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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.

  1. November 10, 2011 at 3:32 am

    Pardon my ignorance of prevailing wisdom but isn’t a relationship between growth and inflation and article of faith?

  2. onebir
    November 10, 2011 at 3:52 am

    “But it is hard to see why 7.25% is so dramatically worse than 6.75% the prior day.”

    There’s an old school economics explanation for this that I think might make sense. Italy’s solvency is unobservable, and depends on growth, inflation and interest rates on Italian debt going forward. Given reasonable distributions for those going forward, solvency at 7.25% might look *a lot* less likely than at 6.75%.

    (Say for example trend growth was the only relevant variable. 6.75% interest might be compatible with stable debts/GDP at 1.75% trend growth; & that’s plausible. But then stability at 7.25% would require 2.25% trend growth. Which is much, much less plausible… So that 500bp movement has just made it dramatically less likely that Schroedinger’s Italy is solvent.)

    Are there any cheap looking inflation hedges for retail investors, or are we just going to have to grin and bear it a while longer?

    • November 10, 2011 at 8:52 am

      Great point. If we think about this as an option, with 7% as the “strike,” then “gamma” could be quite high and the “delta” (in this case, the probability of default) could change quite rapidly.

      There are no cheap retail ways to invest in inflation right now (except through commodity index funds), but OSM is better now that spreads have widened. Still, it’s only “fair” compared to TIPS, so you’re just getting added spread related to the risk of the issuer. I own commodity indices and am short bonds.

  3. hallmachine
    November 10, 2011 at 8:25 am

    “…when the end game is starting to become so clear.”

    I beg to differ. The immediate end game not a larger threat of inflation, it is deflation. Austerity measures, deficit reduction, Chinese hard landing… these all look like a global Japanese style deflationary cycle, not 70s style inflation (where is the bottleneck??). Yields and core inflation are going lower still as the deleveraging cycle and balance sheet repairs continue. The Fed is attempting to counteract this deflationary threat, but so far have been as ineffective as Panda reproduction.

    QE2 was a complete failure – what makes you think these so called ‘loose’ policies will eventually cause inflation? You also are perpetuating the myth of ‘money printing’… how is an asset swap of long term treasuries for overnight reserves ‘money printing’?

    • November 10, 2011 at 8:48 am

      But that’s exactly the chart I just showed…why would you assume that austerity measures and Chinese hard landing would produce deflation? There’s just no data to support that connection. It will impact growth, but not inflation. The prevailing evidence is that the price level is affected primarily by money and velocity. Japan allowed money growth to decline while velocity collapsed. THAT’s why they got deflation.

      You can’t generalize microeconomics supply-and-demand arguments to the economy as a whole. It just doesn’t work. It seems plausible, but the data do not support that it works that way.

      QE2 was a failure in a sense – but not a surprising one. The Fed paid banks to keep reserves, and voila! They kept reserves. QE2 has not passed into transactional money, and so would not have been expected to cause inflation. It is NOW bleeding into M2, however, and inflation continues to rise. I’ve written quite a bit about this in the past. The money multiplier collapsed, but that wasn’t surprising considering there was an incentive to keep reserves. Make IOER negative, and you’ll get your M2 growth and inflation pretty quickly. But no growth to speak of.

  4. hallmachine
    November 10, 2011 at 12:23 pm

    Let me clarify….I’m saying these measures produce deflationary not inflationary effects. YoY CPI might not actually deflate, but it will struggle to rise much above 2%, and will likely stay around there or lower for many years. Until the consumer balance sheets are repaired there will be no meaningful money velocity. Why would you need inflation protection in that environment?

    • November 10, 2011 at 4:10 pm

      Well, i don’t grant your premise. I don’t think these measures have meaningful effects on inflation. If they did, then Zimbabwe would not have inflated. Velocity will probably slowly decline, but if bank reserves find their way into transactional money – and we really don’t know how this happens, and whether it can happen in a flood or a trickle – then you could get a lot of inflation quickly.

      But even if you don’t think that’s likely, it’s a tail risk that is otherwise unaddressed in the rest of your portfolio. Most traditional assets, such as stocks and fixed bonds, do very poorly when inflation surprises to the upside. And the insurance against that tail risk is cheap. If I’m wrong, you won’t lose much to buy the insurance, but if I’m right…

      Finally, the fact that a large part of the Fed is openly discussing whether to let inflation rise to 3-4% should be a warning flare. These are the LAST guys who should be wanting inflation, and if they’re talking about it then there’s yet more reason to get the insurance. The Fed can create inflation easily, if it wants to. The trick is in creating “responsible” inflation – no one knows how to do that, and it increases the chance of policy error.

      So I don’t agree that the growth outlook is disinflationary, because growth doesn’t cause inflation. But even if I’m wrong on that (and it may be that there is some other explanation for the lack of supporting data on that proposition), there are still ample reasons to seek inflation protection…especially when it is cheap!

      Thanks for writing, and for taking the time to clarify your views, and for allowing me to clarify mine!

  5. Frank R.
    November 11, 2011 at 7:26 am

    Happy Grand Binary Day, Michael 🙂 We’ll have to wait a hundred years for the next one. I’ll remind you then.

    • November 11, 2011 at 8:04 am

      *Sniff* Thank you, Frank. I’m so touched you remembered. 🙂

  1. February 29, 2012 at 6:47 pm
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