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Happy Holidays! From: Your Central Bankers
I don’t know whose idea it was, but someone out there is smart enough to push when no one is around to push back.
“Dow Jumps Most Since 2009 as Central Banks Take Action on Crisis.” “Take action,” they certainly did. But what action did they actually take? You will be hard-pressed to find very many people who can explain just what it meant when the central banks of the U.S., Canada, Europe, the U.K., Switzerland, and Japan announced a coordinated 50bp cut in the bilateral foreign exchange swap lines that connect the central banks to one another. The story linked to above summarizes the action by saying the central banks did this “[to make] it cheaper for lenders to borrow in dollars.”
At best, what they did was to cut the interest rates at which banks can borrow dollars by 50bps (assuming that they are borrowing from the central banks, which is in itself a bad thing). With the last couple hundred basis points of easing not doing a lot to prevent or to stem the crisis, it is hard to imagine that 50bps here is a big deal. The real issue here is the availability of dollar funding, more than its cost. What is a big deal, the market thinks, is the fact that the central banks are coordinated – they are all singing from the same hymnal.
And what hymn are they singing?
They’re singing a song of more liquidity, lower interest rates, and more liquidity on top of it. Incidentally, onto the list of easing central banks you can now also add the Chinese Central Bank, which last night reduced reserve ratios for their banks (many people think the Chinese banking system is already a mess, so reducing reserve ratios may be a way to prevent them from going bust as well as stimulating the economy). Equity investors reasonably think that this is good for them (at least, until inflation arrives), so the S&P rallied 4.3% on the day; inflation-linked bond buyers know that this is good for them, so breakevens widened 6-10bps; commodity investors suspect they too will not be left out so Industrial Metals rallied 5.3% and Gasoline jumped 1.1%.
But if it’s good for everyone, why don’t central bankers just do the same thing every day?
Clearly, it can’t be good for everyone. Where all of today’s wealth is coming from is…the future. Today’s jump in prices serves to shift wealth from the future “us” to the “us” right now. (There are also other effects between individuals and groups, such as from consumers who have to pay higher prices to investors who are at least partially immunized, but the main thing is that by pushing up markets now we are assured to have lower returns going forward, assuming that the future real value of the assets don’t change because more money is printed). So the central banks are robbing Peter to pay…Peter. And we are oh so excited about that!
I said yesterday that there was a glimmer of hope. I meant that. It’s a glimmer of hope, not a shining beacon that we can’t miss. Despite stronger-than-expected ADP figures today (+206k vs +130k expected) and higher-than-expected readings from the Chicago Purchasing Managers’ report (62.6 vs 58.5 expected), this is still just a glimmer while Europe flails. To fan this spark into a flame, we need policymakers to have a steady hand and not freak out. Today’s coordinated action is a small thing, but it isn’t clear to me that it is in lieu of freaking out – for example, by implementing a coordinated global QE3.
I noted earlier that today’s rally just takes money from the future “us” to the “us” today. That’s true, I said, if the future real fair values of the markets are not affected by this policy (if those values are indeed affected, then the central banks should just keep easing forever). But in the spirit of positive thinking I will admit to one possibility in which today’s rallies represent real gains. If, by ‘jump-starting’ confidence, policymakers are able to change the future equilibrium level from a depressed state to a growing state, then such action really does represent gain.
However, some people would say that sounds an awful lot like “pumping up a bubble.”
On Thursday, the future “us” will probably start taking their wealth back. While economic data – Initial Claims (Consensus: 390k from 393k), ISM Manufacturing (Consensus: 51.8 from 50.8), Vehicle Sales and Chain Store Sales – have room to exceed expectations, it will be too tempting for investors sitting on 7.6% gains for the week to resist taking profits. And the lack of liquidity cuts both ways. I doubt we’ll plunge 4% on Thursday, but I would not be surprised to give back half of the day’s gains. A slow grind higher would surely have been better…and then we might have snuck up on the “future us.”
A Glimmer Of Hope
Tuesday was a day with quite a bit of news. Some of that news was good. Into that “good” bucket I would put the rise in Consumer Confidence, which jumped to 56.0 from 40.9. As the chart below makes clear, this doesn’t necessarily indicate that confidence is surging, because 56.0 is still egregiously low. Note especially that last November we also had a nice pop in Consumer Confidence, of about 8 points, which followed through for a couple of months before fading.
Confidence jumped, but remains pretty low. However....
However, there is a key difference here. Many observers will scratch their heads and say “but where did this come from?” The one thing you need to know about Consumer Confidence, if you know nothing else, is that it is driven to a very large degree by jobs. This particular blip was doubtless enhanced by the stock market rally – which is what caused the temporary rise last year. But I was never fooled by last year’s jump, because the responses to the employment question remained poor. The chart below shows the percentage of respondents who replied that “Jobs are hard to get” when asked about the condition of the labor market. It dropped to an almost-three-year low this month.
Best Jobs-Hard-To-Get number in almost three years.
Now, the fact that 42% of Americans still call jobs ‘hard to get’ also doesn’t mean that there’s a sneaky surge in hiring out there. But it sucks less than it did. And, to a forecaster, it is possibly significant because it isn’t just a random data point that is good but part of a broader mosaic that might be pieced together to tell a story. Also rising recently have been commercial and industrial loans, as banks are finally extending credit to businesses faster than they are cutting credit lines (I discussed that part of the mosaic last week). A rise in confidence is made more plausible by an improvement in labor conditions, and an improvement in labor conditions is more plausible if there really is some lending being done. The U.S. economy is finally digging itself out of its hole (which complicates the Fed’s policymaking from here, to be sure, but let’s just enjoy this for a bit). We’re not looking at an explosion in growth, but left to its own devices it is not unreasonable to suspect that U.S. growth could be in the low 4%s next year!
Unfortunately, as big as the U.S. economy is it is still too feeble to withstand a major European meltdown, and that is still the elephant in the room. However, it does create a potential non-disastrous exit from the crisis if everything breaks just the right way. If the U.S. economy continues to gain steam, and if the EU is able to hold off a banking crisis for six months or so and if the EU can quickly come up with a sustainable policy that holds the Eurozone together, then it’s possible that the U.S. economy could be strong enough to weather the shock when it comes. Make no mistake, there are shocks a-plenty still coming. But if we get really lucky, we may still be able to look back on this period and still see 2008 as representing the worst of the crisis in the U.S., rather than 2012.
I’m trying to be optimistic. Unfortunately, most of those ‘ifs’ require strong and capable statesmanship and credible monetary policymaking. Navigating through those black shoals while blindfolded seems terribly unlikely.
Other news today was not so positive. The AMR bankruptcy was a surprise to me, but not to most bondholders apparently. American Airlines bonds are higher now than they were a week ago. The bankruptcy was caused, essentially, by the prior bankruptcies of AMR’s competitors. Much less burdened by debt, those competitors could be much more aggressive, and ultimately forced AMR to seek bankruptcy to level the playing field. We saw the same phenomenon in the early 2000s with telecom, and more recently with autos. When a heavily-indebted sector sees one big firm declare bankruptcy but remain in business, the other firms in that industry almost always follow. (This is something to keep in mind if a major bank is allowed to declare bankruptcy but stay in business.)
After the close, S&P cut the ratings of a number of large banks today. BOA, Goldman, Citi, JPM, Morgan Stanley, UBS, Barclays, HSBC, and Wells Fargo all had their ratings cut one notch (according to Bloomberg, “Lenders including Bank of America, Citigroup and Morgan Stanley have said they may have to post billions of dollars of additional collateral and termination payments on trades because of a one-level downgrade in their credit ratings.”) A downgrade is always bad news, but in this case the market probably doesn’t react much since all banks were downgraded due to a change in S&P’s criteria. And, let’s face it, these banks are still overrated given their financial soundness.
The more interesting news from my perspective included two items related to inflation (surprise!). First, in the interbank market a 1-year, 4% inflation cap traded at a price that indicates a delta of around 10%, meaning that the market sees roughly a 10% chance that headline inflation will be above 4% one year from now. I think that’s weirdly cheap. With core inflation at 2.1% and rising, you’re one Middle Eastern crisis away from being in-the-money on those options. The implied volatility that you have to use to get to the option price is quite high, but the use of implied volatility assumes continuous markets for hedging. That’s a very bad assumption in inflation, where an index number is released once a month and markets gap abruptly. There’s also the old option traders’ rule: “don’t be a weenie and sell a teeny.” Selling 10-delta options is quintessentially picking up nickels in front of the bulldozer.
But in my view, the news of the day was that the ECB did not fully sterilize its recent bond purchases. The way the ECB conducts sterilization is to auction short-term deposits in large size. Today, 85 banks bid €194.2bln for 7-day deposits (that is, they put the money at the ECB for a week, which removes the liquidity from the economy), but the ECB had been trying to take out €203.5bln. I think this is a very important event, because it raises a previously-unconsidered (at least by me) possibility. I had assumed that the ECB might at some point stop sterilizing the purchases and convert the price-keeping operation to QE ex-post facto. But I never considered that the ECB might not be able to drain the liquidity. What that means, incredibly, is that quantitative easing might be out of the ECB’s hands, unless they want to start selling bonds back into the market. Now, more than likely this is a one-off event and the next auction (or at least the auctions after year-end) will go fine, but there must be a limit at some point to how much the ECB can drain and perhaps that limit is closer than we thought. If the ECB reaches that limit, then it must either decide to buy bonds without sterilization – that is, QE – or it must stop buying bonds. In any case, it is a bad time for the ECB to be seeing its options limited.
Stocks ended the day back near the middle of the multi-month consolidation range, around 1200 on the S&P, and in an unstable position. Ten-year Treasury yields are back above 2% (2.01%) and looking technically weak to me. Neither of these markets is about to suddenly go sideways for four weeks into the end of the year. On Wednesday, in addition to reacting to the banking downgrades investors will absorb the ADP Employment number (Consensus: 130k from 110k), and I think there may be a bit of upside given the Consumer Confidence data. Also due is the Chicago Purchasing Managers’ Index (Consensus: 58.5 from 58.4), which also may have some upside although it is less clear. In the afternoon the Fed releases the Beige Book.
Whatever the data, the important developments will still come out of Europe. Recent news has been increasingly downbeat about the possibility of actually effecting a new plan (although Juncker announced today that the December tranche of the rescue package will be disbursed). It is important to keep in mind that these are illiquid markets, and investors ought to operate with higher-than-normal levels of caution.
Gravy Train Or Bread Line?
There are stories, perhaps apocryphal, about consumers in socialist countries who, coming across a queue, reflexively got on line because there must be something valuable going on at the front. (Although on the heels of the crazed shopping action of Black Friday, perhaps it isn’t hard to believe these stories might be more-than-apocryphal after all.)
That’s what today’s action felt like. Investors, everywhere, jumped on line because they didn’t want to miss what is promised at the end…and yet, no one really knows what we’re waiting for except that it must be good.
To be sure, the weekend saw rumors and news. There was a rumor of a massive IMF plan for Italy – a plan so massive that it was considerably larger than the current size of the IMF; this rumor was duly denied by all concerned, but when investors are optimistic the denials start to sound to them “like the usual denials of officialdom when something is about to happen.” More in the ‘news’ category was the release of ‘guidelines’ from the EFSF. Wiser heads than mine declared these “more confusing and more complicated than…expected.” Details remain lacking…but these are guidelines! Surely they mean something? Sadly, no.
Most concretely, Germany and France are pushing for a “fast-track” process by which countries can hand over sovereignty to them. I think it’s important that we keep two things in mind: first, “fast-track” in Euro circles means a couple of years (remember, the Greek crisis started in 2010 and there is still no solution to it). Second, any solution that results in most of Europe surrendering their economic sovereignty to a European body that is controlled by the largest members is likely to be voted against by the smallest members. Since each EZ member has a veto, this seems extraordinarily unlikely to result in any solution, absent the force of arms. It’s worth remembering that for the framers to get small states to agree to the Constitution, they had to offer a bicameral legislature in which the small states had size-blind representation in one house plus an Amendment insuring that all powers not granted to the federal government would be reserved to the states. Others may insert political commentary here about the success of such promises, but the point here is that this would seem to be the minimum required to get sovereign countries to surrender their rights to a central committee.
Investors also took heart from strong “Black Friday” and Thanksgiving weekend sales. Now, I’ve been covering markets for several decades and although much is made of how long the lines are and how crowded the malls are on this shopping weekend, I can remember far more times the information was misleading than useful information. Most likely, there’s a tiny signal caught buried in massive noise related to weather, the desperation of retailer sales, the number of shopping days until Christmas, and so on. There’s certainly a better chance that sales will be better than was expected just prior to Thanksgiving, but in my experience these few days of great sales will have a much larger impact on expectations of sales over the balance of the holiday period, and there is therefore a much larger chance now that overall sales will be deemed disappointing after-the-fact.
But the lines formed overnight, and investors saw the markets galloping ahead and leapt to get on those lines as soon as they could. U.S. stocks rallied 2.9%. Commodities jumped 0.9%, led by gasoline (+2.8%), although prices faded throughout the day after the open. Strangely, bonds ended the day essentially unchanged. Inflation-linked bonds rallied a couple of basis points. It really ended up being mostly an equity phenomenon, and I suspect it is going to be a short-lived bounce.
As we continue to bounce aggressively on every rumor and plan, we should be wary if the bounces begin to last shorter and shorter periods of time. I learned a lot during the anthrax scares of 2001: the bond market initially would spike on each report, before selling off when it turned out to be a false alarm. The spikes got more and more ephemeral and the selloffs more and more violent, until one day there was an anthrax rumor and the bond market simply dropped like a stone without rallying first. I don’t see this happening yet in the credulous equity market, but the selloff in bonds this morning didn’t even last the full day. Bond traders aren’t running to get onto the lines that the politicians are creating for them. Since it’s the bond investors who will end up determining the success or failure of the various plans coming out of Europe, this is not a good sign. We may be much closer to a defining moment than the stock market rally today would suggest.
Does Germany Get The Yoke?
If you missed Monday’s comment, “Door-Buster Deals,” you can find it here.
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It has been an interesting couple of days, and I suspect I am probably not alone in worrying about what could happen in the world when the U.S. markets are closed for Thanksgiving and mostly-closed (because liquidity will be abysmal) the day after.
Let’s hope that we continue to call November 25th “Black Friday” only because that’s when retailers go into the black for the year, and not for other reasons!
Traditionally, institutional investors try to get near to their index in the final month or two of the year, and especially don’t want to be underinvested (even more so when cash pays nothing). This minimizes relative performance risk; if the index sells off or rallies, the manager will participate in line with the index. This year, though, I think there should be another concern: investors should position themselves going into the illiquid time of the year by attempting to ensure that they will not be in a position of needing to demand liquidity. If there is a crisis, many managers will be in the position of needing to raise cash for redemptions whether their performance has been good or not – as we saw in the 2008 crisis, many managers were redeemed simply because they offered more liquid terms. With the exception of hedge fund managers with long lock-ups, every manager in my view should be running with significantly more cash than usual in this last period of the year. You really don’t want to have to be liquidating into a liquidating market, even if it means sacrificing some return if your index abruptly rallies for some reason.
An ‘abrupt rally’ seems unlikely at this point.
Equities have been soft for a few days and were again today. We don’t have to look far for the reasons. Here are a few:
- Unrest in Egypt, which we thought ended when Mubarak resigned, has begun again.
- Former AAA credit Eksportfinans (a Norwegian company) was downgraded from AA to junk in one fell swoop. This turns out to be concerning mainly because Eksportfinans was used as a platform for banks to issue structured notes. The way this works is that a client approaches a bank wanting, say, a note that pays off par plus 35% of the S&P 500 price return, but no worse than par. The client, however, doesn’t want to face the A- financial company, so the bank approaches Eksportfinans (or a Home Loan Bank, or one of a few other issuers) with a deal: the issuer pays the coupon to the investor and the bank does a swap whereby it pays the coupon to the issuer and receives, say, Libor minus 25bps for 2 years. The issuer no longer cares about the structured payout because it is hedged by the bank; it has merely obtained cheap funding at L-25. (Of course, no one funds at L-25 anymore, but top credits like Eksportfinans used to fund at that kind of level when issuing 1-2 year structured notes). The buyer of the structured Eksportfinans bond of course faces possible losses if it defaults, but the risk here is that collateral calls from the bank swap counterparty could accelerate the firm’s demise in the same way, and with similar (albeit much smaller) effects as, the failure of AIG played out. And banks don’t need that to happen again.
- The Fed issued instructions to a score of large banks ordering them to submit annual capital plans associated with stress tests, declaring that banks would not be able to pay dividends or other distributions unless they would be well-capitalized even in the worst stress-test cases. Unlike the toothless EU tests, the stress scenarios here include a 13% unemployment rate associated with an 8% decline in GDP and a 21% drop in home prices, plus sovereign default shocks. Now we’re actually talking about stress tests that involve stress, although it likely means the end of dividends from the banking sector for a while. I suspect there are not many banks that can survive that sort of downturn without being pressured, unless there are some quirky assumptions being made about how markets will behave in such a circumstance and what would happen to firm revenues and credit losses.
- The FOMC minutes released yesterday didn’t give the clear signal that many expected to see that QE3 or some sort of Evans Rule implementation was imminent. There was a lot of talk about “price level targeting” and “nominal GDP targeting,” and a “new policy framework” that would entail new risks for the central bank in managing monetary policy. Disturbingly (to me, although not for most other people), there was almost no skepticism evident in the minutes that monetary policy can affect unemployment at all in the short-term. Previous Fed Chairmen, in particular Greenspan dealt with the ‘dual mandate’ question by noting that in the long run, there is no tradeoff of inflation and unemployment, so employment is maximized when inflation is made low and stable. The only tradeoff is in the short run. Now, I don’t even think that there is much of a tradeoff in the short run either, but the peculiar obsession with affecting a variable in the short run with policies that work against the optimization of that variable in the long run is disturbing. Shouldn’t someone be raising this question? Especially since, as the minutes state: “The recent low rates appeared to have only a modest effect on the pace of mortgage refinancing, as tight underwriting standards and low home equity continued to limit the access of many households to the mortgage market.” Faced with such a direct observation of monetary policy ineffectiveness, is it surprising that the stock market is beginning to lose confidence in the Federal Reserve’s ability to make everything all better?
- Germany held a 10-year note auction today, and when the bids were tallied they didn’t have enough bids to have all of the bonds spoken for. In fact, the bids totaled only 65% of the auction size. While it is not unheard of for German auctions to be undersubscribed, no one can remember a miss this large. It hardly needs to be noted that all of Europe’s hopes start and end with Germany; and increasingly, all of the world’s investors’ hopes start and end with Europe.
While equities have been weak (the S&P closed -2.2% today and are now -7.3% on the month) and are rapidly approaching an area where buyers have previously kept the market supported, bonds have been sturdy with the 10y yield down to 1.88% today. My bond shorts have long since become an awkward embarrassment. But still, they’ve hardly been spectacular performers – today the rally was 4bps on a 2.2% fall in stocks – and one gets the sense of an uneasy tension between investors’ desire to own Treasuries as a safe-haven security and investors’ desire to avoid the next market where other investors rush to the exits. Germany’s failed auction raises an interesting question. What would happen if U.S. auctions began to fail, or merely began to get scanty coverage?
Bond investors are clearly addressing this question with some deep introspection. Today the worst European bond market performances were turned in by Italy…and the triple-A countries of Germany, France, and the Netherlands!
While Germany is not about to start crying about 10-year yields around 2.15%, this is more than just a one-off scare. Look at the chart below, which shows Germany’s 10-year yield alongside the yield of a AAA member of the European Union which is notin the Eurozone: Sweden.
Germany's yields are diverging from Sweden's as the former implicitly shoulders more of the EZ yoke.
As you can see, until late September and even as late as a couple of weeks ago, Germany traded at a fairly tight spread to Sweden. The spread is now about 50bps. And that actually means that the condition of the Eurozone countries is worse than we thought, because while lots of focus has been on the widening of spreads versus Germany, Germany herself has been behaving less and less like the top-quality credit of the EU. (Switzerland, which isn’t in the EU either, beats them all with a 10-year yield of 0.83%). And that’s concerning, because as I said before we all know that the hopes of Europe now start and end with Germany.
What about Germany’s hopes?
I am not sure what yield, or spread over Sweden, or other indicator will awaken Germany to the peril of being the Continent’s sugar daddy. But the market seems to be saying that Germany faces a choice between being a prime credit, and saving the Euro. Which does she want? To financially annex other nations and their rotten banking institutions, running their policies from Berlin, in order to establish German hegemony in Europe? Or to preserve the well-being of her own citizens, and trying to be a peaceful and helpful neighbor? I don’t know that there is a middle ground any more.
I am still of the opinion that it is worth buying some stocks if the S&P drops back below 1100, which is looking increasingly likely. I am considerably underweight my ‘neutral’ allocation, and not unhappy about that; however, if the market declines appreciably more than it has already then I will do some bargain shopping and get closer to neutral. I continue to hold my bond short, but only because it isn’t a large position. I may add to it after the long weekend. I remain overweight in commodity indices.
Happy Thanksgiving!
Door-Buster Deals
Rates markets were relatively quiet today and appear to be running out of gas. The 10-year yield fell below 2% again, to 1.97%, but real yields actually rose 2bps on the day. This near-unchanged performance should be viewed in the context of another 1.9% fall in domestic equity markets and 3-4% declines in European equity markets.
Yes, Existing Home Sales reported above expectations, but the picture (shown below) doesn’t change much as a result of today’s 4.97mm print. I doubt that the Existing Home Sales data had enough dampening/counteracting effect to the equity dip that it is sufficient to explain why bonds were relatively weak.
Existing Home Sales are merely vibrating around 5mm units.
I also don’t think that the news that the Supercommittee isn’t going to move mountains – which was hardly unexpected – should affect the Treasury’s credit in the short run, especially given the shortage of other higher-safety locations at the moment. It may simply be that 2%, in the absence of severe dislocations and a flight-to-quality, is hard to get through.
There was one other element of the Existing Home Sales data that is worth noting, however. The inventory of homes available for sale dropped to near the lowest level of the last 5 years (see Chart below), with the seasonally weak months of November, December, and January still to come (inventory tends to fall in the winter because sellers take their homes off the market when the real estate market slows).
On the other hand, declining home inventories is good news for housing, and bad news for inflation.
The current level of inventories, if sustained, is consistent with a rise in CPI-Shelter over the next 12 months of 1.9%. Since CPI-Shelter is currently around 1.8%, this suggests that for all of the carnage in housing the largest component of the consumption basket for most people will not be dragging much more significantly on core inflation than it already is. (What is more, my simple univariate regression of inventories versus CPI-Shelter neglects accounting for a changing level of underlying inflation, so I would actually forecast CPI-Shelter to be somewhat higher than that for next year because of the general rise in inflation).
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In the United States, die-hard shoppers diligently get to the stores early on “Black Friday” (the day after Thanksgiving) so as to be able to snag the best deals before other shoppers beat them to it. We seem to be seeing a similar dynamic unfold in Europe. Over the weekend, Hungarian Prime Minister Viktor Orban reportedly asked the EU and IMF for “possible” financial assistance. IMF chief Christine Lagarde confirmed today that the Hungarian government had made a request for what Hungary termed a “precautionary” loan. We also see this sort of behavior when a firm is facing imminent stress, such as when MF Global drew down all of its credit lines just days before it had to declare bankruptcy. Get the money while it is available, and especially if you need it from the EU and the IMF!
(Some less-diplomatic souls would point out that the Black Friday behavior also bears striking resemblance to a bank run, where you really want to be first in line to withdraw your money. But I prefer the image of jolly shoppers trying to get an outrageous deal before the rest of the shoppers have to pay inflated prices.)
Spain, too, began to make noises. The deputy leader of the People’s Party (winners of the election over the weekend) declared that Spain needs “an agreement through a joint euro-zone operational strategy to save and guarantee our sovereign debt” because the country cannot continue financing itself at 7 percent. I said it before, when Greece first complained in 2010 about their interest rates rising: if the bid is really there at 7%, I’d recommend selling as many bonds are you can, right now. If you can’t sustain your budget at interest rates that would have historically been quite reasonable, then your fiscal situation isn’t going to be saved by a percent or two of carry. But my suspicion is that the only bid around 7% is from the ECB, and so the real question is whether Spain (and others) can finance itself at any level given the deficits being run.
This is even more poignant for Spain at the moment since over the weekend Spain’s rescue fund stepped in to nationalize Banco de Valencia to the tune of €1bln in capital and an additional €2bln credit line.
Get these door-buster deals while they last!
On Tuesday, a revision to Q3 GDP will be overshadowed by the minutes of the FOMC meeting, due to be released at 2:00ET. There is some reasonable chance that the Fed minutes could be market-moving, since in all likelihood they spent some time discussing the Evans Rule and how and/or when to move towards QE3. While they did not implement QE3 at the last meeting, most observers didn’t expect them to do that so soon after Twist. It will be illuminating to see how much discussion of QE3 and what the relationship is between QE3 and European conditions, in the Committee’s minds. As I said, the case for QE3 based on domestic conditions right now is weak, especially with inflation rising; however, a winning coalition might be constructed around the risk of economic infection from Europe. I wouldn’t lean against the equity see-saw right now on the basis of such an indication from the Fed, but I would think commodities and TIPS breakevens may get a bump on that news.
The ‘Fix’ Is In
Economic data last week was not discouraging. If you want to look backward for comfort, the Retail Sales data was a little stronger-than-expected, along with Empire Manufacturing and Industrial Production. Initial Claims retreated to the lowest level since April, at 388k. None of these numbers blew the doors off of predictions, but they were all shaded positively. The chart of the Citibank “economic surprise” index, below, shows that “good” surprises have finally started meaningfully outweighing “bad” surprises for the first time since, again, late March or early April.
Domestic economic data have been pleasantly surprising lately.
The inflation data, too, was good news, although as I said on the radio last Wednesday the slowing of core inflation these last two months was overdue and should not be taken as an ‘all clear’ signal.
This is all encouraging news. The United States is not in recession at the moment and, left to itself, would appear to be on a track to improve (although far too feebly for anyone’s taste) in the immediate future. Unfortunately, the U.S. is not being left to itself. Far from it, and the conditions in Europe continue to deteriorate alarmingly.
Both Spanish and Italian 10-year yields are in the 6.25%-6.50% range. Italian bond yields are only that low because of ECB buying last week. Over the weekend, Spain ousted its ruling party. As with Italy, there will be some cheerful interpretations of this as good news since the new government may be able to implement the “needed fiscal reforms,” but in Spain’s case the existing damage to the cajas probably puts the country’s situation beyond ultimate repair.
We are moving seemingly inexorably to a resolution in which the Euro either dismembers, disintegrates, or draws even closer together. For all of the talk, I can’t imagine that more integration is something that the populace will accept in the middle of a crisis. The view of such plans will be something like “the Titanic is going down! Let’s all hold hands on the deck and everything will be okay.” I believe the choices are dismemberment – letting (or forcing) weak members to leave while preserving a strong-ish core – or disintegration. Secondary and tertiary choices will affect how controlled or how uncontrolled that conclusion is. The signs there are not great, as the political bodies in Europe seem unable to choose the stitch in time that might save nine. Although I suppose I ought to also add that the Union’s changing tone towards Greece, in what looks like triage to me, has the aroma of a fairly grown-up decision.
As the markets slide into ever-less-liquid conditions, this is starting to come to a head. And this isn’t the only thing we will have to deal with over the final five or six weeks of the year. The U.S. “supercommittee” seems unlikely to agree to any meaningful deficit reduction arrangements before the deadline on the 23rd. Now, few people really expected them to do so, but it is an unhelpful reminder of how dysfunctional our political system has become, where increasing deficits is trivially easy and decreasing deficits is almost impossible. Add to this the escalation of anti-Iran rhetoric coming from Israel, that could well come to a head in a week, or not for six months.
To say that we are in a dangerous period is cliché by now. But the fact that we are in this state while liquidity conditions are set to get much worse over the next few weeks makes the danger acute.
Since the beginning of August, the S&P has been in a range from 1100 to 1300, and after exploring both sides of that range finds itself almost smack in the middle. This should be a stable position to be in, and it surely beats being at 1100 or 1300 since there will be plenty of investors with views as the market moves to one or the other extreme. I suspect we will see lower prices into the end of the year. In a normal year, starting from 1200 in a 1100-1300 range would mean the extremes of the range were likely secure. I don’t get that feeling this year, with this backdrop and the illiquidity that we are going to see (made even worse by the stressed conditions of European counterparties).
But don’t get complacent and think that longer-term Treasuries are safe. With the 10-year yield at 2%, in the middle of a 1.70%-2.40% range that has prevailed since mid-August, the same caveat applies. Investors who need safety will hold short-dated Treasuries, but that might also include some current holders of long-dated Treasuries. Twist or not, I don’t care for Treasuries at 2% when the bond vigilantes are riding. Greece, Italy, Spain…can Japan be far behind? And the U.S. is not sacred.
What will monetary policymakers do? In a word, they will pursue every simulative action you have ever seen. Some will buy sovereign bonds. Some will buy mortgage bonds. Some will simply sell unlimited amounts of their own currency (such at the SNB). The forex markets will continue to be choppy and I think hard to trade.
Let’s turn back to the U.S. a little bit, and talk about the probable and possible actions of the Federal Reserve. And again, let me look backwards and note some soothing data. The chart below shows 52-week commercial bank credit growth. While the absolute level of commercial bank credit is still 5.5% below the all-time highs of 2008, and a 2% year-on-year rate of growth is still pretty feeble, it ispositive and the trend is upward.
Yay! Commercial Bank Credit is up almost 2% over the last year!
Is this good news or bad news? Well, it is certainly good news that banks are lending, although the fact that M2 money supply is still expanding at a 10% rate over the last 52 weeks is probably not unrelated to this fact and that creates a clear inflationary possibility. The bad news is that the Fed’s actions are most likely slowing down this process.
The Federal Reserve has added copious amounts of liquidity over the last few years, which as has been well documented has flowed into reserves rather than into loans and M2. That liquidity has been stuck in reserves for two reasons. One is that the Fed is providing an incentive for banks to hold excess reserves, by paying them to do so. The other, which I have not previously mentioned, is that the Fed is providing a disincentive to lending by holding interest rates abnormally low. And the reason why is really Econ 101.
There is no question that loan volumes have been poor. Bullish analysts claim this is because no one wants to borrow money; analysts who actually have spoken to borrowers and lenders know that many borrowers (especially underwater mortgagees and small business owners) want very much to borrow at these low rates, but cannot, and understand that the low loan volumes are due mainly to the fact that standards have changed sharply for lending. The bullish analysts will point to charts like the one below, which shows that the net percentage of domestic respondents reporting tightening standards for commercial and industrial (C&I) loans for large and medium firms has been negative for eight quarters. That is, banks have been responding to the Fed’s Senior Loan Officer Survey by saying that they have on balance been easing standards slightly.
Sure, slightly more Senior Loan Officers report easing standards then tightening, but by how much?
However, the survey doesn’t measure by how much the standards tightened back in 2007-2009 compared to the amount they have loosened recently. For example, if banks had previously been willing to lend money on an unsecured basis in 2006, and by 2009 were requiring 140% collateral coverage of the loan, and then gradually loosened standards so that they now require only 100% coverage, conditions would obviously be much tighter now than they were in 2006 and still quite tight…and yet, going from 140% to 135% to 130% to 125% would result in three quarters of “easing standards.”
We can have some idea this is happening by looking at mortgage loans. The Fed’s Operation Twist was supposedly motivated partly by a desire to lower long rates further so that more consumers could refinance their mortgages. But refi volumes haven’t responded to Twist from the levels they were already at, and the overall level of refinancing (the Mortgage Bankers’ Association Refi index is shown below) remains below levels seen in late 2008, mid-2009, and late 2010.
MBA Refi Index. Operation Twist hasn't done a lot yet - refis were already modestly above the baseline.
Banks are still not lending aggressively at record low rates. And why would they? Given the choice between being paid something for holding risk-free excess reserves or being paid slightly more for extending a ten-year, risky loan, is it so hard to understand why the lending hasn’t happened? Moreover, it makes perfect sense: when you place a ceiling on the price of something…say, interest rates…then you tend to have a shortage as the chart below illustrates. At a price of “a,” “b” units of credit are supplied and “c” units are demanded, so there is a shortage of c-b. Right now, there appears to be a shortage of credit available to borrowers at the price the Fed has “fixed.”
Econ 101 depiction of the supply and demand of a product.
The supply of credit, in other words, is not exogenous. The Fed is treating the amount of credit available as being determined independently from its price, which the central bank is endeavoring to keep low in order to stimulate the economy. The demand for credit and the supply of credit are both functions of price, of course.
Does that mean that the Fed should let long rates rise? If the Committee’s goal is to increase credit availability (it isn’t entirely clear that this is their goal, or that it should be given that the economy is busy recovering from a contraction of credit), then letting rates rise might allow the market to clear at larger credit volumes.
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On Monday, the Chicago Fed Index (Consensus: 0.19 from -0.22) is due to be released at 8:30ET and Existing Home Sales (Consensus: 4.80mm vs 4.91mm last) will be out at 10:00ET. These numbers will probably be largely ignored as most other domestic data has been recently, as investors continue to digest doings in Europe.
Bloomberg Radio appearance
A quick note here to let you know I am supposed to be on Bloomberg Radio today at 2:00-2:30ET, on “The Hays Advantage” with Kathleen Hays. You can listen live on-line, I think, if you care to!
Triage
If you ever go to see the comedian Gallagher in concert, you may notice that some people waiting to get into the theater are wearing raincoats. Now, if you ask one of them “Why are you wearing a raincoat to an indoor concert,” and he says “no reason, no reason at all,” what should your response be? Do you leave it at that? If you do, then you may end up splattered with watermelon juice or something else messy.
When words and actions are in conflict, it is usually smart to look at the actions. This is what interrogation experts and other body language students seek to do. If the person you are negotiating with is saying all of the right things but has his (or her) arms folded across the chest, the body language expert will say you need to make some change to your approach to get those arms un-folded or your chances of actually reaching agreement are small, no matter what your counterparty is saying. (Incidentally, a helpful book on body language is The Definitive Book of Body Language
It is in this context that I note German Chancellor Merkel’s party today voted to offer countries that want to leave the Euro a means of doing so voluntarily while not being excluded from the EU. Merkel has been adamant that Greece cannot leave the Euro and that to do so would be a disaster not only for Greece but for the Euro as well. Merkel and Sarkozy have both pointed out shrilly that there is no mechanism for a country to leave the Euro. Late last week, Merkel backed off her previous comments somewhat when she said “It is time for a breakthrough to a new Europe. A community that says, regardless of what happens in the rest of the world, that it can never again change its ground rules, that community simply can’t survive.” And today, the ruling party of the largest member of the Euro voted to permit the travesty of a Euro exit. I suggest that this is not coincidental, and not trivial. German Finance Minister Schaeuble said “We’re not throwing anybody out, but if a country can’t carry the burden or doesn’t want to carry the burden, and the Greek people have to carry a heavy load, then we have to respect the country’s decision.”
To me, that sounds as close to an invitation as there is likely to be.
Whether this means that Greece will default, and then leave the Euro, or leave the Euro and redenominate all bonds in New Drachma (effectively defaulting if the drachma is weak, as it presumably would be), is not clear. But it has been clear for a long time that one way or the other, Greece would have to default explicitly or effectively, and the fact that politicians have turned from trying to prevent it to instead seeking to make the event seem more graceful is a sign to me that we are possibly getting close to the actual event.
I wonder if the arrival of Italy in the triage center changed the minds of Euro ministers. Triage, you know, is the process of assigning degrees of urgency to injuries in order to decide the order (or the value) or treatment. It looks to me like Greece has been moved to the do-not-resuscitate area while the Eurozone focuses on saving the relatively-healthier Italy.
In which pile are Portugal and Spain?
I have long maintained that once Greece actually defaults, the stock market will rally. It is a little less clear now that there are other sick patients lined up, because there will be more fear of domino-ism. But I still think that’s what will happen.
So, everyone knows there are defaults coming. Greece, probably Portugal and Ireland have big debts and deficits that must be written off. There is mathematically no other way, although we can come up with scenarios where the country is propped up for a year or two before caving in. So, since we know there are going to be defaults, so we all know that whether the Euro stays together or not, there will probably be a big recession.
Now, if a recession is automatically deflationary, as we are endlessly told that it is, why isn’t that fact reflected in inflation markets? Why does the 2-year inflation swap sit around 1.70% and the 10-year around 2.40%?
There are a couple of possible answers to that conundrum. One answer that preserves the possibility that deflation could happen, despite the best efforts of the monetary authorities, is that it is possible the markets are pricing a distribution of inflation that has a much longer “tail” to higher inflation. If there is a significant chance of small deflation but a small chance of huge inflation, it could still warrant positive value for the inflation ‘insurance.’ But I don’t think that’s what the market is pricing.
But it could be that people have noticed that the last pair of recessions did not cause inflation (at least, core inflation) to go negative, and so that probability is being discounted. I think it’s reasonable to do so, especially since all central banks are much closer now to actual printing than they were in 2000 and 2008.
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Stocks declined today, while bonds rallied to put the 10-year note back to 2.05%. Volumes were very poor – by some measures, today was the lowest-volume day of the year on the stock exchange. The VIX is still hovering a little bit above 30. Stocks seem heavy, but on volumes like this it is hard to take a view: it doesn’t take much flow to cause a sharp move, which means that the liquidity option a trader is short is more expensive. Or, to put it another way, the door for position-exit is smaller. As a trader, in times like these my standards for entering positions are higher and I don’t see a compelling position at the moment even though I know how I think this likely plays out.
Economic data might even start to matter again to the extent that the European drama shifts into neutral for a few days. Tomorrow’s data includes PPI and Retail Sales (Consensus: +0.3%/+0.2% ex-autos), which should show deceleration from strong numbers last month, and Empire Manufacturing (Consensus: -2.0 from -8.48). This latter figure is threatening multi-year lows if it penetrates below -10, but it isn’t expected to do so.
At 11:00ET, Chicago Fed President Evans is giving an interview on CNBC. Evans, recall, is the gentleman who is suggesting the Fed should let inflation go a little higher until Unemployment falls to some predetermined level. If he uses the CNBC forum for his crazy talk, it’s a sign that view is starting to become more mainstream in the Fed since a speech to a private audience is one thing but an interview on national financial news media is something quite different. His appearance, and the topics, have almost certainly been pre-cleared by the FOMC. That doesn’t mean they share his views, but he won’t spend a lot of time talking about the Evans rule unless the Chairman is comfortable with him doing so…and I can’t imagine they’d be comfortable with him doing so unless there was some real debate (at least) going on about how much they can let inflation slip higher.
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As you may be able to tell from the decreased frequency of my article postings over the last week, I have been busy. This week has me going to Chicago to speak at the Global Derivatives USA Conference on Wednesday and then back to New York to deliver a full-day seminar on Inflation Modeling at the NYSSA on Thursday. Consequently, there will probably not be another article posted until the weekend.
Oh, THAT Italy!
Equity markets today, especially in the U.S. (which fell -3.7%, underperforming many of their European counterparts), seemed suddenly to realize that the news from Monday and Tuesday about the deterioration in the circumstances of Italy was not irrelevant to the global investing community. From time to time, I think to myself “if I am ever asked by my alma mater to give a speech on efficient markets, here is an interesting exhibit,” and this was one of those times. Nothing new happened today to suddenly trigger an equity rout, as far as I can see. Yes, Italian bonds collapsed further, with the 10-year note at one point about 70bps worse on the day before a rally pulled yields down to only 7.25% (according to Bloomberg). But it is hard to see why 7.25% is so dramatically worse than 6.75% the prior day. Perhaps it’s the rate of change that finally got investors’ attention.
While most European policymakers seem startled, if not downright shocked, at the dramatic turn of events in Italy – as am I; I really didn’t see this happening so quickly – only a few seem to be making statements. German Finance Minister Schaeuble advised that Italy should request aid from the EFSF if it needs it, but also expressed a lack of concern since current Italian spreads to Germany are similar to what they were prior to Italy’s joining the EU and stated his confidence that yields would fall again once confidence returned.
And it is comments like this that ought to be the scariest. Schaeuble is in the thick of the fight, but still professes to believe that this crisis is all about confidence (and mean old hedge funds). Others feel the same way, so they are doing things such as allowing banks to change assumed default probabilities of loans and other credit product so that the banks can claim to be better-capitalized. Surely this will give people more confidence and they can drive markets higher and we will all be happy. But obviously – at least, to most of us – this is not all about investor or consumer confidence. The sovereign issues are about unsustainable fiscal policies and leverage, adopted at times when money seemed free, and frankly the banking problems aren’t much different in source. I don’t know how to unscramble that egg but I am pretty sure it cannot be done painlessly. But unscramble it must. The long-term solution to unsustainable fiscal policies and leverage is sustainable fiscal policies and savings (deleveraging). The short-term solution might well be default.
The S&P still trades at a dividend yield of only 2% and a Shiller P/E of 20 compared to a long-run average of 16. It doesn’t trade like we’re lacking confidence, until today perhaps. Stocks fell hard today and look tired technically. Volumes were heavier today but didn’t even reach the levels of November 1st, much less what we were seeing in August or late September/early October. The VIX rose to 36, which is about the middle of the range it has held for the most part since early August.
Inflation swaps fell 7-10bps, and commodities dropped -1.35%. To some extent, it is a bit surprising how much commodities outperformed equities, since they have been lagging quite a bit recently; from a different perspective it is amazing that they’re not doing much better. A friend today wrote insightfully, “Germany is just going to have to let the ECB print money and hope for the best, or put an end to [the Euro].” To which I would add the question: if the Euro breaks up, do you think the many newly independent central banks would not print? More and more, it looks to me like an endgame that doesn’t include printing money is unlikely. Fiscal austerity and money printing would be half of the right prescription. Add to that the curious fascination that seems to be developing with the “Evans Plan” of allowing U.S. inflation to rise to 3-4% until Unemployment falls below (for example) 7%, and it is incredible to me that inflation protection is still so cheap. I feel like I am already repeating myself with this, and likely will grow gradually more shrill until the market eventually realizes it.
I said above that “fiscal austerity and money printing would be half of the right prescription.” A better prescription would be fiscal austerity without money printing. Money printing will likely make things worse, not better, but it is a matter of faith among central bankers that printing money will help growth. When you only have a hammer, everything looks like a nail. This also explains the hypnotic fascination with the Evans-led concept that somehow if we just let inflation get away from us, unemployment will fall. Because, after all, look how well that worked in the 1970s!
I am continually amazed that such superstitious nonsense still has currency at high levels of economic thought. Let me make this really simple. The chart below shows chain-weighted GDP and the core consumer price index (if you use the headline index, the growth effect on oil prices creates an illusion of correlation, but if there is anything to the connection between growth and inflation is should certainly be seen on the index with those few items removed).
GDP vs the price index.
It can be excused, perhaps, if an economist believed there was some correlation between growth and inflation in the years before the crisis. The correlation was artificial – the series both tend to rise over time – but there was at least some correlation. But 2008-2010 was a grand experiment. If growth and inflation are fundamentally joined at the hip, then the largest recession in three quarters of a century surely ought have caused the price index, already growing tepidly in 2007, to drop at least once. And the result of that experiment was unequivocal: prices continued on their merry way, slowing ever so slightly but not enough to reject the null hypothesis that growth had no effect on inflation. (Note: even I don’t think that growth has no effect on inflation. The point is that we can’t reject even such a radical null hypothesis as that.)
Einstein’s hypothesis was supported by experimentation: the velocity of an object and its mass are related. The hypothesis of a relationship between growth and inflation, by painful experimentation, has been rejected.
There is, however, a long institutional tradition of monetary policymakers attempting to incentivize good fiscal behavior by providing “counterbalancing” monetary behavior. The Federal Reserve “rewarded” the budget-balancing in the 1990s by running looser monetary policy. (The budget balancing helped unleash strong growth, which the “Maestro” got credit for despite the fact that the real effect of his actions was to help provoke a dangerous, and ultimately damaging, bubble in equities.) It would not be at all surprising to see the same bargain being struck, with loose monetary policies “supporting” better fiscal policies. But this time, the monetary policies will have to be extremely loose. All of which is to say: I am not sure why I am allowed to buy commodities this cheaply when the end game is starting to become so clear.
Little Countries, Little Problems; Big Countries, Big Problems
All you really need to know about what’s important right now can be summed up in one chart.
Well, this doesn't look good. Italian 10-year yields.
That’s the 10-year Italian government bond. While Greece still simmers with her problems nowhere near “solved,” we may come to look with nostalgia on the days when we “only” had to worry about Greece. There are real-life market consequences associated with gratuitous “punishment” meted out to buyers of insurance. The gutting of the value of a CDS contract means that bondholders who might otherwise buy some tactical protection instead make strategic sales.
Of course, the evaporation of a bid for Italian bonds recently isn’t merely due to selling pressure created when politicians arbitrarily took money from the insured (some of which are dirty, rotten hedge funds!) and handed it to the insurers. The Berlusconi government, which has almost always been better for entertainment value than for fiscal governance, is toppling. And yet, this itself isn’t news. Berlusconi has been shaky for a month or two at least. The scary part is that it’s not clear what happens if the situation in the market for Italian bonds doesn’t improve.
They can’t put together a very useful summit to assemble a financing package for Italy. That’s the largest issuer of debt in Europe, and the third-largest economy. Oh, and should probably mention is has about €82bln of inflation-linked bonds outstanding, about 28% of the sovereign inflation-linked bond market in Europe. Investors on the Continent who want inflation-linked protection are about to start considering the non-Euro market more seriously.
The equity markets loved the fact that European governments are falling. I’m not sure why that is, but the S&P rallied 1.2%…and the Euro Stoxx index also rose 1.2%. It certainly can’t be because of growth indicators in Europe, which continue to weaken, nor those of the U.S. which continue to bump along sideways ungracefully. It may again be due to the notion that stocks are inflation-protected assets (they’re not, in any time frame that matters to most investors); the options for the central banks are narrowing and in the U.S. the “Evans Plan” of intentionally trying to inflate ‘a little’ is actually getting a serious hearing from otherwise rational people. It’s great for an inflation specialist, but I’m not so sure it’s good for the rest of you since there’s no reason to think that more inflation would help people find jobs.
Commodities in this context have been rising, but rather tepidly if I do say so. Crude Oil is rising strongly, with NYMEX crude up from $75 a month ago to $97 today. That rise, at least some of which is due to the more-animated saber rattling between Israel and Iran, has not yet found its way into gasoline prices, but when it does…well, if nothing else it will reinvigorate the candidacy of Ron Paul. Whether that’s a good thing or not I will leave up to you. Actually, I’m a little surprised that inflation markets are not better bid. The 10-year inflation swap, which had been as low as 2.15% early last month, is back up to 2.45%. This summer, though, it was pushing 3% (see Chart).
10-year inflation swaps, in basis points.
It seems like the year-end lethargy is already setting in. The equity market volume on Monday was the lowest since late July, and today only slightly higher. True, there were no economic releases, but can we really be shrugging off the Italian and Israeli/Iranian situations? Or has everyone already fully battened down the hatches? It doesn’t seem likely that an Italian death spiral is fully discounted, but if it is then that’s certainly bullish! Meanwhile, I am adding to my so-far ill-fated shorts in the Treasury market. At least I am getting good placement, so that I haven’t lost money on balance since I started nibbling around a month ago (by buying TBF). But I’d like to see higher yields happen soon if they’re going to happen. You can get a violent move in either direction when year-end conditions get thin, and I don’t care to be on the wrong side of it!
