Archive for October, 2011

PIIGS At The Trough

October 27, 2011 5 comments

Well, what else am I going to write about today? Markets got to react to the EU deal announced late last night, and went predictably bonkers. Stocks rallied 3.4% to the highest level since August 1st. Note yields also rose to the highest level since early August, up 17bps at the 10-year point to 2.37%. TIPS held up well, as 10-year real yields rose only 7bps (implying that inflation swaps and breakevens were about 10bps wider). The dollar plunged, to its lowest level since early September (see Chart) and falling against every major currency in the process: Euro, Sterling, Yen, Aussie and Canadian Dollars, Brazilian Real…

Rough times for the dollar recently. If there's no safe-haven bid, it seems there isn't much bid!

Commodities, as a result of the sharp dollar move and the general feeling that economic disaster has been averted, rallied sharply. The DJ-UBS was +2.5%, with Copper up 6%, Silver up 5%, Crude and Wheat up 4%, and only Nickel and Nat Gas down by more than 1%.

The catalyst, obviously, was the EU deal. The basic elements of the deal are:

  1. The banking lobby has agreed, with no binding commitment, that private banks will take a voluntary 50% writedown on their holdings of Greek debt. It appears that this will be done through a complicated as-yet-to-be-devised structure, with the EU kicking in some kind of ‘incentives.’ It is all very murky.
  2. The EFSF will be leveraged, probably 4-5 times, by providing first-loss guarantees on primary debt through a SIV that is funded by private investors (crazy ones), sovereign wealth funds (none has yet committed), and maybe the IMF, although the UK is already moving to block the IMF from using cash sourced from England.
  3. The EU will restore guarantees for bank issuance, and require Tier One capital to be raised up to 9% by June 2012. No mention is made of how banks which have just taken billions of Euros in write-offs will raise so much private capital. Details, details.

The effect of the grand bargain will be to reduce the Greek debt burden all the way down to – drum roll, please – 120% of GDP by 2020, a level typically associated with unsustainable debt dynamics and eventual default. So you can see, it’s a big improvement!

Still, given that the EU did manage to produce some pyrotechnics, it is incredible that Greek bonds aren’t doing better. The Greek 5y note rallied all of 4 points, to about $44. The yield fell to 25% or so. Considering that this deal is supposed to put the country on the path to sustainability…and presumably, that means the bonds should be paid off at maturity…it seems to me as if they should be doing better. I would understand if there was some overhang from dealers selling around a price of 50, where they’re theoretically going to have to take losses anyway, but shouldn’t buyers be willing to pay at least that much? It seems to me that bank bond holders should be dumping bonds at 55 or 60 to non-bank holders who plan to hold and be paid par. I suppose if I was the non-bank investor (and I am) I might be skittish at paying very much even given the EU promise. They might have made the promise with their fingers crossed.

Other PIIGS country debts improved as well, but again the rally was surprisingly delicate. Portuguese 5y bonds rallied 93bps to 13.8; Spanish 5yrs rallied 16bps; Italian and Irish bonds only 6bps.

In case my sarcasm isn’t plain enough, I’m not very impressed by this deal. I was pretty sure that something would be announced, and I was pretty sure it would have no substance, but I guess I was expecting something a little more. Even if you believe their numbers, it doesn’t get Greece to sustainability!

Moreover, I continue to be truly amazed at the complete misunderstanding of leverage by politicians and their advisors. Here’s an insight: if you have $400bln of capital and you lever it four times, you don’t have $1.6 trillion of buying power. You have $400bln of buying power. It merely gets spread out over a larger face amount of bonds – now, a 25% move will wipe you out with (ta-da!) $400bln in losses. No amount of leverage changes the fundamental equation of how much of a loss you can absorb. It only changes how many bonds you can spread the loss over. It frustrates me to see such a primitive understanding of markets, market structures, and leverage among the very people who are supposed to be saving us all. At least a banker understands that leveraging up isn’t a solution to a lack of market power.

Well, except apparently for John Corzine, whose MF Global has now been downgraded to junk and about whom, as I write this, Bloomberg is printing headlines saying “MF Global is said to have drawn down credit lines this week.” MF Global is no Lehman, but it’s a significant firm with some very good people…and cavalier leadership, apparently. Still, MF Global was managed better than Greece was. I wonder if they’ll get a SIV to support them.

I don’t think the Greece drama is over. I hate to say that, but I really don’t. Perhaps this buys a few days before skeptics dissect whatever details there are, or some sovereign legislature votes the deal down, or a consortium of banks splinters off from the main deal, or a supranational backs away. Contributing to that pressure will be the other PIIGS at the trough, who will want deals at least as good as the one Greece got (and reasonably so). On the other hand, the Fed meets next week and some observers expect a gesture towards QE3…especially if the European drama doesn’t fade quickly. I don’t expect the Committee to do something that contrasts so directly with what some members of the FOMC want, especially while stocks are up and commodities are also.

Yes, they will be aware too of the next big deadline – in late November, if the so-called ‘Supercommittee’ does not agree on concrete steps to cut the deficit (and there is no sign of any agreement yet), substantial mandatory spending triggers will be enacted. I am sure QE3 remains in the quiver in case it is needed, but I doubt they’ll be pulling it out just yet.

One of my criteria for getting back involved in stocks was that the VIX break appreciably below 30. Well, it has done so by trading down to 25 today. Unfortunately, the decline in the index was mainly due to the directional move (the VIX usually declines in rallies and rises in selloffs, because the index methodology weights strikes according to moneyness, and so when prices are falling the higher-volatility puts gain weight compared to the lower-volatility calls), and the market valuation is too rich for my blood. I participated in today’s rally through my bond short (TBF rallied 3.4% today, keeping pace with stocks) and my commodity index long, but there’s no doubt my performance trails the equity market this month!

The Devil Is In The Double-Entry

October 26, 2011 2 comments

Strong Durable Goods Orders, ex-Transportation, of +1.7% will help end Q3 on a strong note (the first look at Q3 GDP is due tomorrow, and the consensus expects 2.5% growth and a 2.2% rise in the Core PCE price index). It does look like September was generally better than was feared in August; the question from here is whether Q4 data will follow the lead of the miserable October Consumer Confidence figure reported on Tuesday. As ever these days, though, the drama in Europe was the driving force behind market action. Bonds fell, with the 10y yield up 9 bps to 2.20%, and stocks rose 1.1% as investors seemed to see the balance of the news as favoring a brokered peace between EU nations fighting to put Humpty Dumpty back together again.

I confess that I don’t see what they are seeing. There may be a solution, but if there is then it will be force-fed on banks following the old maxim “If a piece doesn’t fit, then you’re not using a big enough hammer.” The ‘plan’ being promoted as such discusses fairly serious haircuts on holdings of Greek debt, required recapitalization of banks (although in some reports the recapitalization would have to come from raising money in the market, which has next to no chance of happening in these circumstances), bolstering or levering the EFSF, and various other bells and whistles. The only little problem is that the folks who hold most of the Greek debt, who must be party to any controlled restructuring, don’t like it.

This afternoon’s Bloomberg headline was “Impasse on Greek Debt Relief With Bankers Threatens EU Crisis Summit Deal.” The Institute of International Finance, which speaks for a consortium of banks, said there is no current agreement “on any element of a deal.” I find the headline chilling because it makes “bankers” the bad guys. It would not surprise me in the least if the politicians are calculating that by framing this as ‘reasonable people vs the bankers’ (why not pile on the bankers?) the politicians will bring them to heel without force because banks won’t want the bad publicity on top of what they already have as the villains of the world today. And, if they don’t comply, then the politicians can frame the bankers as the road block.

Now, unlike for politicians, publicity isn’t everything to banks. What we need to keep in mind is that this argument from the banks’ perspective is about accounting. The economic value has been lost already. What is salient to the bankers at the moment is the question of how much of an accounting write-down they can avoid, so that they don’t have to take any more of a bailout than is necessary. A second salient point, probably, is that whatever haircut they give Greece will be the starting point for negotiations with Italy, Ireland, Portugal, Spain, and some others. The negotiations over Greece are akin, although of course not planned as such, to the ‘targeted negotiations’ that the United Auto Workers historically have applied in contract discussions with the auto industry. The first deal becomes the model for the next deal. This negotiation is about far more than just Greece.

Again, the money is already gone. Nothing can change the fact that Greece will never pay 100% of its current obligations. Nor 80%. Nor 60%, in all likelihood. This is about accounting for the losses. (Do not, in other words, be surprised if any ‘solution’ includes continued regulatory generosity about the counting of losses, just as every ‘stress test’ has).

Since this is not just about Greece, banks are not going to concede easily. Since it is not just about Greece, any political agreement is going to be hard to get past vigilant legislatures. That is to say that even if they get Humpty back together again, the trick is going to be keeping him together.

And all of this happens as we motor into conditions of declining market liquidity as the end of the year approaches. Perhaps the recent odd decoupling of some markets (for example, TIPS were strong today, and equities were strong, and inflation swaps widened 5-6bps even though commodities fell 1%) is an early consequence of the declining liquidity. I don’t know; it seems early for that but I am keeping an eye on this decoupling.


I noted yesterday that commercial bank credit has finally joined the land of the living and has expanded by more than 1% over the last year (and at a considerably faster pace quarter-on-quarter). This I cited as a small ray of sunshine in the overall gloomy murk that is the financial/credit/sovereign crisis. It is a sign that some of the bank reserves, heretofore sequestered due to the attractiveness of riskless interest-on-excess-reserves (IOER) relative to risky lending at low rates, are making their way into the real economy. This does have a dark side, and that’s the fact that – since we have never had excess reserves like this – we have no idea how quickly excess reserves will move into the transactional money supply and put upward pressure on prices. It is foolhardy to rely on a model here, because we’ve never seen anything like this. It could be gradual, and controllable, or it could be a dam bursting. We simply don’t know, no matter what the august Chairman tells you.

But in an attempt to remain cheerful, let me review why QE1 made some sense when it was implemented (it’s hard to argue that QE2 made any sense at all while IOER was in place). At the time, a key worry of policymakers was that the economy may have entered into a major deleveraging cycle, which would be associated with a sharp decline in the velocity of money. Since it isn’t the quantity of money M, but the quantity times the velocity V, that affects nominal output (mainly through prices unless money illusion is epidemic), policymakers are rational to try and offset a decline in velocity with an increase in money. In full disclosure, I was one of those who at the time thought the plunge in velocity would be far more than could be compensated for by conventional monetary policy, and I doubted that the Fed could prevent deflation although I also said that the deleveraging would provide ideal conditions for an inflationary period thereafter.

So what happened, in the event? Money velocity did in fact decline, but the decline was not particularly severe compared to the severity of the event. The chart below (source: Bloomberg) shows M2 velocity since the 1960s.

Money velocity back to the old standard of normal.

Note that the decline in velocity was no more than was seen in the early-2000s recession. What is more, the level of velocity is not particularly low on a historic basis. The last two decades are the outliers. To me, this suggests that the decline in velocity has very probably run its course, absent a more gut-wrenching financial debacle, and so the current growth in M2 is more worrisome if it lacks that offsetting effect.

Also, the deleveraging that you hear so much about is simply overhyped. The chart below (source: Federal Reserve) shows the debt outstanding, in billions, of domestic financial institutions, households, and businesses.

Deleveraging? Hmmm.

You can see from this chart that whatever deleveraging there has been has been predominantly done by domestic financial institutions – and much of that, by the way, is because banks were flush with reserves and didn’t need to roll as much debt. The terrible household deleveraging you have heard about is mostly mythical. It feels like there has been deleveraging, because we’re so used to increasing debt every quarter, but there hasn’t been much. And businesses have essentially the same amount of debt now as they did when the crisis began. Almost all of the leverage, that is, is on the bank side. And neither that, nor household indebtedness, is even back to trend.

So I am skeptical that we are in a grand deleveraging cycle. Yes, we are deleveraging, but no, it isn’t dramatic. The gross level of debt from these three groups is still up 283% since 1990 (although that should fairly be adjusted for the rise in nominal GDP). There are two sides to that observation. It may be that we have only just begun to deleverage, and so we have much further to go and money velocity will continue to fall while we do so. But it may also be that most of the deleveraging cycle, for now at least, is complete. If that is the case, it is bullish for the economy (although please note this is not a call for Thursday, but something that would be felt in 2012 and 2013), but it also means that the Fed has overstayed its welcome and the uncomfortable rise in inflation over the last year is likely to continue.


As I send this ‘to print,’ headlines are flashing across the tape that Euro leaders have either reached a deal on a 50% writedown of Greek debt, or that they have reached a deal with banks on that haircut, or that they are ‘close’ to reaching such a deal. The stock market so far is justifiably hesitant, since only a couple of hours ago – indeed, when I started writing this article – there was ‘no element’ of a deal in place. I am pretty sure they are close to a dramatic announcement. I would be surprised if they were close to an actual substantive deal, given my observations above. This is not about just Greece, and any ‘deal’ that trades nothing to the banks that they don’t already have (they already have the economic losses) in exchange for an order to go raise more money in the market for themselves isn’t much of a deal in my mind! My suspicion is that the banks may have agreed to the idea of 50% but not to any details of structure. Since as my friend Peter Tchir has pointed out the 21% haircut wasn’t really a haircut at all, the structure does matter. So the drama continues, the breathtaking headlines and ethereal details continue. It is all getting quite exhausting.

Categories: Economy, Europe, Private Debt

Up On Fumes; Now Down In Flames?

October 25, 2011 Leave a comment

Volumes remained light on Tuesday, but the clouds definitely darkened some. Bonds responded to weak economic data and a negative turn in Europe by rallying 12bps to put the 10y note at 2.11%. TIPS actually kept pace, which is unusual (10y TIPS rallied 11bps), and commodity indices – even more unusually – rallied 0.6% even though stocks fell 2%.

The data was surprisingly worse-than-expected. Consumer Confidence for October took a further dive to 39.8, which was the worst print since the early 2009 (see Chart) snap-back in confidence in the first hundred days of the Obama Administration. Forget what I said about the optimistic American consumer! This is a bad number, and it is truly remarkable that it could be this bad for this long.

Consumer Confidence is at a low ebb for Obama's Administration, excepting the follow-through during the first months he was in office.

Meanwhile, the headline in the middle of the day was that the EU meeting of finance ministers, due to be held tomorrow, was canceled. The summit meeting between EU heads of state is still scheduled, but the cancelation of the ministerial meeting suggests no deal is imminent. Indeed, some of the news off the Continent today suggested that there are widening cracks in the edifice.

The upshot of this is that if the equity market was rallying because of optimism about the evolution of Q4 economic data, it was probably ahead of itself since the early indications are that the data could be quite weak. If the equity market was rallying because of optimism about the EU summit and the potential for resolution of the Greek crisis, then it was also at least ahead of itself.

Stocks maybe rallying, though, because of the poor opportunities elsewhere and the huge amounts of liquidity that is working its way into the system, and we have to be wary of blithely dismissing that possibility. The liquidity is not just sitting all in bank reserves any longer, either. I’ve detailed the recent rise in M2, which some people pooh-pooh because they view it is a symptom of the weakness of European banks. But the chart below gives more cause for concern (if inflation is your worry) or optimism (for what this says about the availability of credit.

52-week growth in commercial bank credit is expanding after years of contraction.

This chart shows that commercial bank credit is now rising at slightly faster than a 1% per year rate. That’s not all wine and song, but it’s much better than it was over the 2009-2010 period when bank credit was contracting sharply due to much tighter lending standards and plentiful defaults. Note that the aggregate amount of commercial bank credit, at 9.3 trillion, is still well below the 9.9 trillion of mid-October 2008 (after Goldman and Morgan Stanley abruptly became commercial banks). So this is good news for the economy, but only just.

The bad news currently outweighs the good, to be sure. But for the first time in years, there is a glimmer of light in the darkness. I’m not talking about a one-month surge in car sales due to cash-for-clunkers or a surge in hiring around the Census. The slow rise in bank credit is not a manipulation, but an actual improvement. Banks are lending again – not a lot, and credit standards are still quite high, but they are lending.

If Europe spirals out of control, it will snuff out this glimmer of light. It is still far too early to be thinking of getting bullish on equities at a Shiller P/E of 20.5. Bank lending was miserable for several years and it will be some time before it’s truly healthy again. But there will eventually be an end to the tunnel. The worrisome fact of course is that renewed lending will increase the pressure on prices and inflation is quite likely to keep rising with no policymaker will to restrain it for some time (not to mention an explicit promise not to).

On Wednesday, the Commerce Department releases September Durable Goods (Consensus: -1.0%, +0.4% ex-transportation) and the Census Bureau publishes the September New Home Sales report (Consensus: 300k from 295k). Being September numbers, they may not be as bad as today’s glimpse of October, but Europe still dominates anyway.

Categories: Economy

Not Time To Make Big Calls

October 24, 2011 2 comments

I’m don’t know whether it makes sense to read a lot into Monday’s action itself. Volumes were light; presumably, this is mainly because many investors are waiting to see what the second meeting of EU leaders later this week produces.

German Chancellor Merkel is reportedly going to seek parliamentary approval to apply leverage to the EFSF. If she succeeds, and some sort of bank-and-sovereign-backstop package gets approved, it is likely bullish for stocks – but even reaching agreement on anything remains a big ‘if.’ I would also point out that all such an agreement would do is to kick the problem down the road, for a year or less. Also contained in the article linked to above is the observation that the EU wants Greek debt haircut by 60%, while banks think it should be 40%. I find it remarkable, and telling, that no one seems to be asking what number actually makes the Greek situation tenable. Still, 50% would be closer to the right number than 21%, which is what the last deal was.

Stocks rallied again, and are up 14.1% over the last three weeks. For those playing along at home, that’s a 244% annualized rate of gain. Is it notable that volume has returned to the standard that prevailed prior to August – sub 1 billion NYSE shares? Surely it is worth observing that while 10-year Treasury yields sold off from 1.76% to 2.20% from October 1st through 12th, they essentially have not risen further since then. Stocks and bonds have uncoupled as bond investors remain somewhat skeptical that all is well.

Is there reason to be optimistic? There’s always some reason to be optimistic, just like there’s always some reason to be pessimistic (that’s what makes markets, after all). On the optimistic side, let me introduce the rebound in copper, which soared 6.5% today after having reached a 15-month low last week. Front Copper is now 12.8% above those lows. That’s good news, because as you can see from the chart below, while Copper and stocks have moved in lock-step for the last three years, equities have recently been making Doc Copper look somewhat tarnished. (Incidentally, in my view the very fact that copper parallels stocks diminishes the value of that metal’s economics degree. Because we certainly know that stocks do not echo every wiggle of industrial production!)

Of course, the flip side of that same coin is the fact that stocks have been leaping ahead of industrial metals, showing more optimism than commodities buyers are showing. Moreover, higher industrial prices and energy prices can be both symptom of growth…and a cure for it! NYMEX Crude reached nearly three-month highs today, above $91/bbl. This may be related to the passing of the Saudi crown prince over the weekend as well as the revelation that the post-Gadhaffi government in Libya seems to be shaping up to be more Islamist rather than less so. And as these things both make the Middle East marginally less stable (although presumably the succession question in Saudi Arabia will be settled peacefully) at the same time that the U.S. Administration has decided to withdraw all troops from Iraq before they are kicked out, it is perhaps reasonable to put a small additional risk premium into petroleum prices. Interestingly, while commodities had quite a good day, inflation swaps barely moved.

As I said in the beginning of this comment, I’m not sure I want to read deep implications into the modest breakdown in correlations we are finally seeing – stocks up, but volatility still high (VIX around 29); commodities up, inflation swaps unchanged; equities rally but bonds stable. I suspect that we will need to get the results (or lack thereof) from the EU meeting before the meaningful money flows arrive.

Tomorrow’s data includes October Consumer Confidence (Consensus: 46.0 from 45.4), in the first look at October data. The story from September was that the data, which had been weakening since February or March, stopped getting worse. Now, remember that Consumer Confidence isn’t on a 0-100 scale. A reading of 46.0 is horrible – such a level was not recorded in any of the last three recessions prior to the 2008 crunch (see Chart below).

The current level of confidence is incredibly weak - and it's hard to keep it this weak for long.

It is hard to sustain such negative levels of sentiment for a long period of time in a country that has historically had an optimistic citizenry. It would not surprise me to see some recovery, even though I don’t believe an economic resurgence is imminent.

Although it is tempting to get aboard the stock market for a late-year rally, it would be foolhardy to do that before seeing resolution from Europe. I’ve said for a while that stocks would rally once Greece actually announced default; the 14% rally makes the upside of that trade less likely but I really don’t think we’ll see anything like a true default yet. High implied volatilities and low bond yields continue to signal that there is more risk out there than equity investors perceive. I am making no major changes to my allocation at the moment.

Categories: Commodities

After All, Tomorrow Is Another Day

October 20, 2011 7 comments

“I can’t think about that right now. If I do, I’ll go crazy. I’ll think about that tomorrow.” – Chancellor Merkel

Actually, that quote is from Scarlett O’Hara in Gone With The Wind, but it may as well apply to the EU leaders who announced today that the much-heralded summit meeting this weekend would be delayed until ‘no later than’ next Wednesday. The cited reason is that there are still some issues to be worked through before “final agreement” can be reached. I don’t know about you, but that sounds like the NBA labor dispute. If they knew when they were going to reach a final agreement, then they would have reached an agreement. Methinks this is more an admission that the issues aren’t so easily brushed aside as the early-week rumors of a resolution suggested. The good news is that this means we don’t have to trade down into the weekend and then up on Monday (or up into the weekend and then down on Monday) on the basis of expectations set and dashed.

Europe is still hogging the headlines. The Philly Fed index was great, printing +8.7 versus -9.4 expected (-17.5 last month), on strength in New Orders and Shipments. The Number of Employees subindex, curiously, declined. This has been a wild year for Philly Fed. In March it reached a 27-year high at 43.4; in August it reached a 3-year low at -30.7. Remember that this is a relative-strength indicator: respondents describe how conditions are relative to the prior month. The huge swings show great instability in the rate of growth, due to everything from tsunamis and nuclear meltdowns to Middle Eastern riots to large-scale government intervention. I wonder if the significance of Philly Fed right now is less about its level and more about its volatility. It must be hard to make long-term investment decisions in a business when conditions are changing so violently from one month to the next.

Philly Fed has not given much insight recently, but I wonder if the volatility implies something about visibility?

This may also be the reason behind the strong TIPS auction. While the level of real yields is awful, part of TIPS’ appeal is in the option-like character of inflation. That is, if you are wrong owning TIPS here compared to nominal bonds, then you lose a little bit (we’re not going to have -5% inflation for 30 years, and even if we did you’d get par back), but if inflation develops there’s no reason it can’t be +5% or more. So again, the uncertainty about the economy may contribute to the bid. Put another way, there may be interest from nominal bondholders who are more interested in getting a 1% real yield with certainty than some chance of a +2% real yield and some chance of a -3% real yield over the holding period of the bond.

On the flip side of inflation, copper was killed today, falling more than 5%. “Doc Copper” is 34% below its highs (see Chart) and at the lowest level in a year. I think copper doesn’t have the leading indicator character that it used to have (at least in legend), and I think that it isn’t likely to stay down with the world awash in cash (M2 is still rising at 15.2% annualized over the last 26 weeks), but it is a warning sign that should be recognized.

Doc Copper is feeling a little run-down himself these days.

It may seem odd, after looking at copper, to address the question, “Are Commodities In A Bubble?” True to form, perhaps, I am less interested in the answer than in a way to attack the question. Commodities are not like capital market assets such as stocks and bonds which represent an ongoing source of value and a stream of income. A bond pays a coupon or interest at maturity; a stock pays dividends or (hopefully) increases in value over time as the company retains earnings. Because these instruments have definable cashflows, even if they are speculative, they can be analyzed with tools such as net present value analysis or a dividend discount model. But commodities have no ‘yield to maturity.’ You get no dividend from Zinc. And that means we can analyze the current value of a commodity with respect to its supply and demand but otherwise relative value tools are scarce.

But wait, analyzing the current value of a commodity with respect to its supply and demand is already done through the mechanism of price discovery. In transparent markets, it is hard to argue that any particular price represents in itself a ‘bubble’ or ‘deep value.’ Unless there is some reason that prevents the market from clearing normally, the spot price will be driven by the utility of the good for the purposes of consumption.

(As an aside, the demand from commodity index funds that acquire risk through futures contracts does not, cannot, affect the spot price in a meaningful way. This is because for every long contract there is a short contract, and commodity index funds generally roll so as to never take delivery. This may affect futures prices and contangoes/backwardations, but not spot prices. On the other hand, ETFs that hold physical commodities may, by removing commodities from circulation, affect the spot price over time. But this is not a key part of what I am talking about today.)

So what should we mark commodities against? I choose: money.

Commodities, by their nature, should have a zero real return over (a long period of) time. A pile of copper remains a pile of copper. A bar of gold remains a bar of gold. Thus, if the price of a commodity changes over a long period of time, it is probably more accurate to say that it is the unit of account that is changing value. An ounce of gold doesn’t go from $500 to $1000; a dollar goes from 1/500th of an ounce of gold to 1/1000th ounce of gold. This is, of course, the argument of hard-money adherents. I don’t understand why only gold will do – and don’t want to conduct that argument – but the general point is reasonable.

So we want to compare commodities over time to money. Is the price of commodities out of line given the amount of money in circulation?

This is a harder question to answer than it sounds like. The absolute amount of M2 money has grown enormously over a long period of time. In 1959, M2 was $298bln. In 1989, M2 was $3.2trillion. In 2009, $8.5 trillion. Obviously, commodities prices have not grown anything like that amount. This is because the amount of money must grow over time to maintain a constant price level, if GDP is to keep rising. Remember MV≡PQ. If velocity is stable, and prices are stable, then M must grow with output. Of course, velocity is not stable, although M2 velocity happens now to be back in the general range it inhabited from 1960-1990. And of course, in principle, the Fed doesn’t want prices to be precisely stable, either, since a small amount of inflation is seen to have much lower costs and risks than a small amount of deflation. So if we plot M/Q, we expect to see it rise slowly over time. In fact we do, as the chart below shows (incidentally, don’t be concerned about the units on any of these costs. They are artificial; it’s the trend that matters. For example, the chart below shows how many dollars are in circulation for every dollar of output, but the axis units will be different if I use, say, 1982 dollars rather than 2005 dollars as we have here).

M2 compared to real GDP

So again, charts of commodities ought to look something like the chart above. There is more money in the system, but it’s really how much more money there is relatively since a larger economy needs more money just to keep prices stable.

I compare “economy-adjusted money” to commodity prices in the chart below using the CRB (which I use mainly because it has a long price history). I think a case can be made that commodities may have been ‘bubbly’ in the 1970s and perhaps in 2008 they were starting to get there, but it’s hard to look at this chart and see a big bubble now.

CRB compared to economy-adjusted money

Now, certain commodities might be. This is perhaps not as good a way to compare value for individual commodities because for them we also need to consider more microeconomic demand and supply and, especially, long-term changes in the supply dynamic, but we can get an idea of general trend. Live Cattle and Wheat certainly don’t look bubbly. Note that if we didn’t adjust Live Cattle, it looks very much like the M2/GDP chart: it slopes upward and to the right. Ditto Wheat, although to a lesser extent. Adjusted by “economy-adjusted money,” both of these look about fair.

Wheat and Live Cattle (chosen for random illustration)

Crude oil between 1986 and 2003 was pretty stable, and started to look expensive thereafter. To be fair, there are some questions about long-term supply in oil (Peak Oil and all that). I won’t say anything about Gold, because whatever I say makes somebody mad. You judge. I’ve written before about how it makes some sense to think about Gold as an in-the-money straddle on inflation.

Gold and Crude Oil have more interesting stories (and they always do).

Finally, and perhaps surprisingly, I threw in two financial assets that are often thought  of as inflation hedges for different reasons. The chart below shows the adjusted ratios of stock prices and median existing home sales prices to economy-adjusted money. Home prices look pretty reasonable on a long time scale; stocks less so, but of all of these charts I have the least intuition about how stocks should look through this lens.

Is this a reasonable way to 'deflate' financial assets?

So my overall perspective is that the symptom of high prices of certain commodities and of commodities in general in no way should produce a diagnosis of a bubble in commodities. Feel free to disagree and comment…I’m not saying this is the final word on the subject!

Inflation Worrying People Less, But Shouldn’t Be

October 19, 2011 5 comments

Well, it’s definitely getting difficult to attract followers to websites these days. I noticed that one of the visitors to my main commentary website got there by following a link from a Google search of “fraud michael ashton accused.” For the record, as far as I know I have never been accused or even suspected of fraud, but one takes website hits as one can, I suppose. Won’t you help improve the provenance of my visitors by passing along the commentary to a friend and pointing them to the website, syndicated versions of the comment on Seeking Alpha or Safehaven, or the Twitter feed @inflation_guy?

Despite my apparently impending legal problems, it was still an interesting day because it was CPI day.

Headline inflation was as-expected at +0.304%, but core inflation came in at only +0.054%, barely rounding up to +0.1%. That really wasn’t too much of a surprise; I commented yesterday that core inflation had been running hotter than my models suggested it should be. What was a little surprising was that housing inflation wasn’t responsible for that slowdown. I show the breakdown by major groups below.

Weights Y/Y change Prev Y/Y change Year ago y/y
 All items





  Food and beverages




















  Medical care















  Other goods and services






From last month, the following major subgroups showed acceleration in the year/year rate: Food & Beverages, Housing, Transportation, Recreation, Education/Communication, and Other. Those groups total about 90% of the index; the other 10% (Apparel and Medical Care) decelerated. Now, this is on a year/year basis, and it doesn’t tell you where the weakness was this month, but what it does tell you is that overall inflation is still rising. The year/year figure for headline was +3.868%, as you can see from that chart, and core was +1.975%. Remarkably, coming off a bubble bursting Housing inflation has almost caught up with the rest of core. I think this is largely a blip resulting from the hang up in processing foreclosures, and I would expect Housing to fall further behind core over the next six to twelve months.

Now, that could happen if housing kept rising at 1.8% but core ex-housing kept quickening. In fact, that would be good for the economy, or at least the housing part of it, since nominally-rising prices will help clear the inventory overhang more quickly. Any way you slice it, inflation right now is still rising. The fact that y/y core inflation rose despite the small m/m change tells you that last September’s core figure was even lower. It was, at +0.03%, and October’s was +0.01%. That could hint at some problems with seasonal adjustment, or perhaps it was just the low point of the cycle.

As an aside, the Cleveland Fed’s Median CPI rose to 2.1% year/year.

The bottom line is that right now there is no reason in the data to think that inflation pressures will abate. As long as the pumps are on, the basic assumption should be that the price level will continue to rise. Once the pumps are turned off, inflation will tend to ebb. The real questions now are (a) is there any will to turn the pumps off, and (b) given the reservoir of reserves, will we need to reverse the pumps…and is it possible…and is there any will to sell trillions of dollars of the Fed’s balance sheet into the market to compete with new Treasury issuance. The answers to those questions, of course, are unknown.

Now, there is another possible reason to think inflation will ebb (I’m talking about core inflation here; headline inflation will ebb for at least a little bit reflecting the flattening of energy prices unless there is a spike higher). A story on Bloomberg this morning announced that:

“Banks in France, the U.K., Ireland, Germany and Spain have announced plans to shrink by about 775 billion euros ($1.06 trillion) in the next two years to reduce short-term funding needs and comply with tougher regulatory capital requirements, according to data compiled by Bloomberg.”

If you don’t want to worry about inflation, this is the reason. If banks unwind loans, rather than selling other assets like sovereign bonds, then it represents a decline in credit availability that will manifest as a deceleration in velocity. Of course, if they sell bonds from portfolio instead, at the same time that sovereigns are selling ever more bonds, then interest rates will likely go much higher since banks have been big buyers of those bonds historically. That will slow growth, although it won’t do a lot to slow inflation.

This was after all part of what the Fed was trying to offset with QE1: they expected a sharp fall in velocity and needed to offset it with a rise in money. (It isn’t at all clear what they were trying to do with QE2.)

Now, it is plain that concern about inflation is ebbing at least among retail investors. The NYSSA recently postponed a course I was scheduled to give on “Understanding Inflation-Indexed Products,” until such time as “the economy reaches an inflationary trend” (which is a really amazing statement when you consider that core inflation has more than tripled in the last year and is still rising). Institutional investors are still devoting considerable time to hedging adverse outcomes in inflation, but retail investors are clearly less concerned. The chart below, which shows the aggregate adjustment to measured inflation suggested by my “Real Feel Inflation” methodology,[1] can be read as a measure of inflation angst, and it is quite low at present.

A measure of inflation angst - fewer price outliers feels less inflationary to us.

Retail investors generally assume that inflation is related to growth (institutional investors do too, but are generally aware of the money argument), which is why commodity prices these days ebb and flow on an almost 1:1 basis with stocks. When stocks are rising, because of a report that there’s a grand solution to the European mess that will curtail the possibility of a meltdown, then commodities rise as well – as they did on Tuesday. When stocks are declining, because it turns out that the aforementioned report was bunk and in fact Euro leaders are meeting “to Break Debt-Crisis Gridlock,” then commodities fall as well – as they did today.

As an aside, the quote of the day comes from that article:

“Many expect to be underwhelmed at the weekend,” David Mackie, chief European economist at JPMorgan Chase & Co., said in an interview. “If they haven’t settled the leverage issue, then the sense of being underwhelmed will be overwhelming.”

Even those who believe that growth matters a lot to inflation, however, could be a trifle more optimistic today after Housing Starts sharply exceeded expectations by printing 658k compared to a 590k expectation. As the chart below shows, this isn’t exactly “Happy Days Are Here Again!” but it is improvement…and the fact that it was ignored underscores how the market right now eats, sleeps, and voids Europe in preference to all other information.

Nice jump in starts, but in the grand scheme of things no big deal.

So, because Europe is now seeing “division,’ stocks fell 1.3%, commodities fell 1.3% (all subgroups participated in the decline), inflation swaps declined about 4bps, and nominal yields declined 2bps.

Tomorrow brings Initial Claims (Consensus: 400k vs 404k last), Existing Home Sales (Consensus: 4.91mm from 5.03mm) and the Philly Fed Index (Consensus: -9.6 vs -17.5 last). There’s also the auction of $7bln 30y TIPS, which should clear at a real rate somewhere right around 1%. That is only a good deal if your alternative was to buy 30-year nominal Treasuries at a yield of 3.18%; you’ll very likely do better owning 30-year TIPS. But the real question is why you’d take 30-year risk at rates this low. They’re not all-time lows (yields got as low as 0.82% earlier this month), but close enough that I wouldn’t buy them.

Also tomorrow, I plan to present one way to consider whether commodities are “in a bubble.” (I’d intended to cover it today but ran out of space.)

[1] The methodology is discussed in my paper ‘Real-Feel’ Inflation: Quantitative Estimation of Inflation Perceptions, which is scheduled to be published in the January 2012 edition of the journal Business Economics. My company is looking for a commercial partner to further develop the methodology – contact me to discuss.

Those Millimeters Do Add Up

October 18, 2011 1 comment

What’s a millimeter among friends?

Stocks soared late in the day today as the Guardian newspaper in the UK ran a story proclaiming “France and Germany ready to agree €2tn rescue fund.” As part of a ‘comprehensive’ fix, the EFSF would offer “first loss” guarantees, which basically means that if Italy collapse, well, you’d get your recovery plus (for example) 20% back. The purpose of that provision is surely to reduce the write-downs that banks should be taking by 20% – if Italy and Spain go belly-up, having France and Germany pitch in 10% or 20% is actually probably smaller than what everyone assumes they would have to do anyway. A second part of the fix would reportedly reduce the amount that governments would contribute to bank recapitalizations from the €200bln that Christine Lagarde of the IMF says they’ll need, and instead put in €100bln (plus, presumably, changing the rules to make banks look like they’re better capitalized).

So the bank recapitalization part is less than folks expected to eventually need/get from Europe. And the ‘first loss’ idea is trés ironic, considering that also today, the EU reached a deal on a law that will “pave the way for an optional ban on naked credit-default swaps on sovereign debt.” In other contexts, the EU has stridently talked about making senior bondholders “share the pain” of bank failures, and the ECB has repeatedly said that no CDS-triggering event should happen in Greece, even if there is something that everyone with a brain would consider default. So, given that, what confidence to we have that the EFSF would actually pay up in the event they have to deliver on a trillion or two, rather than carefully interpreting the rules to ensure that the insurance isn’t triggered, or simply renege so that paying the insurance doesn’t bring down bigger sovereigns?

If equities do this well on a rumored deal that doesn’t seem to solve the problem, imagine how well they will do when the problem is solved by letting Greece go!

In being balanced, I ought to point out that the Guardian story came out after earlier reports on Bloomberg attributed a statement to German Chancellor Merkel that officials were moving “millimeter by millimeter” to solve the crisis. Either we were only a few millimeters away from a solution previously (it seemed farther!), negotiations suddenly covered a lot of millimeters (it seemed slower!), or this alleged France/Germany insurance deal doesn’t solve the crisis in the view of Chancellor Merkel. On the other hand, French President Sarkozy went out of his way in the Financial Times to promise a big solution coming soon, or else there may be a “resurgence of conflict and division on our continent. He further said that “France on its own cannot cope,” which by now is something the whole world presumably understands.

Bonds were nonplused. 10-year yields rose 2bps, and inflation swaps 4bps. Commodities lurched to an unchanged close although energy was up and precious metals down. The dollar was roughly unchanged. But stocks took the bait hook, line, and sinker and rallied 2%. I advise you to look wider than stocks. Investors in most other asset classes are not ready to blow the victory trumpet over the European crisis yet. As if to drive that point home, after the close of trading Moody’s cut Spain’s rating two notches to A1, and kept a negative outlook.


Tomorrow is the monthly CPI report. The consensus call expects a +0.3% rise on headline CPI (which would bring the year-on-year figure to 3.9%) and +0.2% on core CPI (bringing the year-on-year change to 2.1%). Headline inflation will crest soon, at least temporarily, but there is no sign of any abating in core inflationary pressures. Core inflation is running well ahead of our models, and frankly long overdue for a better-than-expected print. But the monthly data keeps confounding that expectation. If the BLS presented us with an 0.1%, it would not change my views at all about the trajectory going forward, but it would complicate the 30-year TIPS auction scheduled for Thursday!

The mechanism for such a slowdown could be housing. The year-on-year rise in the Housing component of CPI is 1.627%. This is higher than one would expect given the pile of inventory that should be keeping a lid on housing prices; the temporary cessation of foreclosures early this year may have artificially let prices rise a bit and if so, then Housing CPI ought to level out at some point and dampen the rise in ex-Housing core CPI. Of course, if inflation is rising because of a broad money-based inflationary effect, then the microeconomic consideration of excess inventory will not keep prices from rising anyway. Too much inventory will lower real prices, but not necessarily nominal prices. Since many of us have lived a majority of our lives in a stable-inflation environment where those were the same thing, it is understandable that people confuse the two. But supply and demand operate on real prices, not nominal prices.

Housing Starts (Consensus: 590k from 571k) are also due out tomorrow, but that report and the Beige Book are a distant third place in importance behind Europe and CPI.

Categories: CPI, Europe

A Wandering Mind

October 17, 2011 3 comments

It is very hard to write a comment these days, at least about market events. While there are plenty of market events to write about, ostensibly, none of them is one-tenth as important as what lurks behind door # 3. The news on Friday that the U.S., in a rare display of backbone from the Treasury Secretary, was staunchly opposed to proposals to double the size of the IMF as a partial response to the European debt crisis, probably ought to be a big deal. As the primary source of funding for the IMF, the U.S. Administration really does get a vote in any European plan that involves increasing the IMF’s role, and this certainly cools that possibility. Germany over the weekend, and again today, also put a damper on rising expectations that a Grand Plan will emerge at this weekend’s summit meeting – again, this ought to be important, and of course it is at some level.

But we all know that until the announcement is made about just how Greece is going to default – whether there will be a 20% recovery, or a 40% recovery; whether she will resign from the EU or the EU itself has a constitutional crisis; whether it will be done in such a way as to prevent CDS from triggering (I’m not sure why it seems the Wise Men of Europe want to cause worse losses at banks that have bought protection for their bond portfolios, but they seem bent on it); whether the Ireland and Portugal situations will be resolved immediately or remain part of the multiple Swords of Damocles hanging over the market; whether Germany or France will be dragged down with the drowning swimmers or somehow escape; until we have the answers to these questions, the rest is commentary.

So what if Empire Manufacturing was a little weak today (-8.48 vs expectations for -4.00). So what if Italian yields are back to the highest levels since the spikes of July and August. So what if stocks fell 1.9% on light volume, but bond yields only declined 5-10bps. All of this is commentary.

I have no special insight as to when we will finally find out about what is going to happen, in the end, with Greece and the banks whose solvency currently rests on the fiction that Greek bonds will redeem at par or at worst experience only 20% impairment. There might be a resolution this weekend, but I doubt it. Big solutions tend to take big time, and my personal belief is that the length of a meeting grows exponentially with the number of participants entitled to speak. We might be in this holding pattern for some time.

It is a positive that the conversations about the denouement seem to be converging on reality. Greece will have to default in some form, banks will need to be recapitalized in some way, and central banks will have to print money…or, as an alternative to that three-step plan, we can all grab our seats and let the fallout happen, and pick up the working pieces once the grand flushing has occurred. It seems more politicians are recognizing that those are really the only options, and most of the silly promises for a painless solution during some big summit are merely delaying tactics that almost no one believes any more. I continue to think that when a Greece default is actually announced, stocks will rally and yields will rise (maybe after a brief wiggle in the other direction), even though nothing approximating the worst case or even a likely bad case has been priced into the market.

However, a negative to recent developments is that the longer it takes to get to a reasonable solution, the bigger the probability that the default will happen in thinner financial market conditions that will prevail starting the second or third week of November and getting worse for the six weeks thereafter. The default announcement will be scary; we need all (liquidity) hands on deck when it happens. It is better if it happens soon. One year’s seeding makes seven years’ weeding.

But since we’re still waiting, my mind wanders. I saw recently the statement that U.S. debt (and probably developed country debt) is higher as a percentage of GDP than at any point other than a major war. I am not asserting the truth of that statement, but it did make me wonder – what if we get a major war?

That’s not a completely absurd proposition. I am a little surprised we haven’t seen more market upset, at least in the energy markets, over the rising tensions with Iran. The accusation by the U.S. that Iran was plotting to assassinate a Saudi diplomat and blow up embassies in Washington is surprising in that it was made public. What is the point of making the accusation public? To shame the Iranian leaders? This seems unlikely to be effective. Suddenly, we see Democrats who couldn’t figure out why we would fight a war after 9/11 arguing that this constitutes (in the words of Dianne Feinstein (D-CA)) “an escalation.” Rhetoric about how close Iran is likely to be to completing a nuclear weapon – which is certainly not news – has also begun to rise and it is being reported in unlikely places. The New York Times on Sunday noted that “President Obama is pressing United Nations nuclear inspectors to release classified intelligence information showing that Iran is designing and experimenting with nuclear weapons technology” and its ‘Topics’ section on “Iran’s Nuclear Program” (updated today) says that “Official American and Israeli estimates suggest Iran would not be able to produce a bomb until 2012, or more likely several years after that.”

Again, consider the source. The New York Times, and this Administration, openly guffawed at the notion of an “Axis of Evil” that included Iran, and wanted to engage that regime in talks. Now they’re beating the war drums?

Let me say that I agree that Iran’s leadership is a threat to peace and stability in the region and I am concerned about the possibility of nuclear weapons in their hands. I’ve worried about that for a number of years, like many people have; so, I support virtually any action the Administration of this country, or of any other country, wants to take to forcibly disarm that leadership. While I am cynical about the timing, I point it out here because of the market implications. This is one of those stories the reaction to which is being held in abeyance due to the elephant in the room (that is, Greece). If this had happened during the Arab Spring, or when there was otherwise no big news, I think energy prices would surely have reacted more than they have. NYMEX Crude prices remain below last month’s $90 highs. Keep a bookmark in this story, lest it become one that commands more attention than the sorry state of the global economy.

Categories: Europe, Politics

Are CMBS Strains Coming To The Fore?

October 12, 2011 7 comments

One thing is certain these days. By sitting on my hands, I’m missing a lot of tradable swings! I am not too disturbed by this fact, since I am probably almost as likely to trade them poorly as well, but we are most definitely in a trader’s market. Whatever your sense of the current economic environment makes you bullish or bearish, the value of corporate claims is not changing weekly by 140 S&P points. From the October 4th lows, stocks closed higher today by 12.4% (from the October 3rd closing low, the gain is only 9.8%!).

Are people really investing in this kind of crazy market? It scares me to death, and I’m a professional! (Then again, with all of the effort that officialdom has put into soothing us, perhaps it’s only the professionals who are really scared.)

Intraday, the Dow erased its loss for the year before falling back. That sounds impressive until you remember that it was up 10% on the year as recently as July 21st. Volumes were fairly low and the Vix declined but remained above 31. 10-year Treasury yields rose to 2.21%, with 10-year TIPS yields at a hearty 0.23%. Copper and precious metals rallied; grains and energy declined.

The FOMC minutes from the September meeting were released today. There were some interesting items in there, aside from the somewhat crazy assertion that “most FOMC officials said inflation appeared to have moderated.” (see Chart)

Moderating inflation, according to the Fed. This is core CPI, year-on-year.

Bad forecasts and weak monetary policy judgments from the Fed no longer surprise me, sadly, but two notes made me raise my eyebrows a little. Here is the first:

However, some others noted that a recent change in deposit insurance assessments had the effect of significantly reducing the net return that many banks receive from holding reserve balances.

This statement occurred in a discussion about whether interest on excess reserves (IOER) ought to be cut as a stimulative policy measure in order to spur bank lending (apparently they don’t believe the hype about how there’s just no loan demand). It is interesting because it implies that IOER has already been cut, effectively, and this in turn makes me more nervous about the recent rise in M2. For some time I’ve been suggesting that if the Fed wants to really add liquidity, it needs to eliminate IOER and that would tend to flush reserves back into the system. This snippet suggests that something similar has already happened. And that in turn increases the chances that the recent M2 rise is more than just a European deposit-flight one-off. I wasn’t aware of the change in deposit insurance assessments and I don’t know how large the change is, but the FOMC members appeared to think that it was enough to cause a meaningful change in the effective IOER realized by member banks.

The second item would have slipped past me if I hadn’t just seen an interesting chart on the Fed’s own home page. Here is the item from the minutes:

In secured funding markets, term financing reportedly remained readily available for both domestic and European financial institutions through repurchase agreements backed by Treasury and agency collateral. However, some strains emerged late in the intermeeting period in the market for repurchase agreements backed by lower-quality, nontraditional collateral.

And here is the chart:

Borrowing strains are appearing in ABS. Source: Federal Reserve

Lower-quality, nontraditional collateral like AA asset-backed lending, perhaps? I am not tied into the ABS market but I wonder if this isn’t a warning sign for something bigger, like strains in the CMBS market for example (recall that the heads of the CMBS groups at Goldman and Citigroup both resigned the week of … July 28th, and I noted it here. July 28th marked the point just before the first spike on this chart).

Some observers have been looking for an echo-blowup from the CMBS market for a long time after the residential MBS market took heavy fire in 2007-09. With everything that has been going on in Europe I haven’t heard any developments recently, but this FOMC minute and this chart suggest that we should pay more attention. Owners of CMBS-backed paper ought to be looking quite carefully at their exposures not just to the underlying assets but also to the availability of financing on structure.

Tomorrow, a quiet data week continues with only Initial Claims (Consensus: 405k from 401k) on tap. Equities need to break higher fairly quickly, or the bearish crowd will team up with the range-trading crowd and push prices lower again. I’m rather in that camp myself. I am not concomitantly bullish on bonds, though. I would love to have the opportunity to get short 1.80% on 10-year notes again, because I missed it the first time (I judged it too early to be fading the strong seasonal pattern and have missed a 35bp one-way selloff since then), but I don’t think that’s going to happen. I’d be happy to sell some around 2.1% and scale into a short on a further rally, but I wonder if I will even get a chance to do that. I will probably use RYJAX, which is a single-inverse fund that doesn’t have the return drag that a leveraged-inverse fund gets from volatility.

And come to think of it, maybe I’ll start doing that right away in case I’m wrong about stocks!

Categories: Federal Reserve, Trading

Tiny Bubbles

October 11, 2011 1 comment

The definition of a bubble is naturally elusive. Certain Fed Chairmen have been known to observe that while a bubble is usually apparent after the fact they are hard to identify in prospect. I don’t agree with that statement, but it is true that there is no single metric that one can rely on to be able to say “aha! There is a bubble.” Candidates include a change in the characteristic acceleration of prices (as described in considerably more detail in Didier Sornette’s excellent Why Stock Markets Crash: Critical Events in Complex Financial Systems), a very high multiple of price to cash flows – whether that is in terms of a yield or a price-to-earnings multiple – or measures of investor eagerness/greed.

But whatever the measure, one part of the definition must be that in a bubble market, prices are considerably ahead (define “considerably”?) of what a dispassionate assessment suggests the probabilities and payoff matrix would be worth aggregated across all possible states of the universe. A key sign might be when investors believe the probabilities of poor payoffs are essentially nil, so that all possible outcomes are believed to be bullish and not yet in the price. Investors’ classic overconfidence bias should not affect prices as long as the payoff matrix is symmetrical – over-assessment of the likelihood of poor outcomes is balanced by over-assessment of the likelihood of good outcomes – but if the view of possible winning and losing scenarios is skewed to include only winners, then the overconfidence bias could result in a bubble. Metaphorically: if there are lots of fat people on a boat but they’re evenly distributed, it doesn’t matter how fat they are. But if the fat people are only on one side of the boat, it matters.

This metaphysical musing is produced by my head-scratching about the market the last few days. To be sure, the Employment figures on Friday were better-than-expected and had hefty upward revisions; while not good on an absolute basis, they were certainly relatively better than had been expected. But that is small beer compared to what is happening in Europe. On Friday Fitch downgraded Italy and Spain and Dexia was nationalized, we think, over the weekend. Sarkozy and Merkel had another meeting and released a statement declaring their intention for carrying on an undertaking of great advantage; but no one to know what it is.[1] Specifically, they were not specific, but said they would be specific soon about a plan to support Europe’s banks. Italy’s parliament failed to approve the 2010 budget, which has already been spent, in a gesture of no confidence in Burlusconi, and the government in Slovakia fell when its legislature voted down the EFSF (this is a largely symbolic vote and it is expected to pass in a week or two, but the significance is that the government was taken down on support for bailouts). S&P cut the ratings of Spanish flagship banks Santander and BBVA by a notch to AA- with a negative outlook, and other Spanish banks were also downgraded. The U.S. Senate just passed a bill, although probably dead-on-arrival, designed to punish China for keeping its currency undervalued. I think it’s called Smoot-Hawley, but if not then it probably should be. (Geez, folks, there are enough new mistakes to make that can send us down the tubes; do we really need to make exactly the same mistakes that we made in the 1930s?)

The initial cut at the Volcker Rule was released for comment today, and while it will surely be watered down…that’s why they release it for comment…it appears both sweeping and vague. The regulators lamented that they couldn’t define what will be permitted because it “often involves subtle distinctions that are difficult both to describe comprehensively within regulation and to evaluate in practice.” Duh. When the dealer buys a billion 10-year notes from Fannie Mae at 1/256th of a point behind the current bid, they clearly aren’t going to turn around and sell them all at the bid; they’re going to hold some of the risk until the buyers come to them. But how much of that risk, and for how long, will they hold? That’s a proprietary decision, and the dealer is now in a position indistinguishable in every way from what it would be if it bought bonds on a whim to make a short-term trade. Yeah, this is a hair that may be too fine to split.

The demonstrations are continuing around the U.S., although it isn’t clear what the demonstrators stand for. On a recent trip to Tampa, at one demonstration I saw signs saying “End the Fed,” “Afghanistan is not a good war,” “Debt is slavery,” and “End Congressional bribery.” I haven’t the faintest idea what these things have in common, except that the people carrying the signs are young, jobless, and cranky. Kind of like the early 1970s, I guess. Tune in, turn on, drop out, man.

I’m not avoiding reporting the good news. There’s just nothing to report. Well, there are reports that Greece is likely to receive the next tranche of their bailout package when it is needed, despite the fact that they haven’t come close to meeting the requirements of the bailout. Is it good news that the EU is caving in? I’m not sure.

And yet, stocks and bond yields are closer to their highs since mid-August than they are to their lows since then. 10-year real yields are at their highs since the late summer swoon (a whopping 0.20%). Are we at the cusp of a sudden acceleration in growth that will justify higher yields and higher equity prices?

I don’t think so. But the alternative explanation is that stocks may be rising because Europe is about to collapse and US securities are considered safer destinations for all the liquidity that is being poured into the market. This, too, befuddles me. Does anyone think US securities markets will not be affected if the European markets crash?

I may well be wrong about the particulars. I generally expect institutions to display strong survival instincts and to therefore avoid blowing up for far longer than we would otherwise anticipate. So far, this has been the case with the Euro and countries in the Eurozone. But I am surprised at this point to see such little progress being made to preserve the institutions, and yet the markets reacting as if the institutions’ survival were already assured. By “institutions” here I mean in a micro sense (banks) and in a macro sense (sovereign institutions and the Euro itself). I do not think we are out of the woods yet. If the VIX is able to break below 30 and stay there for at least a day or two, I may grow to believe in the stock market rally, but it seems to me it would be truly miraculous to have gotten this close to having the Euro implode without the stock market ever closing technically in bear-market territory down 20% from the highs!

[1] This is actually a classic line from a prospectus of a 1720 offering during the frenzy associated with the South Sea Bubble. See Extraordinary Popular Delusions & the Madness of Crowds. Some issuer actually raised money on this basis.

Categories: Economy, Europe, Stock Market
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