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Quarterly Inflation Outlook
For today’s column I’m going to do something a little different. What follows is the Quarterly Inflation Outlook for Enduring Investments. This outlook is ordinarily only available to clients of Enduring Investments, but I am releasing it (a week or two after our clients received it) to a broader audience who may be interested in learning more about EI’s consulting or investment management services. You may do so by contacting Enduring Investments here.
Note that this post may not be redistributed without the preceding explanatory paragraph attached. The information below has been reformatted to conform to blog standards, but the information itself has not been changed.
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Quarterly Inflation Outlook (Q3, 2011)
This quarterly report is intended to give our clients and select prospects an overview of the economic and financial conditions as they relate to the possibility for an acceleration or deceleration of inflation.
This is the first “issue” of the quarterly report, and we recognize that it is very much a work-in-progress. Future reports may very well have a different form entirely. We welcome feedback on the form or content of the report, and as always we encourage questions about how our strategies should fare in certain conditions such as, but not limited to, those we discuss here.
This document is not intended to provide investment advice but rather presents our analysis of macroeconomic factors that could impact investment returns and our perception of current conditions. The relationship between this analysis and investment advice tailored for you is not addressed in this document, and you should consult us or another competent advisor for a more personalized discussion of your particular circumstances and needs.
Current Conditions and Trends
The data presented below was collected on August 18, 2011 and is complete as of that date. It incorporates the CPI report that was released on August 18th.
Table 1 – Headline inflation is topping out for now, but Core and Median continue to rise.
|
Latest |
1m ago |
2m ago |
3m ago |
6m ago |
12m ago |
|
|
CPI Y/Y |
3.6% |
3.6% |
3.6% |
3.2% |
1.6% |
1.2% |
|
Core Y/Y |
1.8% |
1.6% |
1.5% |
1.3% |
1.0% |
0.9% |
|
Median Y/Y |
1.8% |
1.6% |
1.5% |
1.4% |
0.8% |
0.6% |
Table 2 – Surging money supply has buoyed gold but other commodities have lagged.
|
Annualized rate of change since |
||||
|
Level |
1m |
3m |
12m |
|
|
M2* |
9.5167 trln |
28.9% |
22.4% |
10.1% |
|
Gold |
$1,818.90 |
13.5% |
21.6% |
47.9% |
|
Crude |
$82.38 |
-14.1% |
-17.7% |
9.2% |
|
Retail Unleaded |
$3.585 |
-2.5% |
-8.2% |
31.3% |
|
DJUBS Softs |
201.2854 |
4.6% |
2.7% |
61.3% |
|
DJUBS Grains |
127.0283 |
0.0% |
-5.6% |
27.0% |
|
DJUBS Livestock |
72.1282 |
-1.7% |
0.9% |
-3.4% |
|
DJUBS Industrial Metals |
360.4857 |
-9.3% |
-6.6% |
7.9% |
|
DJUBS Spot Index (all) |
157.0895 |
-4.2% |
-3.6% |
18.2% |
|
Dollar Index |
74.254 |
-1.6% |
-1.6% |
-9.7% |
*Changes for M2 are annualized. All others are changes over the period indicated.
Table 3 – Rates have declined to unprecedented levels while stocks have recently fallen sharply.
|
Now |
1m ago |
3m ago |
1y ago |
|
|
S&P 500 |
1140.65 |
1305.44 |
1340.68 |
1094.16 |
|
3m Tbill Rate |
0.003% |
0.008% |
0.041% |
0.155% |
|
10y Note Rate |
2.063% |
2.929% |
3.181% |
2.634% |
|
10y TIPS rate |
0.011% |
0.511% |
0.776% |
0.996% |
Table 4 – Most subcomponents of CPI are accelerating.
|
Weights |
Y/Y Change |
Y/Y Change (3 mo ago) |
Acceleration/Deceleration |
|
|
All items |
100.0% |
3.629% |
3.164% |
0.465% |
|
Food and beverages |
14.8% |
4.001% |
3.057% |
0.944% |
|
Housing |
41.5% |
1.453% |
0.975% |
0.478% |
|
Apparel |
3.6% |
3.056% |
0.068% |
2.988% |
|
Transportation |
17.3% |
11.980% |
11.791% |
0.189% |
|
Medical care |
6.6% |
3.199% |
2.866% |
0.333% |
|
Recreation |
6.3% |
-0.173% |
-0.363% |
0.190% |
|
Education & communication |
6.4% |
0.982% |
1.004% |
-0.022% |
|
Other goods and services |
3.5% |
0.847% |
1.931% |
-1.083% |
Inflation Is Broadening
Even as financial markets shudder from the European sovereign solvency crisis, which calls into question even the very survival of the Euro itself, inflation indications continue to accelerate. Core inflation has tripled since reaching a low in October of 2010, and shows no signs of abating. As Table 4 shows, approximately 90% of the CPI is inflating faster over the last 12 months (July 2010-July 2011) than over the 12 months ending three months ago (April 2010-April 2011).
There are other indications that the inflation process is taking hold at a fundamental level and that this latest rise in core inflation is not a temporary event. The chart below shows core CPI inflation and the Cleveland Fed’s “Median” CPI (also included in Table 1). Since the lows, these two series have moved in lockstep, which is very unusual.
When the median of a distribution equals the mean of a distribution, it typically implies a balanced or symmetrical distribution (it is the case that a symmetrical distribution has a mean and median that are equal; it isn’t mathematically the case that having a mean and median that are equal necessarily means the distribution must be symmetrical. However, it is a reasonable inference).
A more-balanced distribution increases the probability that the main forces on prices are acting uniformly on them. When there is no systematic inflation, prices ebb and flow according to supply and demand interactions in thousands of individual markets. But when the prices begin to move more in unison, we start to get suspicious that there is a larger macro force at work. Picture a large harbor. If some boats are riding higher in the water than others, you may reasonably surmise that it is because they carry different burdens of cargo. But if all of the boats started to rise, you might reasonably suspect that the tide is coming in.
And the tide is certainly coming in. In a section below, we will discuss the money supply in more detail, but the numbers in Table 2 are plain. Over the last three months, M2 money supply has expanded at an annualized rate of 22.4%; over the last year, it has grown at a rate faster than 10%. That is the rising tide that is raising the pricing boats.
Core inflation is as low as it is, in fact, only because the housing market is coming off an epic bubble. The deflation in the housing market has pressured rents lower and as you can see from Table 4 Housing is more than 40% of the consumption basket of the average consumer. It has an even higher weight in core inflation, and this part of the basket has been artificially restrained by the aftereffects of the bubble. In this circumstance, it is reasonable to consider how fast prices are rising in the rest of the non-food non-energy economy. The chart below answers that question. It shows Core CPI as-reported, and then shows what Core CPI would be if Housing was inflating at the same rate as the rest of the basket. Without housing, core inflation would already be over 2% and, on base effects alone, should be approaching 3% by the end of the year. This clearly indicates that inflation is not only a threat, it is significantly here already.
Misguided Fed Policy
At its meeting on August 9th, the Federal Reserve committed to keep interest rates “exceptionally low” until at least mid-2013. Minnesota Fed President Kocherlakota, who dissented from the decision, clarified the statement a few days later by saying
This statement is designed to let the public know that the fed funds rate is likely to stay between 0 and 25 basis points over the next two years, not just over the next three to six months.
The explicit nature of the promise is interesting. It means that even if inflation starts up, the Fed cannot move rates for two years (unless it wants to permanently lose this as a tool, since if it reneges after one year and hikes rates, no one will ever trust them at their word again). [Editor’s note: the minutes from that FOMC meeting recently revealed that the Fed intended to get the benefit from that promise without that promise being binding, but this wasn’t clear when the report was written. But the following statement remains true.]
It is a policy error, with some chance of becoming a colossal policy error. The Federal Reserve is selling an option, by which we mean they don’t gain very much if it turns out to be the right thing to do (after all, they could always have kept rates down without a promise to do so), but they lose an enormous amount if it is a mistake since either reneging or letting inflation gallop away would be a disaster for the institution.
A generous interpretation of the policy might be that the Fed would actually welcome a little bit of inflation, since somewhat higher prices would help reduce the real burden of nominal debt. However, the central bank cannot ordinarily countenance higher inflation without losing credibility. The Bank of England is having precisely that problem now, as they let inflation run higher than their target rate without wrestling it back lower (obviously, they’re doing so because to wrestle it lower would require restrictive monetary policy, which the BoE believes the economy cannot afford). If we want to be generous to Chairman Bernanke, we can suppose that the Fed is intentionally shackling itself so that it will not lose as much credibility when it fails to respond immediately to inflation. Indeed, the central bank in such a circumstance could conceivably gain credibility by sticking to its promise.
From the standpoint of an investor, who needs to consider the possible inflation outcomes, the Fed policy is very bad. It creates the possibility of a long “tail” to higher inflation that the FOMC would be powerless to address; such outcomes are of course bad for the investor who has not taken steps to guard fully against inflation.
The Money Conundrum
It may turn out that the timing of this Fed policy was also exquisitely poor. Over the last few weeks, the M2 money supply has begun to surge (as noted above).
For some time, our fear has been that the enormous quantity of reserves that the Fed pumped into the system over the last three years would not remain relegated to relatively sterile bank reserves. Because the Fed pays interest on these excess reserves, the money it has pumped in has not circulated through the economy, and remains sitting on in excess reserves where it does not place direct pressure on prices since it is not in circulation to support transactions. The chart below shows Excess Reserves at Depository Institutions, which currently stand at $1.6 trillion. Almost every dollar the Fed has spent to increase its balance sheet has gone straight into the vaults (metaphorically) of banks, and not into the economy. This was by design, since the Fed wanted banks to have a bigger cushion more than it wanted to flood the economy itself with liquidity (had it wanted the latter, it needed only to eliminate paying interest on excess reserves and the money would have entered the economy quickly).
The M2 money supply represents the money actually used for transactions in the economy. Currently, the stock of money stands at $9.5 trillion. You can see that the Excess Reserves, if they entered fully into M2, would increase it some 16.8%. But that understates the risk, because reserves that are translated into M2 typically do so at a multiple called the “money multiplier.” In early 2008, every dollar of “base money” supported $9 of M2. If that ratio were to return, then the extra $1.6 trillion would translate into about $14.4 trillion, increasing M2 by more than 150%. That clearly is highly unlikely, but it points out the scale of the risks. These are the variables that the Fed is toying with.
Money matters because monetary theory says MV≡PQ. That is, by definition the amount of money in circulation, times the number of times it is spent in a year, is the total amount of money spent in a year. That’s the left side of the equation. The right side of the equation is national output, which is the price level times real output – or in simple terms, the price of stuff times the amount of stuff that is produced and sold every year. Since the dollar amount of stuff bought (the left side of the equation) must equal the dollar amount of stuff sold (the right side of the equation), we have a clear relationship between money (M) and prices (P). Specifically, with some simple algebra, P≡MV/Q. If real output is fairly stable, say plus or minus 5%, and velocity is stable, then an increase in M causes a direct increase in the price level. And that’s why we need to watch developments in the money stock very, very closely.
Recently, there was an alarming development in that metric. M2 money supply started rising fairly dramatically and without the Fed doing anything in particular to stimulate it. The chart below shows the 52-week change in the M2 money supply. As shown in Table 2, M2 money growth has been surging at a nearly 30% rate over the last month, and more than 20% over the last quarter. This has pushed the 52-week rate of change to levels not seen since the early 1980s, except in rare circumstances when the Federal Reserve was very consciously trying to add liquidity – in the aftermath of 9/11 and during the credit crisis. The fact that this is happening with no Fed intervention at all is incredibly unsettling.
So what is happening with money? One theory is that the instability of the banking system in Europe has caused investors and savers to transfer money balances from Euros on deposit in European banks to dollar deposits in U.S. banks. Also, since many money market funds hold European bank commercial paper, investors with large investments in money market funds have been reportedly withdrawing those funds to put them on deposit in U.S. banks.
There is some support for this hypothesis. Not only does the breakdown of the money supply numbers illustrate that much of the growth is in demand deposits and large time deposits, anecdotal evidence exists such as the fact that Wells Fargo recently announced a policy of charging interest to large, new depositors – in effect, paying negative interest rates on savings accounts.
What is unclear is whether that matters. If money merely sits in bank accounts, and the investor has no intention of spending the money, then it manifests as a rise in the money supply and an offsetting decline in the velocity of money balances – so that essentially MV remains unchanged. In crisis, this is not a ridiculous hypothesis. Perhaps the money that is accumulating is toothless, and we needn’t worry about the inflationary implications.
It is possible, but we believe that even if this is the case, the violent moves in M2 illustrate that the Federal Reserve would face a very difficult task navigating through these waters even if it had not lashed the wheel. This implies to us that inflation markets are worth a premium at this time.
Valuations
Ironically, while the rise in M2 and other events point up the increasing risks of an inflationary outcome when all central banks are biased towards adding too much liquidity rather than too little, investors have begun to discount inflation markets because of growth fears. We believe there is very little evidence to indicate that growth causes inflation and that a lack of growth causes deflation. Indeed, there are myriad counterexamples, such as the 1970s in the U.S. when we had inflation and stagnation simultaneously…or the last several years, when prices continued to rise even though there was (and continues to be) a vast output gap.
Consequently, while inflation-linked bonds are expensive on an outright (real yield basis), they are inexpensive by recent standards compared to nominal bonds. Investors in nominal Treasury securities will outperform TIPS investors for only a very small range of potential future outcomes. Moreover, your risk in inflation-adjusted terms is dramatically lower when you hold inflation-linked bonds. You can’t ‘blow up’ if you buy TIPS and don’t get inflation; your worst-case in a 10y TIPS bond at the moment is a zero nominal return if there is no inflation at all, or net deflation, over ten years. On the other hand, you can completely ‘blow up’ if you buy nominal bonds and encounter, say, 5% inflation over the next ten years. So while TIPS are very expensive on a real yield basis, we believe they are superior to nominal bonds at these levels.
Commodities, which naturally have a zero real yield over time, typically do very well when real yields are very low (and thus other asset classes are less competitive. Our models continue to indicate that a very high weight in commodities is appropriate.
The table below shows our expected 10-year compounded real return expectations for five major asset classes.
Table 5 – Projected 10-year annualized real returns and risks
|
Real Risk |
Real Return |
|
|
TIPS* |
2.66% |
0.01% |
|
Nominal Govts |
6.00% |
-0.29% |
|
Cash |
3.74% |
-0.50% |
|
Commodities |
13.45% |
3.30% |
|
Equities |
14.96% |
3.19% |
*Note that if held to maturity, TIPS have no risk in real space.
These risks and returns are plotted below. Note that the assets fall in a low-risk and a high-risk barbell. In the low-risk bucket, TIPS are the cheapest asset despite being priced to yield essentially nothing after inflation for ten years. In the high-risk bucket, commodities are still superior to equities although if the equity market continues to decline, dividend yields continue to increase, and valuation multiples continue to improve, they will become more attractive. The slope of the line implies that for an additional 1% of expected real return for ten years, an investor must accept an increase in risk of 3.07 percentage points.
Disclaimer
Information included in this report was collected from sources believed to be reliable but no warranty either express or implied is made with respect to its accuracy or completeness. The analysis and conclusions are the responsibility of (and property of) Enduring Investments.
Fed To Business Cycle: Do You Feel Lucky?
When the facts change, I change my mind as any good trader should (and the best traders furthermore define “facts” as “anything which other people will think is important”).
I have been saying that I think QE3 is unlikely, at least in the form of another Large-Scale Asset Purchase (LSAP). The reason for this is simple: QE3 makes no sense. In retrospect we can see that it had no lasting effect on growth. Anticipation of QE2 pushed commodity and equity prices higher (see Chart), but most of the equity gains had vanished by the lows this month (and, anyway, if higher prices don’t trigger growth through a “wealth effect,” as they evidently didn’t, then who wants equities to trade at liquidity-induced richness? Rationally, only retirees and other dis-savers who are net sellers.)
Stocks and commodities normalized to August 27th, 2010.
Indeed, as has been well-documented most of the LSAP money went into excess reserves, where the Fed paid banks to keep it, and money rates sank to sharply negative real rates. And it isn’t like the LSAP was without cost. A central bank which buys the net debt of the sovereign issuer is de facto monetizing, and the precedent is dangerous. In short, there are a whole lot of reasons to think that QE2 was a net zero or negative, and really no good reasons to think the effects were salutary. Why in the world would a rational central bank think about doing it again?
And then the FOMC minutes from the August meeting were released today. In contrast to the vast majority of the scores of such minutes that I have read, this one contained some dramatic revelations.
The ones that got the most airplay today were the ones related to QE3, of course. As we already knew, participants at the meeting had “discussed a range of policy tools available to promote a stronger economic recovery in a context of price stability,”[1] because the statement released after the meeting said so. What we didn’t know was the range of tools discussed and the relative credence given to each of them. This passage is the key one (my comments in brackets throughout):
Participants discussed the range of policy tools available to promote a stronger economic recovery should the Committee judge that providing additional monetary accommodation was warranted. Reinforcing the Committee’s forward guidance about the likely path of monetary policy was seen as a possible way to reduce interest rates and provide greater support to the economic expansion; a few participants emphasized that guidance focusing solely on the state of the economy would be preferable to guidance that named specific spans of time or calendar dates. Some participants noted that additional asset purchases could be used to provide more accommodation by lowering longer-term interest rates. Others suggested that increasing the average maturity of the System’s portfolio–perhaps by selling securities with relatively short remaining maturities and purchasing securities with relatively long remaining maturities–could have a similar effect on longer-term interest rates. Such an approach would not boost the size of the Federal Reserve’s balance sheet and the quantity of reserve balances.[This is ‘Operation Twist.’ It seems to be an article of faith that lower long-term rates would boost activity although we already have record-low long-term rates.] A few participants noted that a reduction in the interest rate paid on excess reserve balances could also be helpful in easing financial conditions.[As I have been saying for a while, for example here and here, and I still think they ought to do this before blasting away any more on LSAP.] In contrast, some participants judged that none of the tools available to the Committee would likely do much to promote a faster economic recovery, either because the headwinds that the economy faced would unwind only gradually and that process could not be accelerated with monetary policy or because recent events had significantly lowered the path of potential output.[I would love to know which participant said the process could not be accelerated with monetary policy. Hawkish or dovish, almost all Fed officials at least share a cultish faith in the almost-magical efficacy of monetary policy. It’s the membership card you have to present to get in!] Consequently, these participants thought that providing additional stimulus at this time would risk boosting inflation without providing a significant gain in output or employment. [Exactly! I know that saying ‘exactly!’ doesn’t add any analysis but I am so flabbergasted to hear this from even an anonymous person at the Fed that I had to say it.] Participants noted that devoting additional time to discussion of the possible costs and benefits of various potential tools would be useful, and they agreed that the September meeting should be extended to two days in order to provide more time.
So, the Fed is considering more LSAP, LSAP with a twist, lowering IOER, or doing nothing. It seems they are biased against doing nothing; ergo, they will eventually do something if economic data suggest (at least to them) that it is warranted. I want to point out that before Greenspan became Chairman, we recognized that business cycles happen and that the central bank’s main job – as they learned in the 1970s – was to moderate the growth in the price level (i.e., inflation). Then Greenspan ascended the throne, and declared war on any kind of recession. Every crisis was met with massive (or what we used to think was massive) monetary stimulus. Now, apparently, the Fed believes that they need to add tremendous liquidity just because growth is below potential. Don’t we all see that as madness? Either that, or they’re preparing to add tremendous liquidity because they perceive a recession is likely, as do I…but in that case, shouldn’t they be even more skeptical of the usefulness of adding liquidity, since such a recession would be occurring despite QE2?
But there is no doubt that the leadership of the Fed is in love with printing. This is just nuts, but I now believe that we’re likely to see QE3 (although I would be surprised to see it as early as September, the minutes really do open up that possibility – so maybe I was wrong and Bernanke last week really did mean to hint at it).
Even more dramatic was the passage about the low-rate pledge. The Fed at this last meeting changed long-standing policy and stated that economic conditions “are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.” I noted here that linguistically, the statement is a mess. The words “are likely” are a statement of probability, which is inconsistent with the absolute “at least” in the time frame. Analysts clearly thought it was a promise, and Minnesota Fed President Kocherlakota made clear on the Friday after the meeting that “exceptionally low” meant 0-0.25%, not something that could be a little higher. Logically, if it was not a promise, then it was vacuous. If “we’re going to keep rates low, unless we want to raise them” was what they meant to say, then they wasted everyone’s time.
But now we see that that’s exactly what they meant. In the passage below I’ve put the critical part in bold:
In choosing to phrase the outlook for policy in terms of a time horizon, members also considered conditioning the outlook for the level of the federal funds rate on explicit numerical values for the unemployment rate or the inflation rate. Some members argued that doing so would establish greater clarity regarding the Committee’s intentions and its likely reaction to future economic developments, while others raised questions about how an appropriate numerical value might be chosen. No such references were included in the statement for this meeting. One member expressed concern that the use of a specific date in the forward guidance would be seen by the public as an unconditional commitment, and it could undermine Committee credibility if a change in timing subsequently became appropriate. Most members, however, agreed that stating a conditional expectation for the level of the federal funds rate through mid-2013 provided useful guidance to the public, with some noting that such an indication did not remove the Committee’s flexibility to adjust the policy rate earlier or later if economic conditions do not evolve as the Committee currently expects.
So…vacuous it is! The Fed was probably never going to tighten before late 2012 anyway, and the promise to make it 2013 depends on whether they’re right about the economy and inflation. Since they haven’t been right about the economy since Marmaduke was a pup, that isn’t much of a promise.
The FOMC statement was, to me, the most startling part of the day. That is even though it had strong competition today from a truly-abysmal Consumer Confidence figure. Confidence plunged to 44.5, the lowest since early 2009 (see Chart). Among other things, this means that the current economic situation now clearly belongs to the current President even if the last President owned the 2008-09 debacle. At least, consumers experiencing a renewedsense of discouragement are not likely to attribute much of that sense to President Bush. At this point, the Republicans could nominate a ham sandwich and comfortably win the election (and there is some chance they may do so), although of course there is a long way to go until election day 2012!
Consumer Confidence is plunging. Again.
This isn’t a political column, and that observation has market consequences: a desperate Administration is likely to propose increasingly dramatic programs similar to the ones which have provided short-term boosts followed by payback dips thereafter (e.g., Cash for Clunkers). These sorts of programs have drawn increasingly skeptical market responses for each one in sequence, as investors have grown tired of both the borrow-and-spend approach and the intensifying conflict that each one engenders on Capitol Hill.
But the jaw-dropping headline decline was actually exceeded by the rise in the “Jobs Hard to Get” subindex, which historically co-moves with the Unemployment Rate (see Chart). “Jobs Hard to Get” is now just barely shy of the highs from late 2009, when the Unemployment Rate hit 10.1%.
Payrolls and Jobs Hard to Get
That doesn’t mean that the Unemployment Rate on Friday will rise dramatically. The ongoing decline in the labor force as discouraged workers exit is depressing the measured ‘Rate. But the direction seems clear.
Less urgent, but also worth noting, is the fact that Italian 10-year yields are again comfortably over 5%. The ECB had drawn a line in the sand there and appears to be comfortable letting that market slide, but the slide could easily turn back into a rout – keep an eye on it. Spanish yields have also been rising, but not quite as much. Greek yields of course remain near the highs, despite the merging of two large bankrupt institutions to form a larger bankrupt institution (for the life of me I can’t understand why two drowning people grabbing each other is helpful to either of them).
Commodities prices, led by energy and industrial metals, reached the highest levels of the month. Along with bad growth data (in the form of Confidence), we get higher commodities prices – a good reminder that commodities prices can go higher even if growth is poor. I keep saying it, and some people keep scoffing. But they’re not scoffing in the inflation swap market, where the 1-year inflation swap rose 20-25bps today. The short end of the inflation curve had been very cheap, as I pointed out as recently as last week. It is much closer to fair today!
Tomorrow is unlikely to hold such drama (knock on wood). But the ADP Employment number (Consensus: 100k vs 114k last) ought to be weak. Expectations for the Chicago Purchasing Manager’s report (Consensus: 53.3 vs 58.8) should make it harder to surprise on the downside; a consensus print would be the lowest reading since late 2009 and reflect a nearly-stalled manufacturing sector in the Chicago area.
[1] Despite the fact, I will note, that no policy tool has ever been proven to promote a stronger economic recovery in the context of price stability, and the most-recent experience would seem to suggest that consumers are not terribly subject to money illusion – a necessary condition for growth in the money supply to contribute to real growth.
Less Convincing
New York, and much of the East coast, is picking up after Hurricane Irene. While the hurricane itself delivered less punch than it was expected to, it was enough to cause serious disruption in the pace of everyday life – and in the financial markets. New Jersey Transit was inoperable on Monday, which means that most of the Wall Streeters who live in New Jersey probably took it as a ‘snow day.’ Connecticut was hit harder by the storm. In the entire commuting region, in fact, there was a lot of cleanup to do.
So, relieved of the adult supervision, the stock market jumped.
I never know how to think about huge moves on very thin volume when many of the main traders are out. These happen at the end of the year sometimes as well. It is of course a bad approach to pay extra for liquidity when it isn’t necessary, and bid up a market that will probably still be there tomorrow. Are the bulls (in this case; it isn’t always the bulls, though) so impatient to get long that they would lift any price today? The S&P rallied 2.8%, and the NASDAQ – which has more of the smaller stocks that hedge funds like to manipulate into month-end – was up 3.3%. Volume, despite the large gains, was only 870mm shares (and nearly one-third of that came in the final ten minutes).
It may be that bulls are that anxious to get long. Bloomberg today had a headline “U.S. Stocks, ‘Massively Undervalued’ as Gold Gets Bubbly.” The description comes from a report from a little-known firm; apparently, to get on Bloomberg’s “TOP” news you just need to be really strident about being bullish. Now, for stocks to be “massively” undervalued, considering they’re only 12% below the highs of the last several years, this firm must have believed in May that they were already considerably undervalued, and none of the intervening information – weak economic data, the end of the Fed’s QE2, the collapse of Greece, and so on – changed the fundamentals enough to matter. I’m assuming here that “massively” undervalued is at least, say, 30-40%? I suppose that if you think stocks are undervalued by that much, then you might buy aggressively today so as not to miss the rally. Then again, if you think that stocks are undervalued by that much, you’re probably already quite long. From, for example, May.
I do confess to my own sense of frustration, although it isn’t acute yet. Stocks are too strong to aggressively short, and bonds seem to be as well. Moreover, the fixed-income market is coming into the strongest seasonal period of the year, and as a rule I need a darn good reason to get short bonds in September. I don’t have such a reason, although I suspect that 2011 is not going to be typical and we will see rates rise. It’s just hard to position for that right now.
One factor supporting stocks and TIPS, in the short run, and serving as a negative for bonds, is the fact that the ECB’s stance on inflation (according to President Trichet) is going to be “reassessed” by the ECB. Previously, the ECB was tightening into a financial crisis, which was insane (as I pointed out here among other places). While the inflation risks haven’t receded in the slightest, by pointing at headline inflation and saying that they have receded, Mr. Trichet can back off of his prior cuckoo stance and avoid repeating the errors of the 1929-30 Federal Reserve. Earlier this month, the ECB was pumping liquidity into the banking system in the form of LTROs and MROs “as long as needed,” which wasn’t consistent with the hawkish stance of policy; so, it is necessary to adjust the hawkish stance of policy.
All of the world’s major central banks are now providing easy money with inflation on the rise. Let me repeat that: all of the world’s central banks are now providing easy money with inflation on the rise. It is therefore not surprising to me that TIPS yields are only 0.19% at the 10-year point (though that’s too expensive for me), or that equities are having trouble going down since many investors believe that inflation is good for stocks. But I sure don’t understand why 10-year note yields are at 2.27%!
After mulling it over for a while, I think that the rally today is unconvincing. I wouldn’t spend a lot of time mulling it over except for the fact that technically the S&P settled above the high from mid-August, and that suggests further upside. If the S&P hadn’t finished on a technical break, I’d probably be interested in getting short against that level. But a marginal break on extremely light volume is not where I want to jump on board! I may still be proven wrong and see the indices move to new highs, but I still think the low for the year has not been set.
The data calendar is not going to be kind to stocks or bonds. Tomorrow Consumer Confidence for August (Consensus: 52.0 from 59.5) ought to decline to a 10-month low. Of more interest to me is whether the “Jobs Hard to Get” figure (last at 44.1) rises appreciably. If confidence falls, but Jobs Hard to Get doesn’t rise much, then that will blunt the impact of falling confidence. Also tomorrow the minutes of the FOMC meeting will be released at 2:00ET. Since this meeting appears to have been contentious, it will make for interesting reading. Remember that many investors believe QE3 has been effectively promised for late September. I think that the minutes will dent those hopes, and that will tend to steepen the yield curve and drive rates generally higher.
Maybe a tactical bond short isn’t such a bad idea after all.
An Obvious Metaphor
When an obvious metaphor presents itself, I’m just not big enough to turn it down. As I write this, a hurricane is bearing down on Wall Street.[1]
This is one we have seen coming for a while. Prudent people know what to do – clear the beaches, prepare the emergency kit, and get ready to ride out the storm. Some less-prudent people make dinner plans and will scurry home just before the scheduled arrival of Irene. And some crazy ones are always shown on the Weather Channel: usually, surfing.
Investors are the same way. We have seen the storm coming for a while. Prudent people have canceled aggressive investment plans, hunkered down; some people figure they can get out just before the worst of it hits, and a few people are running towards the disaster with surfboards.
I marvel at the modern miracle of satellite imagery and weather forecasting. We’ve literally seen Irene coming for a week. It’s hard to think back to when it wasn’t that way. But it wasn’t so long ago when the early warning system was a few hours at best, and you couldn’t tell the difference between a bad storm and a Category 3 hurricane until it arrived. People lived differently then, more conservatively. Boats headed to shore when bad weather was coming, rather than try to guess whether it was something they could ride out. Storm shutters were closed before it was absolutely necessary to do so. Your safety relied on your conservatism. Nowadays, we know exactly when to batten down the hatches, to within a couple of hours. I think that means that today, we get more done, thanks to modern meteorology.
It is important to remember that meteorology is still an inexact science although it is vastly advanced from the ‘old days’ when your best defense was having an experienced weatherman like Harold Taft at your disposal. At times, like right now, it looks like the worst of Hurricane Irene might miss us, and the storm’s violence is lessening faster than forecasters expected. This is ironically when the storm is the riskiest, because there is a tendency to relax. “Maybe I won’t put tape on the windows after all.” “Maybe it would be okay to drive to Grandma’s for dinner.” But storms also re-strengthen, and they change headings. They don’t always hit where they are supposed to. This happens far less often than it used to, but it still happens sometimes.
Financial forecasting has progressed far less than has meteorology, and yet investors – encouraged by the Federal Reserve’s cult of economists – seem to regard forecasts of warm and sunny weather as a sufficient reason to cast caution to the wind. Investors today protect themselves much less than our forebears did. Dividend yields until the middle of the last century were always above bond yields, because stocks were perceived as riskier. Now, investors believe they are more-sophisticated, and can operate with narrower margins of safety. Although they still occasionally get blown away by a sudden Hurricane Enron or Flash Crash, they view these as isolated events and not part of the unavoidable fabric of riskiness of financial markets.
We are in the midst of a financial crisis that started in 2008-09 and had the “eye” of the hurricane in 2010. Many investors seem to think the worst is over. I had two separate friends on Friday night protest that “the market was up 4% this week!” while seemingly missing the fact that 3.6% of that happened in about one hour during Friday morning.
The cause of that rip higher is curious. Chairman Bernanke delivered his long-awaited Jackson Hole speech, at which many investors expected him to hint at QE3. He didn’t so hint. Stocks began to fall, as you would expect. Then, abruptly, they turned and shot higher. Partly, this was because there seems to have been plenty of fast money that expected (like I did) that the Chairman would not make a habit of proposing major policy measures at Jackson Hole, and those traders needed to cover. But it was at least as much caused by a crazy speculation first propagated by CNBC: the Federal Reserve added a second day to its September meeting, and CNBC commentators suggest that that was the QE3 promise. Obviously Bernanke can’t announce QE3 now; he’s going to do it in September and this is his way of telling people so! To a person with a hammer, everything looks like a nail. If your only hope is QE3, then it is critical that you find a hint of it, somewhere.
Keeping in mind that the Federal Reserve is far from unified at the moment, and keeping in mind that QE2 was at best ineffectual, this is very unlikely to happen. It is actually more likely that a topic of conversation at the September FOMC will be the question of how to introduce an inflation-targeting policy. (That, too, can’t really happen since the Fed tied its own hands for two years, but it is a pet project of Chairman Bernanke and continues to be an object of study and discussion). But “QE3 is coming” is the message the market received. You can see this from the fact that bonds rallied, stocks rallied, and commodities rallied, while the dollar declined. That’s the QE playbook!
So the CNBC meteorologists have declared that it is safe to go back into the water; we got out of Bernanke what we needed to. Happy investors are pounding back into the surf, while sober ones who have seen this before are peering out and shaking their grizzled heads in disbelief. “These kids never learn,” they grumble. “One of them’s gonna get killed one of these days.”
[1] There’s always a degree of comedy involved in watching how elected officials scurry around trying to appear officious and yet calm, trying to do enough that they won’t be blamed for insouciance but not doing so much that if nothing happens they won’t be accused of overreacting and inconveniencing the populace. My favorite example in the extant case is New York City Mayor Bloomberg, who on Friday declared an evacuation of “low-lying areas” in the city. Um, isn’t it all low-lying? Manhattan is built between two rivers. Its elevation is, basically, a few feet on the positive side of zero. The high point is Central Park Reservoir, at around 100 feet above sea-level; Columbus Circle is 60 feet. 8th Avenue and 20th Street, 12 feet. Avenue D, 3 feet. I am not saying that the city should be evacuated, but merely that evacuating “low-lying areas” of the city is splitting hairs.
Constant Inconstancy
The one constant recently has been volatility.
Volatility can be a symptom of a number of different ‘diseases,’ and it is often hard to tell which malady is affecting the market at a given time:
- Volatility can be a consequence of a paucity of liquidity, so that even light flows can overwhelm the capacity of market-makers to sustain orderly bid/offer spreads. This was one inevitable consequence of the war Congress declared on Wall Street a couple of years ago. By blocking banks’ ability to take risks with their own capital, they also ensured that liquidity would be especially hard to come by when risks rose. The question of whether entities which make bad bets should then be allowed to fail is a separate question (I vote “yes”), but it is clear that limiting dealers’ ability to position speculatively has a long-run affect on bid/offer depth and consequently on liquidity. I’ve been writing about this destructive aspect of the Volcker Rule since it was proposed; see for example here and here. I don’t know how much of the current volatility is due to this effect, but I suspect at least some of it. Also factoring into this is the fact that when realized volatility rises, the risk management function at Wall Street dealer firms reads it as an increase in the firm’s VaR, and passes down orders for risks to be curtailed to get back within the risk budget. The longer a period of volatility lasts, the bigger this effect tends to be because more and more of the “VaR window” represents volatile market conditions. I suspect that liquidity is at least part of the reason for the recent volatility.
- Volatility can also be caused when the fundamentals are changing rapidly. Bob Shiller quite a number of years ago (1981) pointed out that this cannot be the main reason for volatility, since the fundamentals just don’t change rapidly enough to explain how much markets fluctuate. It’s known as the excess volatility puzzle. But it is still the case that at times this can be a large contribution to volatility. For example, yesterday the COMEX raised margins for gold futures contracts. Although the news was not released until the close-of-trading Wednesday – after gold had already dropped $162 from its highs over the prior two days, it seems quite likely that some folks knew that a margin increase was on its way – and the prospective increase in margins had a direct impact on the market price of gold. Similarly, the loss of Jobs this week (not Initial Claims; we’ve been losing those jobs for years now, but Steve Jobs) directly impacted the volatility of Apple’s stock and the spontaneous generosity of Bank of America (in giving a large cumulative preferred coupon to Warren Buffet to raise money that it insists it does not need) affected the volatility of that stock. I have trouble attributing, though, the volatility of the general market to rapid and significant changes in fundamentals. The fundamentals are not changing much. They’ve been bad for a while, and they’re getting worse, but they’re not gettingsuddenly worse.
- However, when attitudes towards fundamentals change rapidly, this can also cause volatility. And this appears to me to be a primary cause of the recent amplitude of fluctuation. The economy isn’t suddenly rotten; it’s just that more people are noticing that the economy is rotten, and people who were fairly sure it would be improving are changing their minds. The debt limit debate didn’t change any fundamentals, but it did change some attitudes. It woke some people up to the terrible fiscal situation we are in. Europe isn’t suddenly in dire fiscal straits; they’ve been there for a while. But the Greek crisis (which appears to be starting again since collateral appears to be an issue; see the Chart below which shows the Greek 2y going to new high yields at 43%) woke some people up to the fractures in the EU.
Greek 2-year yields do not project confidence in anything except a default.
Any way you slice it, the volatility is not a sign of a healthy market. Now, it is true (and an article of faith in many quarters) that when volatility declines again it tends to be good news for prices. But unless you know when that is going to happen, it isn’t a particularly useful factoid – buying into high-volatility markets will occasionally get you long at the right time, but also will occasionally get you FlashCrashed, or in a 1987 debacle, or carried out in some other fashion. I always point out at these times the (quite good, I think) article I wrote a while back on the question of sizing trading bets in crisis situations. In that article I said (in the context of the 2008 crisis), for example:
The relevance here is as follows: when a crisis hits, two things are happening to you as an equity investor. First, you are becoming more confident that the market will reward you for buying when everyone else is selling, because (as noted above) unless the world actually does end you are likely to be getting a good price. Second, though, you need to recognize that the increasing chance of debacle implies a worse payoff. In April of 2008, the chances of losing everything the next day were pretty slim. In mid-September 2008, the chances were appreciable that a bunch of your portfolio might be in trouble. So your edge (confidence in winning, if the bet was repeated a bunch of times) was growing, but your odds (payoff if you win, relative to your loss if you don’t) were worsening.
When prices fall, it improves your odds, but volatility impacts your edge. Keep this in mind as we move forward.
And move forward, we shall. On Friday there is a revision to GDP, and a revision to the Michigan Confidence figure; the importance of these releases completely pales beside the fact that Chairman Bernanke speaks at Jackson Hole around 10:00ET. I do not think he will say anything that will be particularly helpful to equity markets – and I anticipate that stocks will trade lower again. Incidentally, ECB President Trichet is speaking on Saturday; for my money, that is much more important and more likely to produce something shocking. I would not want many chips on the table into the weekend.
Elation Should Ebb
Equity markets melted up today, despite weak economic data, on fairly low volume. I know that it will feel manipulated to some of you, but really it’s just thin. It doesn’t take much volume to move prices around, and when the market wasn’t able to break below 1120 it was set up to go the other way for a little bit. The sharp action is actually a great gift for investors who have been making deals with the Creator for a better exit point. The market should continue lower after a brief interlude – perhaps only a day or two, once people figure out that the catalyst today was a smokescreen.
That catalyst was certainly not the economic data, which continues to be weak (although really, who cares about wiggles in New Home Sales when they are at 1/3 the level of a decade ago?). The catalyst seems to have been an announcement from the FDIC.
I ought to preface what I am about to say by pointing out that the FDIC is a horribly-run agency that effectively backs bank deposits with a vague promise that surely Congress would step in and bail it out if necessary – since as its own Chairman admitted in 2009, the FDIC has been effectively insolvent for several years with a negative balance in the deposit insurance fund (DIF) – until the most-recent quarter finally turned it positive again although not positive enough to do very much with a big bank failure.
Today’s announcement by the FDIC was that the list of problem banks shrank for the first time since 2006 (when there were 50 problem banks). There are now “only” 865, down from 888 problem banks. Oh, that’s soothing. The FDIC also pointed out that loan-loss provisions at insured banks declined 53% from a year ago, to 19bln, and that of course that helped net income at banks. The market took this as good news – credit must be improving! – instead of the more-likely accurate read that at least some of this is earnings management. Credit probably improved over the last year. But 53%? That seems quite unlikely over the last quarter or year or 3 years. Now, maybe banks were dramatically over-reserved, and that is possible since in the “kitchen-sink quarters” of 2008 and 2009 one of the use for the big declared losses was assuredly to set aside reserves to manage future quarters of shortfall. (Over- and under-reserving intentionally are both illegal, but everyone does it and everyone knows that everyone does it.) This is a good time to remind readers who are investors in equities that if you haven’t read Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports
But a decline in the number of problem banks! That is great news, right? Well, my friend (and outstanding credit expert) Peter Tchir actually looked at the numbers, and with his permission I am quoting his findings at length:
The data also seems to be a bit misleading. Did any banks actually move from the “problem” list to a better list? If the entire 23 bank decline was from banks improving, that would be good. But I don’t think that is the case. The number of insured banks declined from 7,574 to 7,513. So the number of banks covered by the report declined [my note: by 61, if you’re following along]. And that makes sense since 22 failed and 39 were absorbed via mergers.[my note: 22+39=61] So the number of problem banks declined by 23, and 22 banks failed. I assume once a bank fails it goes of the “problem” list since it is not covered by this report? So at best, 1 bank moved off? Yet of the 39 mergers, were those all of non-problem banks? I find that hard to believe. I suspect that if the list was disclosed, we would find that not a single bank migrated from the “problem” list to a better list on its own. And that some new banks were actually added to the problem list.
As Peter pointed out to me, pretty much anyone could have done this work. The difference between Peter and successful traders and investors like him is that he actually did the work.
I should also note that fixed-income people tend to be more comfortable with numbers than stories, and when you look at the action in the markets there is a strange dichotomy between the elation felt by equity investors, who sent the S&P higher by 3.4% and the NASDAQ by an incredible 4.3%, and bond investors, who pushed 10-year note yields higher by all of 4 basis points. And, by the way, bonds were positive on the day until just after 2:00ET.
Someone out there thinks the problems did not vanish overnight.
Inflation readings were mixed. While gold dropped 1.6%, many commodities were higher and the indices gained on the day. TIPS were weaker than nominal bonds, falling 9bps to put the 10y TIPS at 0.10% and dropping 10-year inflation swaps to a 10-month low of 2.41%. One-year inflation swaps seem very cheap at 0.84%, even though core inflation is 1.8% and rising and energy inflation over the next year (which can be hedged in futures) is implying a drag of a whopping 0.1%. So 1-year inflation swaps imply roughly half as much core inflation as we are almost certain to get. When 1-year inflation swaps were above 2.5%, I advocated selling them while buying gasoline; at this level, I’d be buying 1-year inflation swaps and selling gasoline.
I’ve gone this entire comment without remarking on the earthquake that rocked Virginia and the DC area today. That’s because I don’t think it had any market impact, other than causing a brief jump in bonds. Several nuclear reactors shut down automatically, and at least one is being powered by diesel generators right now, and I am sure that reminds people of the Japanese quake. But there was no tsunami, no containment vessel was breached, and the diesel generators are all online and not under water. So the country was shaken, but not stirred.
On Wednesday, Durable Goods (Consensus: +2.0%/-0.5% ex-transportation) will be driven higher by aircraft orders. Thursday will bring Initial Claims, but neither of these is as important as Bernanke’s speech on Friday at Jackson Hole. I expected a bounce into Bernanke’s talk, but it seems to me we’ve gotten in a single day more than I would have looked for. That doesn’t mean we’ll trade lower tomorrow, but I expect we’ll have difficulty building on today’s gains and I wouldn’t be surprised to see ebbing elation in the equity market. Since I expect liquidity to get increasingly poor over the few days leading up to Bernanke’s talk, ‘ebbing elation’ may be enough to send prices back down.
If A Tree Doesn’t Fall In The Forest
The question du jour is, what if a tree doesn’t fall in the forest, but everyone was waiting around to hear it? Does it still make a sound?
The answer du jour is, of course, no.
The relevance this week is obvious, as investors count the hours, minutes and seconds until Chairman Bernanke speaks at Jackson Hole and (most of them believe) hints at QE3. The problem is that that is very unlikely to happen. The case for QE2 was plausible. QE1 had worked, at least after a fashion, and with core inflation continuing to decline it gave cover to the Fed to pursue an outright inflationary policy. (Many observers didn’t realize, and most others conveniently forget, that even by the time of the Jackson Hole conference last year we knew that core inflation would bottom in Q4 simply because of base effects).
The situation is starkly different this time in some very important ways. I have mentioned them before: inflation is heading up. The evidence is that QE2 was ineffective at the stated goal, which was increasing growth, because the money never entered the transactional money supply; it may have been effective at the unstated goal which was to forcibly increase the reserve cushion at banks. I have also pointed out that this has a depressing effect on earnings, but again this was a fact that many people didn’t think about and many others ignored – as you can tell from the valuation multiples that banks reached earlier this year. The Despite the fact that the NASDAQ Bank index is now 22% below its early-July highs, and despite the fact that Bloomberg omits negative earnings from the denominator of the P/E multiple, the index (CBNK on Bloomberg) still sports a 31.75 multiple.
The re-learned lesson of these last two facts – the obvious impotence of QE and the obvious overvaluation of bank stocks in an environment of awesome headwinds – is that the evidence of one’s own eyes is the only evidence that many investors will accept these days.
But blest are ye who have not lost money and yet believe.
If the Chairman does not announce QE3, this is going to be one disappointed market. Because right now, that’s all the bulls have to look forward to. I saw today that Credit Suisse today made a mild adjustment to their year-end S&P target, just a week or two after there was much celebration about how the targets had remained high despite the selloff. On August 5th, CS dropped its target from 1450 to 1350. Somewhere in the last couple of weeks, they adjusted it to 1275 from 1350. And today, they moved it to 1100 from 1275. At least they’re flexible! But many analyst targets remain high. There is lots of room still for disappointment (although some pundits are making points similar to the ones I make above – the belief in QE3 is not as widespread as the belief in QE2 was).[1]
Some strategists are heartened by the fact that the dividend yield on the S&P 500 (currently 2.29% according to Bloomberg; I calculate 2.20% using data from S&P) is higher than the 10-year Treasury yield. This is the first time this has happened since the first quarter of 2009. “And you know what happened next!” is the subtext to that observation.
Dividend yields of course were once always above bond yields, because stocks were considered to be riskier (who knew?) and therefore required more compensation to own. (It was later that corporate titans discovered that if they just earnedthe money, they didn’t need to pay it out and investors didn’t seem to care if they instead built empires with the money, and frequently blew it.) Dividend yields are now above bond yields not because dividend yields are so high, but because bond yields are so low. As a reason to sell bonds, it’s a good argument; as a reason to buy stocks…not so much. Also dampening the power of this argument is the Japan Rejoinder. In Japan, dividend yields have been above sovereign bond yields – in a country with incredibly low bond yields – for some time (see Chart). So the precedents are not wholly encouraging.
Japanese dividend yields have been above bond yields for several years. So what?
Now that I’ve doused the bulls thoroughly, I will also note that for at least a day or two stocks have failed to fall back through 1120. That level, which doesn’t look particularly important to me, has nevertheless supported the market four times since August 9th. I am very confident that equities will eventually trade below that level, and probably substantially so. I am becoming less confident that this will happen shortly.
At least, while the bulls are able to sustain faith in His Liquidness.
Speaking of liquid, it is interesting to me that NYMEX Crude Oil rallied as Gaddafi appears to be finally losing his grip on his regime (Brent Crude was close to unchanged, however). I would have thought that oil would decline, since a significant amount of Libyan capacity is idled and a resolution in that country would suggest that capacity could come back on-line. On the other hand, for all his legion faults Gaddafi was good at carrying the mail (in a petroleum sense), and so (and I think this is the thought process) the resolution of the conflict in favor of the rebels means we don’t really know much about when production can be restored. If Gaddafi had won decisively, production would have begun fairly rapidly; in the current case, it is not clear.
Of course, I remain a bull on commodities. I am not sure whether it is soothing that I am starting to have a lot of company from fast money, as this story from Bloomberg (“Hedge Funds Buy Corn to Silver to Soy as Commodities Tumble”) demonstrates.
Precious Metals continue to rally, joined today by Crude, Grains, and Livestock. Bonds sagged a bit, but at 2.11% the 10-year is no bargain. Ten-year real yields remain at zero (actually +0.02%). These are eventually good sales, but it’s hard to pick a place to sell especially with September – a great seasonal month for bonds – hard upon us. I would buy puts but vols are too high. I will try to probe from the short side from time to time and try not lose too much in the updrafts.
Tomorrow, the only data is New Home Sales, which will be abysmal even if the most-optimistic forecasts are accurate. Anything related to housing these days is abysmal. 310k is the forecast; wake me when it gets over 400k.
[1] Personally, I keep an eye on Abby Cohen at Goldman Sachs. She recently stressed on CNBC the importance of taking a longer-term view of “months and quarters, if not longer.” I don’t know what her current forecast is – I don’t think she’s allowed to make one any more – but I do know that in December 1999 she was predicting 1525 for year-end 2000 and 1650 for year-end 2001. So she knows a thing or two about ‘longer-term views.’ The S&P never even sniffed the latter level. Cohen is part of a cohort of perma-bull strategists that believe stocks should go up unless something bad is happening, right this second.
Unglued
The precipitating force for today’s selloff again came out of Europe, but this time it had plenty of help from events and data here in the United States. I had mentioned yesterday that the equity markets had been losing momentum and volume at the same time in the bounce that had carried to the 1200-1205 area on the S&P but was unable to exceed that level. On a closing basis, Elliott Wave guys will point out that the bounce was almost exactly 38% of the decline. The ebbing volume bespoke a lack of commitment to take prices higher, and so stocks were vulnerable.
A story that had gotten some quiet discussion yesterday was one describing how Finland either had reached a deal with Greece on collateral for their share of the Eurozone loan, or had not reached a deal. It was a little unclear which it was, but it was a trick question. If Finland had succeeded in getting collateral, then other countries would want collateral as well. If Finland had not succeeded, then the disbursement of the life-saving tranche to Greece was in jeopardy. Only if the talks had not happened at all was this okay.
After mulling on that overnight, Austria, the Netherlands, and Slovakia said they also want collateral on the loans they are making to Greece. And who wouldn’t, since almost everyone knows the money is never going to be repaid, and more importantly in some minds, when one’s constituents see that the Finns got collateral they will wonder why their country did not? (Incidentally, the collateral is said to be a cash deposit roughly equal to the loan, raising the question of where they’re going to get the money to make that deposit since the bailout was in principle to help Greece pay its debts?)
So suddenly, when we’d been getting all worried about Spain and Italy, it turns out that Greece isn’t entirely put to bed either. No wonder markets reacted violently. Equity markets throughout Europe dropped 4-7%.
The U.S. markets dutifully followed suit.
There was an additional following wind for domestic investors: the data today were just awful. Although I always follow CPI dutifully, the number of the day was the Philly Fed index. Remember, it was expected to be +2.0 after +3.2. I said parenthetically yesterday that the estimates were too high. Little did I realize howhigh. The actual print was -30.7 (see Chart), near the worst levels of the 2001-02 recession and not far from the lowest levels of 2008.
Hey, where did all the business go all of a sudden?
In the region, new orders simply collapsed. The New Orders subcomponent, which was +0.1 last month, now stands at -26.8. The Number of Employees subindex fell to -5.2 from +8.9, which is comparatively good – worse than at any time during 2010, but in 2009 that number got to -49.6. I guess if you’re still hunkered down from the last recession, you don’t need to immediately lay off as many people. Echoing that theme, Initial Claims was higher than expected but not much.
Existing Home Sales came in at only 4.67mm units versus 4.90mm. That’s not a bad miss but it is the wrong direction for an investing community that was already jittery.
Incredibly, New York Fed President William Dudley said today that he expects second half growth should be “considerably firmer” than the first half. But the world’s other economists, the bond and stock markets, the oil market, and common sense disagree.
Oh yes, Crude Oil. Energy markets were crushed today, but none more than Crude which fell nearly 7%. Actually, industrial metals rallied, as did precious metals, and agricultural commodities were only down 1%. It was the energy sector, and pretty much only the energy sector, that responded to the sense of the world coming unglued.
Aside from the kneejerk reaction that we have all been taught to have, that low growth leads to low inflation (despite the number of counterexamples that are ‘inconvenient truths’ to that theory), the current inflation data continues to disappoint on the upside. CPI came in higher-than-expected on headline, and core recorded a “high” 0.2% to push the year-on-year rate to a (rounded up) 1.8%. Two-thirds of CPI is accelerating: Food & Beverages, Housing, Apparel, and Medical Care showed faster year-on-year growth than they did the prior month. 21% is decelerating: Other Goods & Services and Transportation (although Transportation fell to 11.98% from 12.58%, so it’s decelerating but from a high level). The balance, Recreation and Education/Communication, is neither accelerating nor decelerating. Core inflation, ex-Shelter, rose to 2.02% and is on track to be at 3% by the end of the year.
There is something else that is interesting about the inflation data recently. Look at the chart below, which shows both Core CPI and the Cleveland Fed’s “Median” CPI.
Core CPI and the Cleveland Fed's Median CPI are now moving in almost perfect unison.
The fact that “mean” CPI – that is, the normal concept of average price changes of a fixed basket of goods – has recently started matching so well to “median” CPI has a quantitative implication. When the mean and the median match, it says that the distribution of price changes is balanced, with outliers either nonexistent or balanced. In other words, prices are rising in a very orderly manner.
That’s actually not very good news. The ordinary give-and-take of a capitalist economy means some goods and services will always be increasing in price relative to others, even if there is no net rise in price. But if the same tide is lifting all ships, then there’s no reason for relative prices to change sharply. I think that tide is the green tide of money.
And that tide continues to rise, incredibly. M2 was up another $43 billion last week, raising the 13-week annualized rate of change to 22.9%. That is actually higher than it was in late 2008 (by a smidge). The 26-week annualized growth rate, at 14.33%, also exceeded the 2008 equivalent. The 52-week change, still puttering along at a mere 10.179%, is still a bit shy of the level it reached in the credit crunch. But we also don’t even have a crunch yet.
Despite the CPI figure and a fair auction of 5-year TIPS, the inflation-linked bond market was completely clocked. While nominal yields fell 8bps in the 10-year note (2.08%, after briefly dipping under 2%), nominal yields on 10-year TIPS rose6bps. The combination of those effects means that breakevens dropped 14bps, and the carnage was worse at the long end than at the short end. 10-year inflation swaps are now the cheapest they have been since the growth scare last year, and lots cheaper than they were a couple of weeks ago (see Chart).
10-year inflation swaps are cheaper than they have been for a while.
Now, we should remember that during the elevated period between late 2010 and now, the Fed was pretty much buying all of the new float in TIPS and that had something to do with the wide breakevens. But notice that the run-up in 2010 started when Bernanke first hinted at QE2 in August. And now, we have a Fed that has completely taken its hands off the wheel at the same time that money supply is surging. It seems to me that there is a lot more upside to this relationship than there is a downside. I included the end of 2008, when horrible liquidity in inflation-linked bonds helped drive breakevens and inflation swaps much lower, so you can see how low some people will expect that inflation expectations could fall. But at the time, crude oil was also in the process of falling about 78% and Lehman had collapsed. The lesson of 2008 is that even with an almost completely-frozen financial sector and with 40% of the consumption basket collapsing (that is, housing), core inflation couldn’t drop into deflation. It would be wonderful to be able to buy 10-year inflation protection below 2%, but I will be very surprised if it happens. Inflation is as cheap as it has been in a while because the people who believe that growth causes inflation (you know, like the inflation we have now: clearly caused by the run-away growth we are experiencing!) like to sell commodities and inflation-linked bonds when growth surprises on the downside. Look for opportunities to buy inflation. TIPS are getting cheaper, at least relative to nominal bonds!
Brace yourself for a bumpy ride. Although there is no economic data tomorrow, there is a lot to work out about Europe and not a lot of good news here. We’ve just had a high-volume selloff and the calendar says Friday. I would not be timid about cutting risk further.
Prosperity On The Layaway Plan
I keep wanting to be bearish on bonds, but for the third day in a row the stock market was unable to achieve the 1200 level and hold it (it “held” the 1200 level on Monday, but only because the bell sounded; it traded sharply lower in the morning on Tuesday). And the bond market is rallying again/still. The 10y note rallied 6bps today (to 2.16%) and the 10y TIPS rallied 4bps (to -0.02%). Volume was light in the equity market, and the essentially-unchanged close obscured a reasonably wide range that was achieved on still-declining volume.
The only news today was PPI – never very exciting – but fear not because there is a large slate of data on Thursday. I’ll get to that in a minute, but in the meantime I will say that the technical condition of the stock market is worsening the longer it fails to punch convincingly above 1200, as momentum continues to ebb; meanwhile, the commodity market is hanging in there. It isn’t just precious metals, either; softs and grains have also risen over the last month and if it wasn’t for the substantial decline (around 8-9%) in the energy complex over that period then the commodity indices would have risen over the last month. Energy prices are the ones which react most immediately to growth scares, which is what we have had. The other components are surfing on the money wave. Energy will eventually follow.
Since the market over the last couple of days has been relatively contained (anyway, compared to the prior week’s worth of trading as well as to the turbulent undercurrents), let’s not spend much time looking at the past. The markets will have to navigate quite a bit over the next few weeks, running from the heavy slate of data tomorrow until the Jackson Hole economic symposium a couple of weeks hence. In between there could be plenty of randomly-dispersed tape bombs. I am keeping an eye on Capitol Hill again/still. You would think after the last debacle our policymakers would want to leave well enough alone for a while, but noooooo. Today on consecutive headlines Bloomberg TV noted that President Obama is going to ask the deficit-reduction committee to make deeper cuts in the deficit, and is also going to ask for a bunch of new stimulus spending. I guffawed, thinking it was a mistake or a bad joke, and then realized no one else was laughing. So the plan, as I understand it, is to spend a lot now and pay it back later. How creative. How fresh. How different. How very reminiscent of one of my favorite “Saturday Night Live” skits of all time, which also happens to be chock-full of great advice for the current Administration and Congress. The advice is timeless and the clip is free.
I can’t predict what the market will do when Obama proposes to increase the deficit again with new spending “to reduce unemployment.” I can’t imagine it will be a good reaction. The last trillion did nothing other than a temporary spurt, and helped put us on an unsustainable fiscal path. I think investors know this; even ones who didn’t know it before understand it now – money injected into the economy has to come from something. You are either taking it from people in taxes or you’re taking it from investors and replacing that money with bonds. Only if you’re taking low marginal-propensity-to-consume money and putting it into the hands of people with a high marginal-propensity-to-consume should it do anything. Otherwise, it’s a net wash except that it changes the allocation of capital. And not in a good way. I thought by now, everyone knew this.
But the alternative fable that big spenders tell is that the stimulus was working and we just got unlucky with the Japanese earthquake and then all the bickering over the debt ceiling. If we’d just spend, spend, spend without griping about it, the story goes, we’d be on the road to prosperity. The funny thing is that the road to ruin looks a lot like the road to prosperity for the first few miles. Current office-holders are sort of hoping that we will not be able to tell the difference for those first few miles, and that they’ll be able to slide through the next election. But I think that even equity investors are starting to figure out that “stimulus” spending on “shovel ready” projects and other clever catch phrases are just another way of saying “I will gladly pay you Tuesday for a hamburger today,” and I believe if any such proposal appears to have support the markets will react negatively.
Before any of that has a chance to provoke angst in us, however, we will get another gauge of the current prosperity with the data tomorrow. Initial Claims (Consensus: 400k) and Leading Indicators (Consensus: +0.2%) will take a back seat to CPI for July (Consensus: +0.2%/+0.2% ex-food-and-energy), Philly Fed for August (Consensus: 2.0 vs 3.2 last – consensus is probably too high given other activity metrics recently), and Existing Home Sales for July (Consensus: 4.90mm from 4.77mm – watch the inventory, which should rise from 3.765mm) plus the added bonus of a 5-year TIPS auction in the afternoon (and M2!).
The estimates for CPI are interesting. According to my (not very sophisticated) calculations, if we get the consensus +0.2% on headline then the year-on-year figure ought to be 3.4% or 3.5% (depending on whether it is a “low” 0.2% or a “high” 0.2%). But the consensus estimate for the year-on-year change in headline inflation is 3.3%. This seems inconsistent, and it gets worse. To get an 0.2% on headline then unless the seasonal adjustment factors have changed quite a bit this year the NSA CPI index value would have to be no higher than 225.55 or so. But the consensus estimate for that value is 225.85. The answer to this conundrum is that the “consensus” in each case consists of a different sample of economists. The shops that have more experience with inflation are the ones producing the 225.85 estimate for NSA CPI; that would give us 0.4% on headline inflation and 3.6% on year-on-year. In other words, I think there’s upside risk on headline just from conducting a beauty contest of economists (ick, bad image).
More interesting of course is Core CPI. It has printed 0.25% and 0.29% month-on-month for the last couple of months, so the consensus guess for an 0.2% is not an aggressive prediction even though it would give the appearance that an 0.2% would follow a couple of 0.3%s (which were rounded into 0.3%s).
I’ve noted before that the current year-on-year core rate of +1.6% (which even with a consensus number should rise to 1.7% tomorrow) happened a good 3-6 months before the time that my models suggested it should. So it wouldn’t be surprising to me to see a +0.2%. But it is much more significant if we see another 0.3%. One reason economists are expecting a retracement is that the recent jump has included some ‘non-sticky’ groups like hotels, apparel, and vehicles. I don’t see the data the same way. What I see is that the rise has been quite broad-based, so that the non-sticky stuff that is rising may simply be rising with the general tide. I agree that Apparel’s recent jump is probably not going to persist, but it’s only about 5% of core. Hotels are only about 1% of core. And motor vehicles in the PPI accelerated further this month. So, unless housing skitters backward this month, we could well see another 0.3%. Of all the economists, only UBS is forecasting such a print.
Now, 0.3%, pushing the year-on-year core rate to 1.8% or 1.9% (depending, again, on whether it’s a ‘low’ or ‘high’ 0.3%) instead of the consensus 1.7%, wouldn’t have a major implication for central bankers since they can’t do anything right now anyway without looking really, really stupid. But it would have an implication in one immediate way: in the auction of $12bln in 5yr TIPS securities, which will happen tomorrow afternoon.
I don’t like the 5y TIPS. I never have. I think that people who need inflation protection generally need it for the long-term since inflation is a long-cycle phenomenon. That being said, with the Fed pinning the 5-year nominal Treasury at 0.90% at the moment, consider that even with the real yield of the 5y TIPS bond at -0.85% all you need to be indifferent is for inflation to average about 1.75% over the next 5 years. As of tomorrow, that will be the approximate core rate. As long as energy doesn’t provide a net drag, and as long as core inflation doesn’t suddenly roll over, you would be hard-pressed to underperform 5-year nominal Treasuries over the next five years. And your real risk is much lower (you can’t blow up buying TIPS and not getting inflation; your worst-case is -0.8% nominal return in the case where there is no inflation at all. If there’s deflation you still get your money back at par so you again get a -0.8% return. On the other hand, you can completely blow up if you buy nominal bonds and get, say, 5% inflation for five years). Accordingly, even though I hate all of these yields, if you’re going to hold 5 year Treasury paper anyway I don’t know why you wouldn’t hold 5-year TIPS. It seems like a cheap option to me at these levels, even if the optics of a negative real yield are bad. I think the auction will go well, even though I don’t like 5-year TIPS as a rule.
Short Comment On A Quiet Day
Lost amidst all of the cheering about the stock market’s performance today – the S&P was up 2.2% – were a couple of key facts.
First, the Empire Manufacturing index fell (to -7.72), rather than rising as expected. Empire isn’t a key release, but it has been growing in importance as economists get more experience with the series and its relationship to national manufacturing indices. The -7.72 nearly matched June’s -7.79 and is in roughly the range it inhabited throughout the middle half of 2008. Second, the volume on the equity rally was very light – much lighter than on any day last week, and more consonant with the light-volume trading of the rest of the year (just squeaking over 1bln shares in the minutes after the close). This is not good behavior; if these levels represent bargain prices, then there should be robust buying. The buying was steady, but light.
To be sure, much of Europe was absent due to the Assumption Monday holiday (and…August), but if Europeans are net sellers then all that says is that there will be two days’ worth of selling on Tuesday.
That might not be terribly far-fetched anyway, since France’s Sarkozy and Germany’s Merkel are conducting a high-profile summit tomorrow. I am not sure how much Sarkozy is likely to bend to Merkel (let’s be honest, we know who is in the driver’s seat in this meeting), but if there isn’t a major announcement of some kind then there will be a selloff!
Commodities rallied again, led by energy markets (Crude was +2.9% and gasoline +1.9%) although Grains and Softs also rallied ~1% and Precious Metals were +0.8%. The dollar weakened back to the bottom of the recent range, and with interest rates (both real and nominal) low, equity markets expensive, and plenty of money cascading forth I can’t help but think we could be on the cusp of a significant break lower in the dollar unless Europe breaks first. What a lovely choice! Italian and Spanish yields remain just barely on the sunny side of 5%, and it’s clear where the ECB bid is sitting. The ECB also reported that it bought about 50% more bonds last week than it had previously announced (around €22bln), which is either a sign of resolve or a sign that the selling was stronger than expected.
Despite the strength in commodities and the weakness in the Empire Manufacturing index, nominal bonds sold off and TIPS actually sold off more (5bps for nominal 10y rates, 7bps for TIPS, putting yields at 2.31% and 0.05% respectively). This implies that inflation compensation actually fell slightly although it remains high. This may be because the Treasury is planning to sell 5y TIPS this week, and dealers are setting up.
While I am skeptical that the equity rally will continue, the fact that the S&P managed to close above 1200 means that I’m ready to be actively short the bond market. With the amount of data due this week, I suspect there is no hurry but if the stock market trades higher overnight then I’ll sell bonds (or some positional equivalent) in the morning.
Economic data due tomorrow includes Housing Starts (Consensus: 600k from 629k) and Industrial Production and Capacity Utilization (Consensus: +0.5%/77.0%).
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