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A Many-Ouch Day
Once again, the news was almost uniformly bad; once again, equity markets reacted as if each piece of bad news just brings closer the days of good news. Bonds also suffered today, for a change, but that is more likely related to the inflation data.
I shouldn’t get ahead of myself. Our first ouch was provided this morning by UBS. For the love of Pete, when will these banks learn to supervise traders? UBS announced a $2bln loss stemming from “unauthorized trades” in the equity unit. Seriously, how hard is it? Someone needs to be sending collateral around – is it so difficult to get the collateral management system to talk to the risk management system? Granted, it’s very difficult to catch a determined rogue trader from causing damage in a short period of time – real-time surveillance isn’t possible when markets require real-time reactions. But these losses – today’s announced $2bln loss, the $7.2bln that Kerviel lost for Soc Gen, and others we have heard about and smaller ones we have not – generally occurred over a period of time, exploiting a loophole in the system.
This is another argument for smaller financial institutions. Forget “Too Big To Fail;” what about “Too Big To Supervise”?
After the UBS announcement the economic data ouches started to roll in. Initial Claims rose to a 2-month high at 428k, and is essentially unchanged from a year ago. Empire Manufacturing, expected to be -4.0, was actually -8.82. Philly Fed was -17.5 versus -15.0. And of course, there was CPI.
The consensus for core inflation was for a ‘soft’ 0.2%; instead, we very almost saw another 0.3% print. Year-on-year flashed 2.0% (although it was actually 1.951%). These sound like small details, but the internals of the number were strong. For starters, core inflation ex-housing is at 2.2% and a bit ahead of pace to reach the 3% by year-end that I first mentioned in this July comment. So, while core CPI is approaching 2.0%, remember that it is being restrained by housing.
Having said that, it isn’t being restrained that much anymore, although I think there’s another down-leg to housing prices now that foreclosures are picking up again. The following table shows the year-on-year change by major subgroup in the CPI. Housing is now back to 1.6%. Along with Apparel, Food & Beverages, Recreation, and Education/Communication, the y/y pace of change quickened in August. That’s ¾ of the whole CPI, and the balance is either unchanged or showing marginal declines in the case of Transportation.
| Weights | y/y change | prev y/y change | Year ago y/y change | |
| All items |
100.0% |
3.771% |
3.629% |
1.148% |
| Food and beverages |
14.8% |
4.372% |
4.001% |
1.000% |
| Housing |
41.5% |
1.627% |
1.453% |
-0.391% |
| Apparel |
3.6% |
4.183% |
3.056% |
-0.395% |
| Transportation |
17.3% |
11.684% |
11.980% |
4.918% |
| Medical care |
6.6% |
3.194% |
3.199% |
3.168% |
| Recreation |
6.3% |
0.063% |
-0.173% |
-1.075% |
| Education and communication |
6.4% |
1.094% |
0.982% |
1.929% |
| Other goods and services |
3.5% |
0.878% |
0.847% |
2.948% |
This breadth of advance is one reason that the CPI figures are starting to get scary. I pointed out last month that the Cleveland Fed Median CPI is no longer giving reason, as it did throughout 2010, to think that core CPI still has a lot of catching up to do. The Median CPI printed 2.0% this month, just what core CPI did.
I think what is also underappreciated is that while the level of inflation isn’t worrisome yet, the acceleration is. Core inflation, and median inflation, are by design very stable. They’re supposed to capture just the important moves. The chart below shows that the Cleveland Fed Median CPI hasn’t accelerated by more than 1% in a year since 1984, and only deceleratedfaster than that in the recession of the early 1990s and in the credit crunch when the velocity of money plunged. In short, median CPI is pretty stable. The picture for Core CPI looks similar.
This kind of acceleration in median CPI was last seen under Reagan.
It is in that context that we might look with some alarm at the 1.5% acceleration in median CPI (and 1.1% in core CPI). Not only is it already quite unusual, it is almost guaranteed to get worse in the next couple of months (since the bottom in CPI was in October 2010). Note, by the way, that the acceleration in 1984 occurred in the context of much higher core numbers, so a 2% acceleration was less impressive than it would be today.
Now, a fellow inflation trader pointed out that previous spikes in the acceleration were always in the past followed fairly quickly by an outright drop in inflation. The difference, though, is that in those cases the spike precipitated Fed action to restrain inflation. The Fed was tightening in 1988, in 2000, and in 2004. That is why inflation decelerated, not because of any natural cycle. The difference is obvious – in this cycle, the Fed is aggressively easing. I trust I don’t need to connect the dots any further than that!
In case it helps, though, I will note that with the release of today’s M2, the 13-week rate of change is now over 24% (annualized), the 26-week rate of change is up to 14.7%, and the 52-week rate of change is 10.55%. And I will also point out that today the SNB, BOE, ECB, Fed, and BOJ jointly announced the provision of dollar liquidity arrangements to banks that need it. (Seems it was only a day or two ago we were told no banks needed it!)
And that, perhaps, is the biggest ouch of all. The inflation data, and not the growth data, was the reason that 10-year rates rose 10bps today. Half of that came from breakevens, and inflation swaps at the short end of the curve were even more well-bid. TIPS continue to sport extraordinarily-low yields, but we are seeing why.
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Housekeeping note: This is the last commentary I will be writing for a couple of weeks. My family and I are traipsing off to New Zealand on a vacation and to watch some World Cup rugby (Go Eagles!). My next post will be circa October 4th. Good luck in the meantime, and good trading.
Prescience, or Nostalgia?
Other pundits have already observed it, I am sure, but the equity market these days is trading as if it is tuned into a news feed that is either six months behind, or six months ahead. I sure wish I knew which it was, but the point is that stock prices are trading up or down with complete disinterest in what related markets are doing or – heaven forbid – what the political economy is doing. The S&P ripped above 1200 today before fading into the close. The data was lackluster: Retail Sales was slightly soft, and there was nothing interesting (if there ever is) about PPI.
On the news front, the ECB announced that it had a $575mm take-up in their regular 7-day dollar liquidity-providing operation, at a rate of 1.1%. As the story linked to above notes, it is the first time banks have taken an allotment from this auction since August 17th, and two banks did so this time. In what is I am sure a coincidence – and I really mean that this time – Moody’s cut the ratings of SocGen and Credit Agricole, two French banks, while leaving BNP untouched (but still on review).
Meanwhile, the brilliant Treasury Secretary Tim Geithner described the current situation as “an economy at this early stage of the crisis given the shocks we face.” While we all know that he meant that in a good way, trying to generate a groundswell of support for the latest “really, this time it will work” jobs package,[1] it’s still an amazingly undiplomatic thing for a Treasury Secretary to say three full years after the crisis began and without ever having experienced the “Recovery Summer” we have been promised repeatedly. Let’s face it, folks: if even Tim Geithner knows we are in a crisis, and if he is so sure we already know it that he considers it an okay thing to say, then we really might be in for some turbulence.
And the stock market powered blithely upward. The low-to-high range on the S&P was 40 points, or about 3.4%, but far more of that on the upside and with very little volatility. We went down in the morning when a headline hit that exaggerated the vote the Austrian parliament took with respect to the EFSF (the parliament declined to fast-track approval, but initial headlines said they rejected the EFSF), then when the headline was corrected it was a slow, low-volume, but inexorable trade higher.
That sort of behavior makes me wonder about quant funds or 140-40 strategies that care much less about market direction than about inter-security relative value. Commodities drooped a little, bonds were roughly unchanged, and TIPS fell slightly (the Treasury will announce the size of the July-21 reopening tomorrow, and the yield is now up to a hearty 0.07%!). But equities bounded ahead 1.4%. Equity investors are clearly listening to another news wire than the one that the other markets are listening to. I just wish I knew if they were prescient, or nostalgic.
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In contrast to the rest of this week, Thursday is full of data. Empire Manufacturing (Consensus: -4.0 vs -7.72 last) is only a marginal surprise from setting a new 2-year low (below -10.44). Initial Claims (Consensus: 411k vs 414k last) is befuddling both economy bulls and bears by simply going sideways; for the year, the average Claims has been 415k and we are right in the middle of the year’s range as well. Something below 400k or above 420k is needed to get a reaction. Later in the morning we’ll see August’s Industrial Production and Capacity Utilization (Consensus: 0.0%/77.5%) figures and the September Philadelphia Fed Index (Consensus: -15.0). Remember that Philly Fed last month plunged to -30.7, which was a big shock and one of the wake-up calls that growth had slowed abruptly in August. It will be closely watched and another figure in the mid -20s will be construed negatively (at least, in the fixed-income markets where they may notice).
I’ve left CPI for last, although it is unlikely to be a market mover. The consensus call is for +0.2% on headline inflation (keeping it steady at 3.6% year-on-year) and +0.2% on core inflation (raising core to +1.9% y/y). Core inflation on a year-on-year basis should rise even if we get a ‘soft’ 0.2% (meaning, it is rounded up rather than down) because of base effects, and should exceed 2.0% through the end of the year for the same reasons. Indeed, if we continue to get relatively innocuous 0.2% prints then core inflation will still be around 2.5% by the end of the year.
Although people tend to think that I have a vested interest in projecting higher inflation, I always point out that from 2003 until 2010 I argued that core inflation would be pressured lower. And in the current circumstance, I have to confess that the current level of core inflation is running ahead of where my company’s models suggest it should be. That is, our projections for core inflation in 2011 were significantly too low, rather than too high. I had seen full-year core for 2011 around 1.6%-1.7%, and we are going to go bounding over that figure handily.
The fact that inflation is appreciably above where my model projected it could indicate there is downside risk to the numbers going forward, but what it is more likely to mean is that the models were calibrated on a different sort of environment than the one we are now experiencing. Of course, that’s absolutely true – we’ve never experienced this sort of environment, so it isn’t in the historical data – and a good analyst here doesn’t lean too heavily on calibrated models. There is some art involved in the forecast…or at least, a heavy dose of caution.
An important observation can be made regardless of the exact forecast going forward: if the Fed is going to do QE3 (which in fair disclosure I thought they wouldn’t do until I listened to the speeches following the last FOMC meeting, and read the minutes), they will prefer to do it sooner rather than later since it is easier to be dovish in the face of 1.9% core inflation than in the face of 2.5% core inflation. The economists at the Fed aren’t spectacular, but they can project as well as I can where core inflation will be if 0.2% numbers keep printing. It is no mystery to the FOMC that they are going to have backward-looking inflation up over their target quite soon. And in this case, they are clearly going to be leaning on nostalgia when they make the call next Wednesday on whether to do QE3.
So maybe, maybe, equity investors are being prescient about the Fed’s nostalgia?
[1] Since Krugman keeps saying, no matter how much is spent on jobs packages and green jobs and alien invasions, that the amount of stimulus is far too little, (see for example here, although the estimate of the post-Depression stimulus is absurd as pointed out here) I think we ought to discuss all such packages in Krugman units. So if we really need $30 trillion in stimulus, then let’s call that one Krugman. $3 trillion can be a mini-Krugman. And $300bln can be a micro-Krugman. So the latest jobs package is about 1.5 micro-Krugmans. Hardly seems worth it.
Not The Weakest Link
Equity markets remained buoyant with anticipation today, but I have begun to lose track of what it is anticipation of. By definition, we can’t wait for something that won’t happen, so we can’t be waiting for Greece to not default. By the same token, we haven’t priced the damage that is likely to follow if Greece does default. Ergo, we are either waiting for Greece to announce that it will not default (but they have already done so, and everyone who is going to believe it already does), or we’re waiting for something that has nothing to do with Greece, Portugal, Ireland, Italy, or Spain. But I can’t think of what that might be.
Surely it won’t be PPI and Retail Sales. Those figures are released tomorrow (consensus on PPI is 0.0%/+0.2% and consensus on Retail Sales is +0.2%/+0.2% ex-Auto). Thursday is much busier with CPI, the Empire Manufacturing number, Industrial Production, Initial Claims, and Philly Fed. But does any of that really matter if the Greek ‘bond exchange’ fails?
I actually think my speculation above isn’t far wrong. Credulous investors are waiting to jump aboard any positive announcement, however far-fetched. For example, stocks rose today when German Chancellor Merkel today said she’s “very optimistic” that Finland will get its special collateral as part of the bailout package. If I assumed the package was going to get done then by definition I’m optimistic about that too, since the package fails otherwise. She said nothing about the fact that most other EU countries will, reasonably, demand treatment similar to Finland’s, and that such a system of ‘compensating balances’ make the whole deal untenable – so the content of what she said was, at best, empty.
For those who are confused by the term “compensating balances,” it is a banking term for a practice that inflates the effective interest rate a bank receives on a loan. The banker sometimes will demand (actually, I don’t know whether this is a common practice any more or not) that on a commercial loan of (for example) $1mm at 6%, the borrower must keep at least $100,000 in its non-yielding deposit account at all times. The effect, of course, is that the bank actually lent $900,000 but is receiving $60,000 per year in interest, so the effective interest rate is really 6.67%. In the case of Finland, though, they are demanding that Greece provide collateral equal to the loan. A compensating balance of 100% is essentially the same as not making a loan at all, since all of the funds must be kept on deposit. I would call this a clever scheme to cause Finland to appear to be participating while not actually taking any risk, except that it is about as subtle as a defensive lineman.
Greek Prime Minister Papandreou will hold a conference call with Merkel/Sarkozy tomorrow, mainly I am sure because announcing such a conference call is seen as being good news. I don’t understand why that is, but it seems that every time the names “Merkel” and “Sarkozy” appear together in a news story the stock market rallies.
Markets also reacted positively to a back-and-forth on BNP. In a Wall Street Journal op-ed today, Nicolas Lecaussin claimed that someone inside of BNP had told him the bank is no longer able to borrow dollars in the market. BNP came out with something that sounds like a denial, saying they can finance the dollar-based part of their balance sheet “directly and through foreign-exchange swaps.” That’s not as strong a denial as saying you can fund your entire balance sheet directly in the market; if you’re having to borrow in Euro and then conduct a swap through the ECB and indirectly through the Fed (for example), then it’s not quite the same as having free and unfettered access to dollar funding. To the layperson that difference may not be obvious. I expect that that subtlety is fully the intention of the person writing the denial.
I don’t have any reason to think that BNP, normally considered a very strong bank rated Aa2 by Moody’s, has a bigger problem than any other European bank. They are probably very well-capitalized if PIIGS debt and bank crossholdings are valued at par, and probably thinly capitalized if they are valued at market. But I think we already knew that. Ordinarily, markets drag down the weakest link, and I don’t think BNP is it.
I understand that there isn’t much to this comment, and that is because there wasn’t much to this day. But implied volatilities remain high and volumes remain above where they were earlier in the year. I don’t think the market is about to go back to sleep. I expect stocks to resolve lower, and bonds higher (but not a lot higher unless a disaster occurs in fact rather than merely in prospect), and I don’t expect that resolution to take very long.
All The Money In The World?
China doesn’t really have all the money in the world. It just seems like they do.
From what I can tell, the Chinese – at least, if the rumors are to be believed – are supporting the dollar, supporting the stock market, and supporting the Italian bond market. The notion that China, despite the awesome size of its foreign reserves, can meaningfully affect every financial variable that someone needs to go up, is implausible. China enjoys some $3.2 trillion of foreign exchange reserves, according to this article on Wikipedia, but it is thought that about half of that is in U.S. securities and there has certainly been no sign that the PRC has been selling bonds and dollars! If we assume that half of the balance is in Europe and half in the rest of the world, that brings us to $800bln of Italian bonds that they could buy if they spent every Euro on Italian bonds. This seems grossly unlikely, since they would need to sell lots of other Euro bonds in order to do so. What is a ‘large purchase’ that doesn’t involve them selling lots of other bonds? $50bln? While that is a huge sum, Italy has around $1.6 trillion outstanding according to Bloomberg (do BTPS 2 06/01/13<CORP>DDIS<GO>, and be sure you’re picking the top-level issuer), and I suspect that there are easily $50bln in sellers. So, while that news was good for a 2% rally in the S&P over the last half-hour of trading, I wouldn’t think that sellers of BTPs will suddenly decide to hang on because the Chinese are bankrolling the Coliseum….even if it turns out to be true.
I also wonder at the fact that the focus seems to have shifted to Italy now. Does that mean everyone has given up on Greece, Portugal, and Ireland? Surely no one thinks those problems have gone away, and the collapse of the banking system in Europe is definitely not ‘priced in.’ China can’t buy everything. (Frankly, if I was China I’d keep my powder dry to buy, combine, and recapitalize Euro banks into a Sino-European Bank, although it isn’t like China’s track record with banking systems is very good given the state their own is in).
Maybe stocks have one more bounce in them before we plumb new depths, but somehow I don’t think so – because Greece doesn’t seem to have any bounces left. As a summation of the current situation I can’t do better than what my friend Pete Tchir wrote today so I’ll simply quote it verbatim:
“You know the first time someone plays poker they are afraid to bluff. The second time they decide bluffing is great. By the third time they are so confused about who is bluffing and when that they might as well just hand their chips to the best player at the table and save everyone the time and effort or taking the chips. I think the central bankers and governments have gotten so confused they are bluffing with a few low off suit cards and don’t even realize the cards are face up. A few polite people are choosing to ignore the cards. The governments and central bankers may still win but it will all come down to the luck of the draw since the odds are stacked against them.”
I concur. And I think we’re in the final round of betting.
And that probably means also that US rates have more downside (remarkably) and the dollar may have more upside after breaking out of a 5-month-long consolidation zone. As you can see from the chart below, such a ‘breakout’ is by itself not a significant event in the context of the volatility of the last few years. However, it does have the effect of postponing the worst of the possible idiosyncratically inflationary outcomes for the US. The translation of foreign exchange movements to core inflation is very slow (as in, more than a year or two), but the worstoutcomes for domestic inflation involve a sharply lower greenback.
The breakout is micro-important but not macro-important except to defer the downside.
Eventually, I would expect the dollar to respond to the increased supply of dollars relative to other currencies over the last few years and the relative dovishness of the Federal Reserve compared to other central banks. But right now, the probability of a sharp increase in the supply of other currencies such as Sterling, Swiss, and Euro is growing. Now, here’s the rub for inflation. If the dollar is performing because our money-printers are being caught up to by foreign money-printers, then our idiosyncratic inflation (think of it as US inflation minus global inflation) will be lower, but global inflation will be higher. Unless, that is, the supply of money has nothing to do with the global price level. The “good inflation” outcome happens if all central banks are hawkish together. That will happen someday…hopefully before I retire in a quarter-century or so.
And here’s the rub for China – when the world’s central banks print more currency, it has an effect like the effect on current shareholders of a company issuing new shares. Spreading the same GDP over more units of currency represents a “dilution” of the value of the foreign currency China holds. So, while they may seem today to have all the money in the world, China in fact stands to lose more than any single investor in terms of purchasing power. I guess they may as well spend it, but in doing so they are enabling the money printing. Like large investors anywhere, they probably prefer the status quo to the risk that a change in the status quo is even less agreeable.
Help Is On The Way (But Maybe Not Soon)
Yesterday’s spike in the equity markets seemed dramatic, until you realize that all it did was reverse most (and not all) of Friday’s selloff while leaving the rest of last week’s selloff intact. Wednesday’s rally was driven by relief at the ruling from the German high court, which said that Germany could continue to participate in bailouts of desperate EU countries as long as the Chancellor involved the legislature. That’s really not a wonderful result for Ms. Merkel, since there isn’t much chance that the legislature – increasingly populated by people who won their seats by opposing bailouts of desperate EU countries – will give the Chancellor everything she wants. However, it is better than the worst case, which was that the high court could have declared the entire bailout mechanism illegal.
Within minutes after the ruling, the ECB swung back into action to buy Italian bonds, whose yields had risen to over 5.50%. The ECB had been silently letting the bonds fall, probably wanting to avoid provoking the German jurists (since one question about the whole mechanism, although not addressed in the suits, was whether the ECB has the authority to buy the bonds of member countries in a price-keeping operation). Italian and Spanish bonds rallied, although interestingly not as much as in the first operation a few weeks ago. Italian 10-year yields are still at 5.25%.
Also helping equities on Wednesday was a speech by Chicago Fed President Evans, who argued in favor of a “rebalancing” of the Fed’s dual mandate more towards the employment part and away from the inflation part. It is worth remembering that Greenspan routinely observed that there is no tradeoff between inflation and employment in the long run – stable-inflation policies are what is best for the long-term growth of the economy. This lesson, one of the few that Greenspan taught, has been forgotten. President Evans suggests that the Fed should declare they will keep the fed funds rate around zero until the unemployment rate has fallen to 7%-7.5%, provided that core inflation does not exceed 3%. Today, former Fed governor Larry Meyer seconded the motion that the Fed should retreat from its inflation “obsession” to focus more on jobs.
There is no ‘wiggle room’ in the Fed’s mandate, which is bestowed by Congress, so the Fed in fact can’t declare such a thing without thumbing its nose at its authorizing legislation. I am not a fan of the dual mandate, which I think is an impossible assignment that attempts to have it all. However, it is the law of the land. Now, the Fed can pursue that dual mandate in the way it wishes to, and may in fact employ Evans’ strategy; they simply must be circumspect about it. That said, the political reality is that few in Congress will complain about the Fed being too easy (some will, most won’t), but many will grouse if they are too tight.
These were optimistic thoughts on Wednesday – that maybe a Germany-backed ECB can turn back the tide in Europe and perhaps the Fed can let inflation slide a little higher and get unemployment back down. But by Thursday, those brief moments of sunshine were past.
An article in the Wall Street Journal opined that the Fed is actively considering a wide variety of tools to deploy, but did not give a lot of hope that the decision has been made and help is on the way. Initial Claims nudged up, and Chairman Bernanke spoke.
What the Chairman did not do in his speech today was to make any promises, or even any concrete hints, that a near-term QE3 is likely. Listeners who expect QE3 this month were disappointed, expecting to hear a trial balloon; they didn’t get one.
While much of the speech is eminently forgettable, there’s actually some reason for hope. In places, he sounds like he has figured out some things that the Fed has gotten wrong for a while. For example, it has become routine for Fed officials and honest third-party observers to report that there is a “lack of credit demand” and that is why bank lending isn’t expanding. This has always been untrue, and in this speech the Chairman at last recognizes the true state of affairs:
“Credit availability has improved for many borrowers, though it remains tight in categories–such as small business lending–in which the balance sheets and income prospects of potential borrowers remain impaired.”
Since, after all, it is small business that provides most of the new employment in this country, this is no small matter. His emphasis is still wrong – it is far worse for the economy that small business owners cannot get loans than it would be if large companies, which have many sources of capital, could not tap bank loans. Large companies use bank financing to maintain dividend policies and to lever the company appropriately in order to minimize the weighted-average cost of capital. Small companies use bank loans to finance growing businesses that tend to be cash-flow negative.
There is also, unfortunately, the continued reliance on magical elixirs and divine intervention. A common theme recently from the Administration has been the “I will gladly pay you Tuesday for a hamburger today” approach: run bigger deficits today and make it up with smaller deficits in the future. While this is exactly the approach we’ve taken for the last thirty years, and it has gotten us into a deep hole, it is apparently preferred. And Bernanke supports this approach (perhaps he figures there is no alternative):
“But, while prompt and decisive action to put the federal government’s finances on a sustainable trajectory is urgently needed, fiscal policymakers should not, as a consequence, disregard the fragility of the economic recovery. Fortunately, the two goals–achieving fiscal sustainability, which is the result of responsible policies set in place for the longer term, and avoiding creation of fiscal headwinds for the recovery–are not incompatible. Acting now to put in place a credible plan for reducing future deficits over the long term, while being attentive to the implications of fiscal choices for the recovery in the near term, can help serve both objectives.”
I won’t spend much virtual ink on Bernanke’s dismissal of inflation pressures, because he relies on the usual concoction of “stable inflation expectations” (which – since they are not measured well – have not been demonstrated to restrain inflation, although the Fed has speculated that they do), “substantial amount of resource slack” (there are numerous examples of inflation occurring despite resource slack), and “subdued unit labor costs” (labor costs clearly follow inflation; they do not lead inflation). It is sad that the Chairman would continue to repeat these mantras, but he is looking for excuses to ease, not reasons to tighten, so we can’t really expect him to give much weight to the counterarguments even if they include models that actually work. For example, models that consider the growth rate of the money supply, which as of today’s numbers is now up at 23.5% (annualized) over the last 13 weeks, 14.5% over the last 26, and 10.3% over the last year. Each of these is a new high for the last several years, and disturbing to anyone who doesn’t think stable inflation expectations are more important than the amount of money sloshing around the system.
Tonight’s speech by President Obama is not likely to rock any boats. I predict that there will be promises to do more of the same (spend money to create jobs in the short-term), lots of finger pointing, and a stern expression. Oh, and he’ll speak about four times longer than necessary to make his basic points. None of this will have market impact, unless it is to make the dollar which has recently been strengthening look weak once again.
Last Friday saw a serious waterfall close lower, and it turned out to be justified as Merkel lost an election and the troika walked out of talks with Greece. That doesn’t mean we will see stocks decline markedly every Friday, but investors will probably be reducing risk this weekend. Since there are many more longs than shorts in the stock market, that likely means there is a bias to close lower.
Actions Speak Louder Than Words
I start today with a couple of simple news items that I think speak volumes. However, in my normal fashion I will then write further volumes.
- “India Plans to Sell Inflation-Linked Bonds, RBI’s Subbarao Says” – India last sold inflation-linked bonds (ILBs) in 1997 – a 5-year issue. India hasn’t decided when they will start selling the bonds, but RBI Governor Subbarao said “We will think through this but we will certainly reintroduce them.”
- “Germany Suspends Inflation Bond Sales on Better Budget Outlook” – Germany, which has about €52bln in ILBs outstanding (about half of what Italy has), is going to put its regular sale “on hold” this quarter. The German Federal Finance Agency says that this is partly due to the improving budget outlook (apparently, they haven’t caught on that there are a few – ahem – extra budget costs queuing up), and partly because in the words of the article “Investors’ appetite for the bonds has also diminished.” Obviously this is true…you can tell by the huge real yield of -0.17% that the 5y German ILB bears. The 10-year is even higher at 0.19%!! Clearly, the demand is very light for these bonds, right?
As additional commentary in the “one picture is worth a thousand words” category, see below the Indian inflation trade (in red) and the German inflation rate (in white). One of these wants to issue inflation-linked bonds; one has abruptly decided not to issue any more right now because they don’t need the money and besides, no one wants them.
One of these countries evidently believes their inflation is going to go down. One is less sure.
Hmm. I would say ‘draw your own conclusions,’ but let me take you one more step.
Emerging economies issue ILBs for two main reasons. One is that many emerging markets cannot access the debt markets without indexing principal, since they have a history of devaluing the currency they pay back the bonds with. The other reason is that they want to indicate a seriousness about getting inflation under control, since clearly their interest payments will be less in nominal terms if they can restrain inflation.
Developed economies can stop issuing ILBs for a number of reasons, including an outstanding budget situation with projected surpluses and lack of investor interest. But if I was in the national Treasury, watching inflation crawl higher, and realized that I wasn’t in control of the money-printing process, then unless I had to raise as much money as possible (the situation the U.S. is in, by the way) I might consider whether inflation-linked bonds were the best vehicle.
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The bond market today roughly broke even, which is a fairly weak performance considering that the stock market started the day plunging. Equities were trying to catch up with the 2-day decline in Europe, and doing a darn good job of it until the S&P hit the upward-sloping trendline off recent lows (and parallel to highs of the recent consolidation, forming what looks unfortunately like a ‘flag’ on daily charts) and began to rally back. The net result, a loss of only -0.7% on fairly light volume – by recent standards – of around 1bln shares, was positively heart-warming and the market continued to rally after the close.
This may be premature. The German Constitutional Court is due to rule on Wednesday (that’s after I post this at http://mikeashton.wordpress.com and release it on Twitter as @inflation_guy but possibly before it appears in syndicated channels) on whether the bailouts of Ireland, Portugal, and Greece that were financed by the European Financial Stability Facility are illegal. The consensus is that the court will not declare it to be so, but the consensus appears to believe that simply because it would cause unfathomable chaos almost immediately. A bailout mechanism without Germany is not a bailout mechanism, it’s a bunch of drowning people fighting over a single life preserver. But even if the consensus is correct, that doesn’t mean the court will not greatly limit the prospective participation of Germany in the future, or at least limit the ability of the Chancellor to make bailout decisions essentially unilaterally.
That event is the key to tomorrow’s trade, and it will be done before we wake up.
While bonds ended the day today near-unchanged, and stocks ended much closer to unchanged, TIPS got painfully smacked. The 10-year TIPS yield rose 8bps, and with unchanged nominal yields that produced an 8bp decline in 10-year breakevens. This means 10-year inflation swaps, illustrated in the chart below, are at the lowest level they’ve seen since the last growth scare, which not-coincidentally preceded Bernanke’s Jackson Hole speech and the proposal of QE2.
10-year inflation swaps from Bloomberg. The yield here is in basis points, so 231 is 2.31%.
This strikes me as borderline crazy, but only borderline. If the growth data continues to do what it has done, then there will be better opportunities (finally) to buy TIPS and to go long inflation at dumb levels again. The 10-year inflation swap had much more business being around 2% before QE2 was launched than 10-year inflation swaps have being around 2.30% with a US QE3 being debated, QE preparing to launch again in the UK, the Swiss National Bank pledging to sell unlimited Swissy (which is an ease unless sterilized, which it doesn’t appear to be), and the ECB buying bonds (and sterilizing imperfectly at best). However, investors insist on believing that inflation is related to growth, and inflation quotations could go significantly further south if there is a debacle in Europe.
Let’s hope there’s not a debacle, but that we get a chance to buy TIPS and inflation swaps cheaply again!
Priming The Pumps Again
The stock market, which was recently dubbed “insanely cheap” by a number of observers, is in the process of getting even-more-insanely cheap.
In any event there is little debate that it is getting cheaper. Whether or not the market is cheap is a different question. There is a natural tendency – it’s called the ‘recency effect’ – for human beings to place greater weight on things which have happened recently than on things which happened long ago, even if the ones which happened less-recently should also carry a great weight. This is why, when the Internet bubble unwound and many stocks lost 80-90%, brokers were calling you all the way down to persuade you to buy Lucent or CMGI, or some other dog at 20%, 40%, or 60% off. “It’s very cheap! CMGI traded at $150 just three months ago, now it’s $50!” (Note: I looked it up because I was curious. CMGI, which is now “ModusLink Global Solutions Inc” (MLNK), trades at 3.84 versus a split-adjusted high over $1500).
So when people say that stocks look “cheap,” I think in many cases that what they mean is that they are cheaper. And indeed they are. The S&P at 1174 is definitely cheaper than at 1350. But the landscape has also changed, the risks have evolved, and investors’ alternatives have changed.
Let’s look at the ways the landscape has changed, just since Friday.
(1) Nonfarm Payrolls was weak. It wasn’t an unmitigated disaster, but it was pretty bad. Payrolls printed exactly zero. You can add 45k back to ‘correct’ for striking Verizon workers, but downward revisions to the prior two months were 25% more than that, so it’s no salvation. Almost as much of a concern were the decline in hourly earnings (-0.1% versus +0.2% expected) and the average workweek (down 0.1 hour), the combination of which implies weak income growth. The Unemployment Rate stayed at 9.1%, which is something of a triumph – but a hollow triumph given the rest of the number.
(2) “IMF Said To Oppose Push for Greek Collateral in Potential Snag” (Bloomberg) – So, if the Greeks post collateral to satisfy Finland, then the IMF will get antsy because it “would deny the IMF priority creditor status and violate Greek bondholders’ rights.” If the Greeks don’t post collateral, then Finland will likely prevent unanimity in a rescue … which can potentially block a rescue of Greece.
(3) “Lenders suspend Greek bail-out talks.” (Financial Times) It seems that somehow Greece is missing its budget targets. This is nearly as surprising as the news that PETA thinks “fur is murder.” Greece’s official shortfall is only $1.7bln, which is peanuts compared to what is at risk, but there is eventually a straw that breaks the camel’s back. In this case, the EU, IMF, and ECB walked out of talks about the next tranche of the Greek bailout. I suspect that Greece will call their bluff and these entities will cave in, but – one never knows. To be sure, I have always thought the Greek “rescue” had approximately zero chance of success, but I am surprised this is happening so quickly. The Greek 2-year yield is now at 44.5%, up 249bps today, and the 10y is at a new high of 17.60% (up 69bps today). The bonds are trading essentially recovery value only – pricing in a virtual certainty of default.
(4) The party of German Chancellor Angela Merkel, who has continued to do just enough to help the EU hold together despite her protests, lost an election this weekend. Merkel’s party has now lost all six elections held in Germany this year. The elite in Europe still want Europe at any cost, but the proletariat does not. The problem for the elite is that at some point, they must answer to the proletariat and they are beginning to be rather ticked off at being ignored.
And the markets aren’t really happy about it either. If Germany begins to waver, the whole edifice gets shaky. Today Italian 10-year yields are up 29bps to 5.54% (see Chart), and Spain’s are +12bps to 5.21%. Remember that the ECB moved in to push these yields down below 5% several weeks ago. Apparently, they got tired of running interference, or began to see the writing on the wall that they’re not going to be able to buy allthe bonds, or are concerned about the fact that some people – I confess no direct understanding of the issues – are saying the ECB bond purchases were illegal to begin with. I don’t really get that, but the chart below speaks volumes. Investors – including a lot of banks – are plainly saying “Game On!”
Seems like the ECB bid isn't there any more!
The equity markets are obviously not enjoying the combination of weak growth, election losses, missed austerity targets, and balky creditors. The Euro Stoxx 50 fell 5.1% today, and recorded what was easily its lowest close of the year although the spike lows from last month are still holding for now (see Chart).
Euro Stoxx 50 is looking ugly. This is the year's low close.
The S&P equity futures at this writing – they were open today – are down 24 points (2%), off the lows for the session (when they were down 30 points). And now you see why Friday’s trading session saw no bounce: there was a great deal of weekend risk, and wise traders were aware that there was a lot that could go on over the three-day weekend…most of it bad. And we still have another overnight session to go before the stock exchange opens tomorrow. My worry is that there have been a lot of people waiting for the sign to hit the exits, figuring they could get out in time if the crisis was not over yet, and the exits are just not that wide. Hopefully I am wrong about that.
We may well be in the ‘next phase’ of the crisis, and this time the world’s legislatures and central banks face the specter of disaster without any dry powder. Citigroup and Goldman expect the Bank of England to re-start QE (that’s Quantiative Easing; Queen Elizabeth does not need re-starting) as early as this week. The odds of some kind of QE at this month’s Fed meeting certainly rise proportionally to any fall in equity markets as well. The Swiss National Bank is already flooding their economy with Francs to push its value down, and the ECB is busy buying bonds without a lot of concern for sterilizing the purchases. The monetary pumps have not yet blown a fuse and soon will be pumping for all they are worth.
But deflation is no longer the threat, and all this money can do is change the price level. Obama will present a jobs package, and other legislatures may come forth with new stimulus, but most politicians of solvent countries are now starting to understand that the choice of whether to stay a solvent country or become one of the insolvent starts now. Even those who still believe in Keynesian pump-priming are aware that they will need to face the voters, as Merkel has done with little success so far. I am not sure what can be done, other than the obvious, and I don’t think the elites are yet ready to sunder the Euro and default the Greeks (and Irish and Italians and Spanish and Portuguese). Eventually, that possibility will get a much wider hearing than it is currently getting.
While all of this makes inflation that much more inevitable, it is challenging to think about shorting bonds into the teeth of a crisis. The window for a selloff is closed for now. September 6th also marks the beginning of the strongest seasonal period of the year for fixed-income in the US. Over the last thirty years, 10-year yields have fallen in the 30 days following September 6th an amazing 23 times, and the average yield decline is 16bps (note that includes the selloffs as well as the rallies). The chart below shows that the tendency persists to a 60-day window, where yields have fallen in 20 of the last 30 years by an average of 22bps. I think the next good chance to sell bonds strategically may not come until late October or early November, when big supply into declining year-end liquidity could make for a big year-end bond market selloff. But that’s not today’s trade. Today’s trade is bracing for stocks to drop below last month’s lows, potentially violently.
This chart shows both the average 60-day change in 10-year yields, and the frequency of falling yields, over the last 30 years.
Tuesday’s data is the ISM Non-Manufacturing index (Consensus: 51.0 from 52.7). Ignore it – only Europe matters right now.
All Is Not Lost
The heartwarming message delivered by today’s ISM figures was all is not lost. It could be worse. Against expectations for a 48.5 print, the rumor started swirling about ten minutes before the number that the actual figure would be around 43. When the true data showed up at 50.6, there was a sigh of relief and a swift pop in the stock market. Bonds took a beating at the same time. The message sent by ISM is this: manufacturing is not in a recession (to be sure, 48.5 wouldn’t have indicated a recession either, because negative growth is associated with a number a few points below 50, but the symbolism is important).
We could be cynical and sneer “…yet” at the end of that sentence, but while the trajectory of manufacturing is something less than awesome it is something more than ominous. Maybe (See Chart).
Nothing to panic about yet, but also nothing to celebrate here.
Still, if the best we can say about manufacturing is that it isn’t in outright recession, that’s certainly damning with faint praise. The fine economists at Goldman Sachs (and I don’t mean that ironically; while they’ve lost their best guy they still put out terrific economic research) put out a piece today, pointing out that the “soft” data – such as consumer confidence surveys – has been truly awful while the “hard” data involving actual measurement of economic activity – employment and production indicators for example – haven’t been too bad at all. Anyone can notice that, but Goldman took it one step further and asked “Well, in circumstances like this should we put more weight on the more-timely (but ‘soft’) indicators or the less-timely (but ‘hard’) indicators?” Typically for Goldman, they produced a bunch of regressions but the simple conclusion was that:
The basic message from the estimates is simple: the timely soft data should get a high weight, regardless if we are projecting the total CAI—which already includes the survey-based indicators—or measures of hard data. Although the strength in lagged hard data is moderately encouraging, these equations suggest that the downturn in the soft data is quite important for the outlook, and that we should expect somewhat slower growth over the next few months.
They observed that there are some reasons that this might not be as true this time, for example if the confidence bust was mostly due to the debt ceiling debate, but overall they suggest focusing on the more-timely data.
Which brings us to tomorrow’s Nonfarm Payrolls data. The consensus for jobs is +68k (from +117k last month). That estimate has been falling a bit recently, despite the gradual improvement in Initial Claims (although it’s still 409k). One excuse will be the Verizon effect (45,000 workers were out on strike during part of August), but look for the BLS to estimate that impact if it is significant in the data. I think that the estimate is reasonable, and plus or minus 20k from there shouldn’t matter. Alarm bells will sound, however, with a sub-zero print…whatever the explanation.
Can the stock market survive a negative print, or a rise in the Unemployment Rate? The consensus estimate for the rate calls for it to be unchanged at 9.1%, but the large jump in the “Jobs Hard to Get” reading in the Consumer Confidence report suggests that a rise is likely. Do I feel bad going against the grain and ‘forecasting’ (as much as I ever do play that game) a 9.2%? Not really. Look at the chart below, from Bloomberg, and see if you can divine the economist heuristic for estimating the Payrolls number.
You too can be a Wall Street economist.
As near as I can tell, the median estimate is unchanged, every month this year. The green line looks like the white line, shifted one period!
If the Unemployment Rate does not rise, I will next look at the Participation Rate and see if the reason it didn’t rise is because people have been dropping out of the survey. And I’ll look at the “Not In Labor Force, Want A Job Now” statistic. While the Unemployment Rate has been behaving okay over the last few months, those latter two statistics haven’t been very good and have certainly contributed to the sense of malaise.
We have a three-day weekend coming up in the U.S., and I suspect that investors will prefer to head home long the bond market rather than short it despite levels that appear very rich. TIPS and Treasuries both rallied convincingly today, and the inflation curve flattened (that is, near-term inflation swaps rose more than long-term inflation swaps). The 1-year inflation swap is almost back to fair value now, in a blistering move as it has tried earnestly to keep up with gasoline. October RBOB (that’s gasoline) is almost back to the levels seen in July, right around $3/gallon. The front contract in July was higher, closer to $3.20, but some of that is a normal seasonal effect as gasoline prices tend to be higher in the summer. Price at the pump is only about $0.08 below the July level although well off the May highs near four bucks. Keep an eye on gasoline prices. Consumer confidence is already bad; if discretionary expenditures take a hit because gasoline prices eat up what are already tight budgets for many Americans, there might be a march on Washington! I’m only half kidding.
Have a nice Labor Day weekend.
