was trading around pick-8. My apologies for the error!). The bid:cover was 2.62:1, and the auction stopped through the screens (that is, no tail). Direct bidders took about three times their normal share, around 13.7%. The extra billion they took down allowed dealers to take a billion less, so there is less to clean up. With 10-year nominal yields up 8bps on the day to 3.01%, 10-year real yields were unchanged so inflation expectations rose about 8bps: 10y CPI swaps ended up around 2.82%, once again threatening the highs for the last few years.
None of this mattered. Stocks took any and every excuse to rally. It rallied on good data. It rallied on bad data. It rallied on the rumor that Greece was going to be allowed to default (I suppose because France and Germany had come to an agreement on it). The bullish interpretation is that the market seemed to do really well with bad news. The bearish interpretation is that the news sucks.
It looked like there was a chance it could be worse than it was. As the afternoon dragged on, dealer “analysis of the debt crisis summit” calls began to be postponed. Overnight, we had heard that Sarkozy and Merkel had come to a meeting of the minds (whatever that means when the two people we are talking about are Sarkozy and Merkel); if so, then where was the announcement of the grand plan?
Just before 3:00 ET, French President Sarkozy began to speak with reporters on the results of the meeting. This was our first indication that the meeting was over. There was no communiqué; all of the politicians just started holding press conferences.
I want to make one quick observation here. It is much easier to say something in a press conference and later take it back, than it is to say something in a communiqué that you later want to withdraw.
Sarkozy’s comments meandered; there was lots of “we pledged this” and “we can’t let that happen” and so on. We heard there were “strong measures taken.” Great, Mr. Sarkozy. Isn’t the communiqué supposed to tell us what those measures are?
I imagine that there will be a document of some kind eventually, but perhaps not. We know the general outlines of the grand bargain, though, and … it’s pretty much what we already thought it was, and it isn’t grand. Here’s what Sarkozy said (and it was in substance – whatever that term means when it is Sarkozy speaking – confirmed by other ministerial mutterings):
- There will be a European Monetary Fund (basically IMF-Europe) that will have the power to “operate on secondary markets” (that is, manipulate bond markets) and can recap banks. Sarkozy did not mention a timetable, and it is unclear how this helps Greece today.
- The interest rate on the bailout loan will be lowered. I guess this is like a “loan mod” for a sovereign nation. Since Iceland has already demonstrated the proposition that once the money has been dispensed, the terms can be renegotiated to a lower interest rate, this isn’t much of a concession especially if the alternative is default, now is it?
- These measures “won’t be repeated for other states.” He didn’t say which measures, but it seems a funny thing to say if you’re saving Greece partly to stop the run on Portugal, Ireland, Italy, and Spain!
- Sarkozy wants a “European rating company.” Any guesses as to whether it will be tougher than S&P, Moody’s, and Fitch when it comes to rating European banks and sovereigns? “LeCredit…they understand us, mon frères.”
- The private sector will contribute €135bln, in thirty years. That’s actually the way he said it, which is kinda funny when you think about it. It’s really the next thirty days that is the concern with Greece, isn’t it? What he meant was that private bondholders will be forced into a conversion that will make them lenders for thirty years. What he really meant is that the contribution will essentially be made over the next thirty years, as banks carry the bonds at par and just suffer a much-worse-than-market interest rate. That’s really the optimistic version; the more likely version is that the private sector will contribute those sums, and a lot more, within a few months or a year when Greece defaults anyway.
I might have taken this press conference for a farce and a bad joke, if I hadn’t known it was not. The French President, echoed by other senior European figures, said “Greece will repay its debts.” Hold it just a minute, Monsieur President…isn’t that Greece’s decision to make? The EU can make many decisions that affect Greece, but surely the French and Germans don’t get to decide if Greece defaults. At best, they can make it less-advantageous for them to do so, although it isn’t clear they have done that yet.
The grand plan, the meeting of the minds, appears to have basically produced the plan that the French already liked, Merkel had already rejected, and the ratings agencies had already said would probably be a default. I don’t see any new cash. And yet, the stock market rallied. The dollar was whacked to 6-week lows, while equities gained 1.4%. Crude oil rallied 1.2% and is near $100 again although commodities as a whole weakened.
After the close, M2 was released; it rose slightly in the most-recent week. Since it didn’t retrace any of the recent spike, the period-on-period growth rates remain elevated and worrisome.
I think that once Friday dawns investors will realize that the European deal isn’t that big a deal, isn’t even ratified yet, and seems short on specifics. I remain bearish on stocks but I will say this: if we get past the debt crisis – and by ‘past’ I mean that fiscal and monetary authorities are able to extinguish the contagion and stabilize the woefully under-capitalized banks in a convincing way – then the backdrop otherwise is improving somewhat. The problem with equities is that they already incorporate much of that improvement in the price without incorporating much of the risk, but I don’t think it would be impossible to inflate a little mini-bubble. It would be hard to keep it going, because interest rates would have to rise and basically the perfect environment for stocks – low and stable interest rates and inflation – would turn into something less-perfect. But I can imagine the stock market rallying, even from here, if, and it is a very big if, the sovereign debt crisis is stayed for now.
Of course, with the amount of debt and the size of the deficits, the crisis will not go away forever. Indeed, there are plenty of other crises waiting in the wings including the U.S. deficit situation and the wall of money waiting to pour into transactional balances and inflation. But if I pucker up my face just right, tilt my head and squint, I can imagine the equities bull market getting one more leg.
But I am not positioned that way. I am positioned short, through put options, and our models are long commodities and cash in preference to TIPS and equities. The odds still favor a bad outcome for the long equity investor, especially in real terms.
Readying the Next Bumper Crop of Money
It has now happened twice in the last few weeks that equities have blasted off, seemingly on nothing or next-to-nothing, before trading sideways for a couple of days in a moderately disinterested fashion. After the last episode, earlier this month, a final spike was followed by a series of somewhat-alarming slumps to erase most of the surge.
Bulls will take solace that the slumps only erased most of the surge, and not all of it, before another series of staccato jumps pushed the market higher.
There seems to be a growing belief that the monetary authority is behind the equity rally. The theory is that Bernanke has said quite clearly that the wealth effect from the stock market rally (a) has been very important and (b) was one of the things the Fed hoped to provoke with QE2; is it really that hard to believe the Federal Reserve is actually bidding up equities?
That is a really attractive theory, but unnecessary to explain the rallies. I also think that, although in 2008 the Fed cut some corners and bought assets that it was technically not allowed to buy, they took advantage of a clause that gives them much wider latitude when disaster is about to strike. It would be very difficult for the Fed to actually buy equity securities (and where would they hide them?) directly, especially if the world isn’t actually ending. So I’m not on board with this conspiracy although I completely understand that it feels suspicious!
And we don’t need it to explain the rallies. While there is no solid, good reason that stocks ought to rally, there are a number of plausible reasons they could rally, at least a little.
For one thing, there have been some companies beating earnings estimates. To be sure, in some cases these estimates were not very aggressive estimates, but Apple, Intel, IBM, Novartis – there is no question these were beats. The counterargument is that there have also been some big misses – Bank of America’s $8.8bln loss leaps to mind. Cisco is laying off workers, and Goldman missed estimates. Some banks are doing well, but the ones that are beating estimates are doing so mainly on “decreased costs to cover bad loans,” and there is only so long that game can last (especially with Europe about to explode). Then again, the financials are dead money anyway so arguably the market is right to focus on the Apples and the Intels.
The market also got a bit of a goose yesterday from the jump in Housing Starts to 629k, besting estimates. There’s nothing particularly exciting about that in the context of where Starts are (see Chart), but it was a positive surprise.
If all of these housing charts look about the same, it's because they ARE all about the same. Down, then flat.
Counterbalancing this was the weak Existing Home Sales report today; home sales also remain in a range, but inventories rose again.
There was also the glimmering of a deal to cut the deficit and raise the debt ceiling. The outlines of the deal involve a tax hike of around $1 trillion and spending cuts of around $2.7 trillion over the next decade. Does anyone want to place bets as to which of these components will be rolled back next year? Hint: more people benefit from government spending than are hurt by paying taxes, and 2012 is an election year.
Now, I am trying to be generous about the couple of pops we’ve seen recently in equities, but honestly I’m not buying it. There are reasons, and more importantly there are lots of people trying desperately to inflate the importance of those reasons. But the road ahead doesn’t get smoother, rather it grows bumpier.
Thursday brings Initial Claims (Consensus: 410k vs 405k) with the question of whether last week’s surprising drop was the start of a return to lower levels or an aberration from a current run-rate closer to 420k. Economists are voting with their estimates that most of the drop to 405k from 427k, 432k, and 429k the prior three weeks represents real improvement. I think that’s aggressive. Then we have the Philly Fed index (Consensus: 2.0 vs -7.7), with economists suggesting that last month’s drop was a complete aberration and a bounce to near May’s 3.9 is expected. But that would mean that the weak showing from Empire a couple of days ago was the outlier. For both of these data, economists are quite optimistic against pretty weak evidence that they ought to be. I’m all for optimism, but I don’t see the sudden rebound they see.
We’ll also be treated to more Bernanke chit-chat as he testifies on the Dodd-Frank anniversary. Seriously, we’re going to celebrate anniversaries of legislation now?
Some investors say that the stock market could get a spur from Leading Indicators (Consensus: +0.2%). Stone & McCarthy are forecasting 0.5% as a result of the jump in M2. If it is the case that economists haven’t incorporated the rise in M2 into their estimates, there may be a surprise, but market participants don’t generally pay any attention to LEI because the component data – the indicators themselves – have already been released and therefore there is no new information.
But then there’s the niggling detail of the European summit tomorrow, at which a grand plan for saving Greece, or the banks, or the Euro, or all three is supposed to emerge. I find the market’s sanguinity about this summit to be incredible. The Greek Prime Minister has said that his country has sacrificed about all that it can, and that it needs money immediately. European banks and the ECB itself is at great risk if no agreement can be reached, and it isn’t like it’s an easy call. The EU is reportedly discussing using the European Financial Stability Facility to extend credit lines to tottering countries, but that implies there must be a triage debate going on: save Greece, or let Greece go and try to save everyone else, or try to do a little bit of everything. I don’t hear anything that sounds like a solution, although surely tomorrow just after lunch we will hear of some grand plan (or a little plan, made to sound grand). I just don’t know how they can get enough done before they all take off for vacation during the month of August. And I doubt very much that the market will hear the marvelous results it seems to expect.
Right about the time the summit releases a statement, bids will go in for $13bln of 10-year TIPS. The lessening of the cacophony around European bond markets the last couple of days – Greek 10-year yields fell 63bps today; Portuguese yields dropped 64bps, Irish yields 59bps, and Italian yields 14bps – lessens the need to de-emphasize Italy in the global inflation-linked bond indices. The when-issued (WI) 10y TIPS are yielding 0.48% right now. At that yield, I think there will be a pretty sloppy tail although as usual the issue will clean up well once the landscape becomes clearer. In the meantime dealers will be forced to hold a lot of the event risk, and right now holding extra risk is not high on the list of things that the head of the desk wants to do.
Finally, let’s not forget that Thursday afternoon produces the money supply numbers, which have been positively buoyant recently. I expect that we will see some retracement, but the upward surge is now a few weeks old and it may be that no retracement is coming. That would be amazing, and frankly a little scary. The translation of M2 into inflation is not automatic, and it isn’t instant. But it works exactly the same way that it works if there is suddenly a bumper crop of tomatoes so that there are now four times as many tomatoes compared to apples as there were previously. In that case, the price of tomatoes relative to apples will fall. If there is a bumper crop of money, then the price of money compared to apples (and gold, and copper, and coffee, and gasoline, and everything else) goes down – or, since we take the value of money to be constant, the price of those other things will tend to rise.
So this is one thing of which we don’t want any more record harvests. And yet, at the same time, it seems the one crop for which the weather is always perfect. Whatever comes from Europe, it will include more money!
If The Change In Our Pockets Isn’t Enough
I begin to wonder how much more ‘flight to quality premium’ there can be in U.S. Treasury bonds. Today Greek 10-year yields rose 59bps to match the old highs around 17.7%, Italian bonds rose 20bps to a new high of 5.95% (and the 10y BTPei real bonds +33bps to 4.13%), and Spanish bonds rose 25bps to a new high of 6.27%. The dollar rallied (a little), and equities dropped fairly sharply for a day with no news although indices recovered half of their losses by the close (S&P -0.8% and now down for the month after a torrid start).
And Treasuries? Unchanged.
TIPS rallied 3bps to 0.50% on the 10-year issue – I pointed out last week that weakness in Italy could perversely benefit TIPS and other ILB markets – but the real winners on the day were Precious Metals, +2.1%. Are precious metals becoming the new flight-to-quality (FTQ) instrument?
Please, gold bugs, don’t plaster me with hyperventilated assertions that precious metals have always been “the” safe-haven instrument. They have always been “a” safe-haven instrument, but as they are less liquid than Treasuries and much more volatile, they have not traditionally been a flight-to-quality investment for institutional investors. Buying a billion dollars’ worth of gold is not something you can do in ten minutes to hide out for the weekend, but you can do that in T-Bills. Actually, in T-Bills it will take you less than a minute.
Perhaps a more-nuanced answer (that will keep my house from getting egged by “the gold people”) is that while precious metals are not a flight-to-quality instrument for normal crises, they do serve as a FTQ instrument for catastrophic crises, and while we have never really had one of those during the life of this republic, arguably our crises are starting to look less and less normal and more and more catastrophic.
But the simple answer to my hypothetical question is “no,” for the reasons I have just given. But then, what is the FTQ investment these days?
It needs to be something with a stable value (preferably, stable in real space), and part of a deep and liquid market. This is why short-dated Treasuries have historically been the FTQ investment: the market is huge, you can buy and sell a whole lot of them very easily, and for short-dated maturities there isn’t much price risk (because you’re assured of par at maturity). TIPS would be better, because you’d be protected from inflation (albeit with a lag), but there aren’t nearly enough short-dated TIPS to serve the function. T-Bills historically have tracked inflation with a lag and provided a small negative real return; in a crisis this isn’t going to happen since the Fed will tend to clamp short rates at zero and intentionally produced a large negative real yield, but it’s as good as it gets.
However, if the crisis involves the solvency of the U.S., then what?
We don’t have to worry about that yet. T-Bills can trade (and have in fact traded) with negative nominal yields, so there’s always a price at which you can buy some. But the reaction today in fixed-income land despite significant moves in some other markets suggests that investors who are buying Treasuries – especially longer Treasuries – for something otherthan a FTQ reason are already paying a not-insignificant FTQ premium to do so. There are other solutions, but this article is too small to contain them.[1]
The main U.S. contribution to trading intrigue will actually come in the evenings. Kansas City Fed President Hoenig will be speaking on Tuesday night on “Monetary Policy and Agriculture.” As a frequent-dissenter, his speech will be a decent indicator of how tight Chairman Bernanke has pulled the choke-collar with the new communications policy. On Wednesday the head of the NY Fed’s Markets Group, Brian Sack, will be speaking to the Money Marketeers. That’s the group before which, in December 2009, he delivered a great speech (which I discussed and excerpted here) about the effects of large-scale asset purchases on market rates that had one glaring error. I like to call it “Dr. Sack’s Perpetual Motion Money Machine.” Dr. Sack proposed ways to drain liquidity from the market when it was time to do so, and seemed to think that although the Fed pushed rates lower by buying securities (anyway, that was the whole point of it), they wouldn’t push rates higher by selling securities. If that’s true, then the Fed ought to do this constantly, in the largest size they can, because they can add tons of liquidity without any market cost and can drain it at will without ill effect. I discussed the perpetual motion machine here. There is another speech by Dr. Sack that I excerpt here.
Dr. Sack is unusually clear in his exposition, and worth listening to for several reasons. One is that you will usually get something pretty close to the party line; the other is that you’ll probably learn something about how monetary policy works – or how the Fed thinks it works, which is even more useful.
However, I probably shouldn’t beat up Dr. Sack too much, since I will be a presenter myself tomorrow evening (which is the reason I am mentioning Wednesday’s data – I won’t be posting tomorrow). I will be speaking at the NY QWAFAFEW meeting on the topic of “Quantitative Estimation of Inflation Perceptions.” Let me know if you’d like me to come speak to your group about something exciting like that!
[1] A reference to Pierre de Fermat’s teasing theorem in the margins of a copy of Arithmetica. For a wonderful, entertaining, and easy-to-read book about Fermat’s “Last Theorem,” I heartily recommend Fermat’s Enigma: The Epic Quest to Solve the World’s Greatest Mathematical Problem
Page Ten News
On Friday the BLS released the monthly CPI figures, and there was again a little gasp when an 0.3% on Core inflation graced the tape. This month’s 0.254% was only barely rounded higher, but considering that many economists had been expecting last month’s jump in Apparel and other “volatile” core components to be reversed this month, it was impressive nonetheless. The year-on-year figure didn’t quite make it to +1.7% (+1.639%, actually), but this constitutes a second consecutive monthly surprise and the first time that consecutive 0.3% prints in core inflation have been seen since June and July 2008, when the year-on-year rate was 2.5%. Before that, the last time was January/February 2001, when the y/y rate was 2.8%. And before that, you have to go back to March and April 1995 when the y/y rate was 3.2%.
That’s right: in the last sixteen years – 195 months to be exact – there have been exactly three prior episodes of consecutive 0.3% prints in core inflation, and in each of those was a much smaller aberration from the monthly run rate at the time.
Unless, of course, the true underlying run rate of core inflation is not the latest 1.6% print but something higher. For the first half of this year, core CPI rose at a 2.5% pace, and that is with Shelter, ~41% of the core index, rising at only 1.6% annualized.
In Thursday’s article, I promised a chart of core inflation ex-shelter. That chart is below, but I introduce it with a reminder that the reason it makes sense to strip out housing – although I am usually reluctant to strip out one component or another – is that housing was in a bubble through the latter part of the 2000s, and has been unwinding that bubble ever since 2008. It is unreasonable to think that monetary policy operated over a normal range to have much impact on a portion of the economy that is recoiling from a bubble; moreover, while shelter is a large component of consumers’ basket it isn’t what they see every day. Looking at Core ex-Shelter is a good way to get a simple view of broad price pressures that consumers are facing (incidentally, the chart says “Ex-housing”, but it is actually ex-shelter, a subtlety that only matters if you’re an inflation guy or an economist, but I thought I’d make it clear).
The assumptions I’ve made in the projections below are very simple. I assume that core slackens to a 2.0% pace in the second half of the year and Shelter, which has been at 1.2% over the last year and 1.6% in the first 6 months, drops back to a 1.2% pace in the second half. That’s a pace roughly consistent with the current level of housing inventories.
See text for the projection assumptions.
With those parameters, in December core inflation reaches 2.25%, but core ex-housing gets to 3.04%. Obviously, if overall core inflation stays at a 2.5% pace, or if shelter inflation slackens further (as there are some signs it may), the core-ex-shelter number could be even higher. As the chart shows, there has been a general uptrend in core inflation if you take away the housing bubble, since a low not in 2010 but in 2003. That uptrend should reach new 18-year highs this year.
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Other economic data on Friday was also discouraging, although the stock market managed to shrug off all of the bad news and post a nominal gain along with bond prices (the 10y yield fell to 2.91% and the 10y TIPS to 0.54%). The Empire Manufacturing Index, which economists expected to rebound and demonstrate that last month’s swoon was an aberration, instead stayed negative at -3.76 (versus +5.00 expected). The Employment subindex dropped sharply, from around 10 to near flat. Later in the morning, the Michigan Confidence number, which economists expected to rise to 72.2 from 71.5, plopped to 63.8. That is the lowest confidence number since March 2009, the latest in a growing string of numbers to echo that refrain.
The bond rally, then, is easy to understand but why did stocks nudge higher? There were two reasons that the optimists carried the day. The first is that there was news the House of Representatives is planning to vote on a $2.4 trillion debt limit increase, combined with spending cuts, a cap on spending, and a proposed Constitutional amendment to balance the budget. (Most states have such amendments. It isn’t a great idea but it’s like throwing away the cookies if you’re not able to be disciplined about keeping away from the cookie jar.) The presumption is that this is a political gambit by the Republicans to force the Democrats in the Senate to vote against the debt limit increase, thereby highlighting the differences in fiscal responsibility. However, two can play at that game and as long as it stays a game we’re no closer to a deal. I stand by my view, though, that some deal will be reached to raise the ceiling by enough to make sure the Administration doesn’t need to choose whether to pay for essential government services or the bond coupons. It is just too easy to avoid the contrived crash. It would certainly be ironic if we were to put ourselves in the dock rather than waiting until the people who lend us money eventually do it.
The other reason equities rallied is because of the sweet credulity of equity guys. The European Banking Authority announced the results of the latest round of ‘stress’ tests on European banks. Only eight institutions failed (sixteen “just missed”), and only two of those in Greece. That constitutes your hint, because if Greek debt is at risk of default surely every Greek bank would fail, right? It turns out that if Greek debt is in the ‘hold to maturity’ book, rather than the trading book, then it isn’t subject to stress because no amount of economic weakness can cause a sovereign to default. Really.
The stress scenario was to assume an 0.5% economic contraction in the Euro area in 2011, plus a 15% drop in European equity markets and some modest trading losses (around 22 cents from par on Greek bonds) of sovereign bonds not in the hold-to-maturity book. So one way to think about the stress tests is that eight banks failed assuming a garden-variety recession, without an equity bear market, and with Greek bonds rallying about 50% from here (from $0.52 to $0.78). I think it’s fair to assume that those other 16 banks would have failed the test under even slightly more-challenging (or less-political) assumptions.
Bond investors just held their sides and had a good belly-laugh on that one, but equity investors decided the coast was clear and that it was time to stick the head up out of the burrow where they have been all week (similarity to the game “Whack-A-Mole” intended).
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One of the reasons I write this commentary is because I will occasionally be forced to think of something I would not have thought about on my own. Someone on Friday was quizzing me further on why M2 was growing (a topic I discussed last Thursday, then again on Sunday and on Wednesday this week), and asked about whether money leaving the Euro for dollars could be the culprit.
I responded:
“No, because that doesn’t change the amount of money – if you sell Euros and buy dollars, you’re buying them from someone who already had dollars.
“Now, if you’re BORROWING them from someone and lending Euros, then that could increase M2 if it’s a bank lending you dollars. It is possible that more people are borrowing from US banks than from European banks…I never thought of that, but maybe…”
It would be interesting if the relative strength of US banks meant that relatively more lending is being done in dollars because of the Euro crisis. In that case, the Euro crisis would be causing US money supply to expand, and perversely causing US inflation. What a twist that would be! Thanks to the reader who provoked this realization with a thoughtful question.
And by the way, it remains a timely topic since M2 continued its surge thisweek. The 13-week growth rate, which had been 12% (annualized) last week, rose to 14.9% this week. The 26-week growth rate was 7.5% and rose to 10.1%. And the 52-week growth rate, which ordinarily moves in quite staid fashion, rose from 6.3% last week to 7.7% this week. Those are again highest-since-2009 numbers (see Chart).
It almost looks like the money supply chart just hit buy stops.
The recent surge should be disturbing, and it is. But it isn’t yet in investor consciousness yet. It’s page 10, moving forward I think. And that means I am waiting for the debt ceiling deal to be announced, and hoping that it gets announced before M2 moves to page 1. I think I want to be short bonds when it gets to page 1.
Deflation Fears Are A Distant Memory
A whirlwind of data this morning left the market undisturbed. Retail Sales and PPI came in as-expected; Initial Claims was stronger-than-expected by 10k, but last week was reviser weaker (higher) by 9k so that was a wash as well. The trajectory of Claims looks better, with today’s 405k the best number since April, but we would need a few more weeks of such improved data to say that things are moving in the right direction again. I’m not terribly optimistic that one week below 420k augurs great improvement, especially with seasonal adjustment issues around auto re-tooling, but we can always hope.
More newsworthy, but only just, was Bernanke’s reprisal of yesterday’s Monetary Policy Report to the Congress, in front of the Senate today. In Q&A, the Chairman clarified that the fed is “not proposing anything today” including explicitly a new round of QE. Somehow, people had gotten the wrong idea from the headlines yesterday, and from CNBC. I don’t think that was unintentional except in the sense that to shill for stocks is reflexive for many of these observers. But there wasn’t much room for doubt around Bernanke’s statement today, and equities fell partly as a result (more below about why QE3 becomes increasingly unlikely as time passes, absent a major calamity).
Bonds fell too. Partly, this is a reaction to heavy supply which had previously been taken up by the Fed; dealers now actually have to find real buyers for the stuff and typically it helps to mark something down to sell it. We will see how long it takes for buyers to be truly saturated, but it may take a while.
TIPS buyers also got markdowns today with the 10y TIPS selling off 9bps to 0.61% after the Treasury announced that it will auction $13bln of a new 10y security next week. That wasn’t a huge amount when the Fed was sucking them up regularly but again, it helps to mark ‘em down if you’re going to sell ‘em. I am not terribly worried about either nominal or real U.S. debt markets right now.
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The biggest concern to me about tomorrow’s CPI is that right now, beforethe data comes in, the trajectory of core CPI is already exceeding the projections of all of my models. Last month’s 0.287% rise in core was the highest monthly figure recorded since 2006, and has helped produce the most looking-like-a-trend chart in inflation in a long time (see Chart).
Chop, chop chop...until the last 9-12 months!
I mean, look at that chart! Ordinarily the month-to-month wiggles are mostly noise. The last 9 or 12 months’ worth of data almost look like they come from a different series. It is therefore very hard to immediately dismiss this move higher. As I pointed out last month, too, all of the subcomponents of CPI accelerated their Y/Y prints except “Other Goods and Services.” So there are some reasons to be concerned that there may be something going on here.
That sense will be greatly enhanced with another 0.3% on core CPI tomorrow. The consensus looks for 0.2%, but an unblemished 0.2% (as opposed to an 0.155% that merely rounded higher) would also push the year/year core CPI to 1.7% (economists are hedging their bets by expecting a 1.6% y/y core CPI along with an 0.2% monthly, so they’re effectively calling for a “soft” 0.2%).
By the way, even if the 0.3% turns out to be an aberration and we see 0.15% for the balance of the year, be aware that because of base effects – that is, core price inflation the second half of last year was extremely soft – such a performance would result in y/y core inflation reaching 2.3% by the end of the year. If we get 0.2% each month, we’ll be at 2.7% by the end of the year. This is the context to keep in mind when you’re thinking about the likelihood of QE3. QE2 was issued into the teeth of what the Fed knew was likely to be very low core prints for a few months in late 2010. But QE3, if it were to happen this year, would happen with core inflation already scripted to be well above target by year-end.
Now, it is also possible that sagging home prices could pull down rents, which in turn keeps a lid on core CPI. One of my models considers housing separately and produces a soft forecast as a result (but the forecast is still more or less in line with my other models overall). But this is hardly encouraging, since it would mean that deflationary pressures in one part of the economy are masking inflationary pressures in the rest of the economy. Or, to put it another way…core inflation, ex-housing, is likely to approach or exceed 18-year highs by the end of the year. I will run that chart in my post-CPI article tomorrow (or Sunday, depending on my ambitiousness tomorrow).
As core inflation moves almost inexorably higher, driven by secular pressures of debt and monetization, the inflation market itself has begun to back away from forecasts of high medium-term inflation. The chart below shows the core inflation implied in the quotes of 1-year inflation swaps (which are structured on headline inflation, but from which I have extracted implied energy inflation). When implied core was over 2.5%, it was clearly mostly pricing tail risk; now that it is at 1.6% it seems like it is pricing tail risk in the other direction!
Implied Core CPI from inflation swaps for the next year is only 1.6% or so.
Also out tomorrow is the Empire Manufacturing figure, which shocked everyone last month by plunging to -7.79 from 11.88, versus expectations for 12.0. The consensus call this month is for a bounce all the way to +5.0, in effect suggesting that the dip was a seasonal aberration or temporary effect. Industrial Production (Consensus: +0.3%) and Capacity Utilization (Consensus: 76.9%) are not too important. The Michigan Sentiment figure (Consensus: 72.0 vs 71.5 last) has been quite stable at a low level for a while.
The backdrop for fixed-income continues to be poor, but the wildcard of a budget deal which will happen sometime in the next two weeks make it hard to argue for putting on shorts. Equities too will face trouble rallying if investors keep trying to lean on improvement in Europe – which appears to be shifting back into reverse – and the possibility of QE3 which the CPI figures will soon squelch. Implied volatilities have been rising; even though the S&P has fallen less than 1% since Monday, the VIX has risen from 18.39 to 20.80. I think that fear is justified.
