Archive for December, 2011

Long-Term Portfolio Projections Update

December 26, 2011 7 comments

Let me first point out what this article is not: I will make no effort to predict the 3-month, 6-month, or 12-month returns of any market. Indeed, although I will later present long-term risk and return outlooks, and they are presented as point estimates, I want to make it very clear that these are not predictions but rather statements of relative risk and return possibilities. For many types of instruments, the error bars around the average annual performance are so large as to make point estimates (in my view) nearly useless. The numbers come from models of how markets behave when they are priced “like they are now” in terms of several important metrics. They are not prescient. However, that is what investing is really all about: not making the “right” bet in terms of whether you can call the next card off the deck, but making the “right” bet with respect to the odds offered by the game, and betting the right amount given the odds and the edge.

I also will not make portfolio allocation recommendations here. The optimal portfolio allocation for you depends on more variables than I have at my disposal: your age, your career opportunities, your lifestyle, your goals, any insurance portfolio and your risk tolerance, to name just a few.

What I will do here, though, is to give top-down estimates of the long-run returns and risks of some broad asset classes, and make some general observations.

Compared to last year, 10-year projected real yields are lower. For all relatively low-risk investments, expected real yields are negative. This is not terribly surprising given the current landscape: risk-aversive behavior is expensive behavior at the moment. This exercise helps to remind us of the fact that in avoiding short-term risks, we are sacrificing considerable long-term returns.

However, with that said it must be also observed that the preceding statement only is strictly true if a fire-and-forget investor makes a single portfolio decision at the beginning of the 10-year period. For an investor who may exit safe securities and enter risky securities once the compensation for taking risk is adequate, it could well be prudent behavior to eschew short-term investments in relatively risky securities. While I do not make 1-year forecasts explicitly, as investors we must always take into account the fact that we have to pay to wait for a better entry point, but at times this waiting is justified.

I don’t analyze every possible asset class. For this exercise, I limit the universe to stocks, TIPS, nominal bonds (both long Treasury and corporate bonds), commodity indices and (since many of us already own it) residential real estate. My estimates and some notations about the calculations are in the table below.

Inflation 2.40% Current 10y CPI Swaps
TIPS -0.10% Current 10y TIPS. This is not at equilibrium, but it is what we can lock in today.
Treasuries -0.38% Nominal bonds and inflation-linked bonds ought to have the same a priori expectation, but Treasuries trade rich to TIPS because of their value as repo collateral. Current 10y nominal rate is 2.03%, implying -0.38% real.
T-Bills -0.50% Is less than for longer Treasuries because of liquidity preference.
Corp Bonds -1.52% Corporate bonds earn a spread that should compensate for expected credit losses. Chart 1 below suggests that Moody’s “A”-Rated Corporate yield is about 40bps rich to where it should be for this level of Treasury yields. And these yields, remember, are being artificially held down at the moment. If Treasuries were at 3%, Corp AA fair values would be another 75bps higher. I think corps are very rich although I admittedly don’t use an actual default model.
Stocks 2.57% 2.25% long-term real growth + 1.98% dividend yield – 1.66% per annum valuation convergence 2/3 of the way from current 20.8 Shiller P/E to the long-run mean. Note that I am using long-run growth at equilibrium, not what TIPS are implying. See here for more on this method.
Commodity Index 4.78% Various researchers have found that commodity futures indices have a long-run diversification return of about 3.5%. To this we add 1-month LIBOR to represent the return on the collateral behind the futures, and a ‘relative value’ factor to reflect the performance (relative to the expected model) of hard assets relative to currency.
Real Estate (Residential) 1.38% The long-run real return of residential real estate is around +0.50%. Current metrics (see Chart 2) have Existing Home Sales median prices at 3.25x median income, versus a long-term average of 3.55x. Converging to the mean over 10 years would imply aan 0.88% per annum boost to the real return.

Chart 1: Corporate AA yields are low compared to Treasury yields. (Source: Bloomberg)

Chart 2: Existing Home prices may still fall, but they are no longer virtually guaranteed to fall!

The results, using historical volatilities calculated over the last 11 years (and put in terms of ‘real annuitized income,’ a term that means essentially the variance compared to a fixed 10-year real annuity, which in this analysis would be the risk-free instrument), are plotted below. Return as a function of risk is, as one would expect, positive. For each 0.30% additional real return, an investor must accept a 1% higher standard deviation of annuitized real income.

10-year real returns and risks (Source: Michael Ashton and Enduring Investments).

There are some surprises here (indeed, some surprises for me since I don’t do this calculation every day). The biggest of them is that the way I do the analysis, home prices are actually slightly cheap to other available assets. Please remember, this isn’t a forecast of 2012’s return, but after a long round-trip it appears to me as if we no longer need to regard our homes in general as albatross assets!

Treasuries, not surprisingly, are extremely rich and should probably be avoided by most investors who are not hedging fixed nominal liabilities. Fixed-income allocations are better in TIPS and T-Bills, although neither offers very exciting real returns. Corporate bonds look quite rich, with yields that are even lower than they should be given the level of Treasury yields, and the latter are (as I’ve just pointed out) themselves rich. Yield-seeking investors are extending credit to issuers on terms that seem not to adequately reflect the very risky business environment that currently exists.

Stocks are rich, but not as rich as they have been in the past. Last year, my 10-year projection was 2.58% annualized real return, so equities have held steady while many other asset classes (TIPS, Treasuries, Corporate bonds) have gotten richer. Be careful about whether you read that statement as “stocks have cheapened,” or “stocks are cheap.” The former, a relative statement, is true, the latter, a (more) absolute statement, is false. As investors, we clearly would prefer to make the latter statement. As a long-only investor, you should care about the value of equities relative to equilibrium, not relative to other overvalued markets, anyway. Right now, if you compare in the chart above Stocks (which are overvalued) to Treasuries (which are more overvalued), stocks look ‘cheap.’ But making such a statement is analogous to someone in Holland a few hundred years ago remarking ‘This tulip is less-overvalued than that tulip, so it’s a good investment!’ Of course, no tulips were good investments, even the ‘cheap’ ones.

As I have been saying, Commodity Indices are the most-attractive investment in my little universe. While they are historically as risky as stocks, they offer much greater value given their performance over the last year (-11.8%, basis the DJ-UBS index) compared to both equities (S&P +0.61% as of this writing) and the money supply (M2 +9.5%). The “best” portfolio depends on a lot of characteristics of the investor as well as of the portfolio, but one could do worse with a portfolio consisting of TIPS, T-Bills, and Commodity Indices as the liquid assets balancing the illiquid investment in one’s home. If you are afraid of missing the next bull market in equities and not being able to look people in the eye at the next cocktail party, then buy out-of-the-money calls on stocks. Implied volatilities have fallen sharply over the last week or two (based on the VIX), and so protecting the ‘downside’ from a regret standpoint is much more affordable than it has been.

Finally, one caveat to all of this: I have not mentioned the economic backdrop, nor incorporated my view of that backdrop into these forecasts (with the exception of choosing to value corporate bonds off of a higher Treasury yield than is actually extant, recognizing that the Fed has artificially depressed long Treasury yields). The “risk” spoken of above is based on the historical standard deviation of the various asset classes, and is independent from the macroeconomic risk we all face at the moment. From a strategic perspective, abstracting from the tumult of the time makes sense; however, every investor must also be cognizant of tactical considerations. I hope that this column helps raise some useful questions about those tactical considerations, even if it doesn’t often provide the right answers to those questions.

That’s all for 2011. Thanks to all followers and one-off readers of this column! Have a happy new year!

Scrooge Businesses

December 22, 2011 8 comments

Stocks rallied today, as did commodities, in thin year-end trading (I am very tired of this latter phrase, which it seems we could have accurately used since October). The putative reason for the rally was that Initial Claims remained low (364k) rather than bouncing to 380k as the consensus estimate had predicted. The quality of the Initial Claims data will deteriorate rather sharply over the next couple of weeks and for the first few weeks of January, but it does seem likely that we have moved out of the old range of 400k-425k and into a new lower range. This is consonant with a general improvement in the overall data (and in the mood in the country!).

M2 money supply leapt $32bln last week. So much for the possibility I mentioned a few weeks ago that the pace of money growth might be slowing. The 52-week rise in M2 is back up to 9.8%. One of the restraints on inflation, despite this money growth, has been the slower rise in transactional money in Europe, where the year-on-year rate of rise in M2 as of the end of October was only 2.1%. This is soon to change, however, thanks to the ECB’s new operation. As a blog post from The Economist pointed out yesterday, ECB President Mario Draghi has stopped the stern denials about the ECB engaging in quantitative easing.

“Each jurisdiction has not only its own rules, but also its own vocabulary. We call them non-standard measures. They are certainly unprecedented. But the reliance on the banking channel falls squarely in our mandate.” (The source of the quote is an interview with the Financial Times here, but the Economist article makes for better reading.)

The ‘news’ of the day being thus dispensed with, I can proceed directly into a belated observation or two about the Fed’s Z.1 “Flow of Funds” release that was posted in early December. The Z.1 is a rich source of bauxite with just a little alumina within it, but one does occasionally find something valuable and/or interesting. I like to plot the debt numbers in various ways, because the Fed helpfully slices up the debtors into convenient categories (although they seem to still include Fannie Mae and Freddie Mac debt in “private” domestic financial institutions, which is a ridiculous fiction. More on the impact of that fiction in a moment).

I have published charts with roughly quarterly regularity simply to provide a concrete reminder that the popular story about household deleveraging is largely a myth. The chart below shows it very clearly: most of the deleveraging has come from domestic financial institutions. This will continue, as the Fed moves to implement substantially all of the Basel III recommendations and demands an extra layer of “protection” in the form of capital from systemically important institutions. Households have de-levered somewhat as well, but not really very much in the grand scheme of things. It just feelslike deleveraging compared to the wild leveraging behavior seen prior to 2008. Relative to income, consumers are carrying less debt, and it is the first decline in a generation, true. But it isn’t very much.

Businesses are adding debt!

But here’s the interesting thing in the chart above. Businesses are re-levering. Okay, technically they are not re-levering, but they are adding debt. This also spears a popular story, that of the cash-hoarding trolls that run businesses in America today. We are told that if businesspeople would only have confidence (those lousy one percenters!) the economy would be healed. Well, it’s a wonderful story, except for the fact that ‘taint so. Business owners are behaving like Scrooge, all right, but it’s Scrooge after the visitation by Marley’s ghost.

It is true that there is more cash on corporate balance sheets than there was five years ago. In some cases, it looks as if companies are issuing debt to hold cash! But that may not be far from the truth. After credit lines evaporated in 2008 and 2009, a prudent business will need to keep lots more cash on hand as an insurance measure. It is a good sign that business debt is growing, and it means this measure confirms the recent expansion in commercial bank credit that I mentioned and illustrated in a comment last week.

The second interesting chart is shown below. It computes the total federal, state, and local government debt as a proportion of GDP. The ratio currently stands at 86.6%.

U.S. public debt is approaching 100% of GDP.

That would not be a big story in itself, but the red line is. The red line is the ratio if you simply recognize that Fannie Mae and Freddie Mac debt are de facto obligations of the Federal government. And that ratio is at 96.1%, and will almost certainly exceed the magical 100% level by the middle of next year.

[Of course, you could plausibly argue that if you include Social Security and Medicare obligations, the obligation ratio is wayyyyy over 100%. But there are two differences with those obligations. One is that the government can decide to stop paying those benefits and it would not constitute a default. An abrogation of the social contract, yes; a default, no. The other difference is that Social Security and Medicare are inflation-linked, so the government can’t inflate out of them. Therefore, the existence of those obligations shouldn’t influence whether or not a calculated decision is made to spur inflation to reduce the real burden of the debt.]

Have a very Merry Christmas, a Happy Hanukkah, or be otherwise jolly no matter what your religious or secular persuasion. There will be one more article before the new year – but not this week!

Nomination For A New Villain

December 21, 2011 10 comments

It seems very strange to find myself suddenly on the more-optimistic side of opinion when it comes to the situation in Europe. That isn’t to say that I am optimistic in an absolute sense; I still think that the Euro will either fracture or dissolve, a number of banks will fail, be nationalized, or be zombied, and several nations will default or restructure debt significantly (although if the Euro disintegrates, then inflation in some countries may take the place of an overt default since countries will then control their own currencies and have that alternative). I think that still places me squarely in the long-term pessimistic camp. But I am more optimistic about the near-term trajectory of the crisis.

Maybe even “optimistic” is too strong. I suppose I just think that the huge ECB program is the best real attempt that the European policymakers have made so far to at least extend the game. Unlike all of the other measures that have been taken (or hinted at being taken, or promised and not taken), this is the first one that has at least a chance to push off the day of reckoning. Yes, as I wrote yesterday, there are lots of things that can still go wrong but there are at least incentives for the cartel to remain together for a while.

The solution so far looks to be just naked printing in everything but name. The take-up of the 3-year ECB lending facility today was an enormous €489bln, a number which will likely grow to be more enormous before it shrinks. And there is just no way that I can see that the ECB can sterilize the activity on such a scale. I could be wrong. I always could be wrong. But whatever this does for the ‘ol can, it certainly seems to represent another goose for the global reflation trade.


The other big news on Wednesday was the National Association of Realtors revisions to past Existing Home Sales and inventories. Sales from 2007-2011 were revised down 14-15% and inventories as well. The main ‘technical issue’ was that beginning in 2007 some houses and sales were double-counted when they showed up in multiple listings, and there were several related issues of that ilk (all of which, it seems, inflated sales). Changing the data doesn’t really change the depth of the crisis, but we now have a better idea of how deep the crisis actually was. But one Wall Street economist who shall remain nameless wrote this in his/her analysis:

“…the revision does NOT imply that the NAR has deliberately been cooking the books over the past few years, trying to paint an overly rosy picture of the housing market. There were genuine data issues to be overcome.”

Sure, and interestingly all of the data issues began in 2007. Hmmm, what else was happening in 2007? Oh, I remember – existing home sales were beginning to fall alarmingly (see Chart, source Bloomberg). The white line, which represents the original release for the pace of sales, actually rose in early 2007, right when the actual sales, based on the revisions, were falling off a cliff. The NAR at the time was assuring us that the market was healthy, and somehow their estimate of sales was suddenly off by a 1mm units/year pace and no one thought anything was funny with the data. Sure.

Bloomberg chart showing original release and new, revised level for Existing Home Sales.

The fact that home sales fell more steeply and more deeply than was previously thought would have been great information for policymakers to have had in, say, 2007 when the Federal Reserve was holding the Fed funds rate steady and considering hiking further. I wonder what would have happened if, data in hand, the FOMC had started easing 9-12 months earlier than they ultimately did. It’s an interesting thought experiment. Why is it only bankers’ heads that should be hoisted on a spit?

The “new” trajectory of sales has another implication. It makes it even more amazing that core inflation never declined. The housing crisis was significantly worse than we had thought, which makes the arguments of the classical economists even less defensible than they were. By all that is good and holy and Keynesian, the core price level – nearly half of which is housing – should have declined. In only two months out of the last 48 have prices declined on a month-over-month basis, and one of those was so marginal it rounded to 0.0. The only meaningfully-negative month, January 2010, saw a -0.13% decline in core inflation. The worst recession in 80 years had almost no effect on prices. Does that evidence count for anything?

Pardon the rant, but it continues to baffle me that this even remains a debate.

Tomorrow, I plan to write my next-to-last comment of the year, and look at one or two items from the Z1 data release that the Fed put out earlier in December. Ordinarily I get to it sooner, but the story has been constant for quite a while. There is one interesting little twist this quarter, and I want to bring it up before I forget it. The last comment of the year, which will come out sometime next week, will be my year-end portfolio-allocation exercise.

Flim-Flams Can Work For A While

December 20, 2011 3 comments

The thin trading conditions continue to lead to wild swings in these last couple of weeks of the year. In some years, markets just float sideways, with investors more or less content with current allocations. This clearly has not been the case this year. The month of December has already been wild and today’s 3% rally in stocks did nothing to change that trend.

The immediate trigger for today’s rally was a stronger-than-expected Housing Starts number (685k versus expectations for 635k), but in normal times such data would not have as dramatic an effect – especially given the fact that the absolute level of Housing Starts, even with today’s second-highest-print-in-three-years figure, is drastically below the levels of a few years ago (see Chart).

Yay! Big spike in Housing Starts! Right?

German manufacturing data was also strong, in contrast to much recent data off the continent, but also not something that would ordinarily move mountains much less markets.

Bonds sold off sharply (10-year yields up 11bps to 1.92%), while inflation-linked bonds were roughly unchanged (10-year TIPS yields at -0.15%). This produced an impressive 11bps rally in 10-year inflation swaps and breakevens.

And therein lies the hint about what is really behind today’s action, if it has any external motivation at all and is not merely the twitching of a market in coma.

Increasingly, it is dawning on market participants that the recent move by the ECB to offer unlimited quantities of 3-year money to banks to buy domestic sovereign bonds is just the crazy scheme that might work. The effect of it, if it works, is to (a) push the day of reckoning for the EU, which will still come as surely as the sun rises, off by a period of time up to three years, (b) ease the transition from the Euro back to distinct national currencies (because if every bank has loans and assets from their own nation rather than from the whole of the EZ the breakup will be less traumatic for those institutions), and importantly (c) print money, since the ECB giving money to a bank to buy bonds is no different than the ECB directly buying the bonds. Admittedly (c) is only true if the ECB doesn’t sterilize the loans.

And so, after working this through, you get inflation-linked bonds outperforming their nominal counterparts by 11bps.

Now, it is true that the new ECB President has taken pains to declare that “the treaty forbids monetary financing” of governments by the ECB. There seems to be some debate on this topic, but what I have learned over the course of my career (and everyone has been reminded, in spades, over the last few years) is that people in power are all too happy to bend rules or to look the other way when they are being bent, if they believe the ends justifies the means. It looks to me as if by funding banks that then fund governments, Draghi has created enough distance that politicians who want to look the other way anyway, but had previously made strident statements that were hard to back off of, now have some cover to do so. Frankly, it’s nauseating but not surprising.

I have a weird feeling that this idea is just crazy enough to work, because in principle it can’t be pressured too much from external forces. The ECB sends money to banks, who buy high-yielding sovereigns that they pledge to the ECB. The sovereigns continue to sell their bonds to a new and ready market for them, and don’t have to worry about funding themselves in the short-run. The banks increase their leverage still further, but also increase their interest margin and, if they match-fund the sovereign bonds with ECB loans and don’t mark the bonds to market, they won’t have any more earnings volatility than they had. The ECB prints without sounding like it is printing. And everyone is happy, as long as no one blinks.

Cartels are difficult to maintain because there tend to be big incentives to cheat. (OPEC has survived as a cartel mostly because for many years – although it’s questionable if this is still true – the low-cost producer was willing and able to police compliance.) Where are the incentives here? Obviously, the ECB won’t cheat, and the sovereigns will have increased pressure on them to honor their covenant with the banks and work on getting their finances stable since in three years they may really have to raise money on their own merits rather than on the bank of a scheme. What about banks? Here is where I have some mild concerns. If it is good for a bank to take in 3-year funds and buy 3-year sovereign bonds, then is it better for a bank to take in 3-year funds and buy 6-month sovereign bonds ‘just in case’? And I am sure there are other ways for a bank to try and extricate itself from this diabolical compact. Still, it is pretty easy money if everyone in the club plays along.

Spanish 10-year yields have abruptly fallen back to near 5%, which is as low as they have been in 13 months. Italian bondholders are less-impressed (perhaps because the ratio of bank balance sheets to sovereign debt isn’t as good), but 3-year yields are back to 5.58% and 10-year yields at least haven’t gone any higher.

It has been a long-shot bet all year that the EU would find a way to delay this train wreck. They failed in Greece and failed to build a firewall to prevent other countries from circling the drain dramatically and publicly. But it has also been a long shot for many, many years to bet that “the system” would collapse. By rights, after the equity bubble burst in 2000 the country and the world should have entered a deep and prolonged recession to unwind the excesses of the 1980s and 1990s. It didn’t happen, because institutions act to protect themselves (selfish memes!) and so we got outlandishly easy money rather than dealing with the consequences of the years of plenty. In 2008, many of the same institutions acted to avert what they considered disaster, and this time it required cutting some corners such as the central bank guaranteeing and financing toxic waste by means of the creation of a pair of off-balance sheet entities. Hmmm. But I don’t mean to be a scold; I’m just pointing out that it is hard to bet on the ultimate collapse because as the stakes get higher, the scruples of the people tasked with the rescue get lower.

I have a funny feeling we might have reached that moment where the crisis turns aside for a few years until the next, and probably larger, crisis hits. It is harder for me to tell that from where I sit, outside rather than inside of these institutions – in 2008, it was crystal clear exactly when the system had passed the critical point if you were sitting on or near the bank’s funding desk. It is more of a guess for me now.

That being said, it does not imply that it is time to jump into equities – although I am sure some will read my words that way and we could well get a melt-up if my read of the situation is accurate. But stocks remain expensive and the outlook for future earnings if banks are locked in a zombie embrace with their regulators and central bankers is not good. It does seem to support the reflation trade, since part of the deal from the central banks must be that they will keep rates low (the Fed has already promised explicitly to keep them low for two years).

On Wednesday, the main economic data is the Existing Home Sales data. The consensus is for a selling rate for November of 5.05mm units (annualized), but the real story is that the entire series is being revised, and being revised by a large amount. It seems that this is another case where the Cassandras were right. The National Association of Realtors (NAR) has apparently been overstating the sales for years, double-counting sales and making many other “mistakes” (which all turn out to be errors in the direction of increasing the sales count). As much as people complain about government statistics, they are generally compiled by bored civil servants who get no direct benefit it the numbers they produce are high or low. The statistics you should be naturally suspicious of are the ones produced by industry groups. This is a case in point. Flim-flams usually come to light eventually.

The actual numbers are thought to be as much as 20% or more lower than the numbers originally reported. Although this has been reported now for a few days, the data may be shocking and today’s trends may well reverse on the news. It’s what they do after the initial shock that should draw your attention. In thin markets, impulse moves tend to follow through since there aren’t as many ‘value’ players leaning against the prevailing price action. If after an initial selloff in equities (and rally in bonds) on seemingly awful housing numbers the markets reverse, then respect the move…at least, as much as any move in December can be respected.

Categories: Europe

The Inflation Trend Is Not Yet “Tamed”

December 16, 2011 11 comments

Inflation Unlikely to Be a Cause for Concern,”  expressed the Wall Street Journal today. “The cost of oil, metals, and grains would have to jump another 20% to 30% in coming months [my note: actually, just oil] to trigger a repeat run-up in consumer prices next year. Absent that, headline inflation rates are poised to weaken.”

U.S. Consumer Prices Stagnate as Fuel Costs Show Inflation Tamed”  said the headline on Bloomberg.

Why the sudden emphasis on headline inflation, now that it’s converging back to core? Why are pundits abruptly myopically focused on fuel, which is 9.1% of the consumption basket (although a good part of its volatility)? I would suggest that this spin on the headline derives from the fact that economic prognosticators have been saying for some time that the slow global growth will keep inflation contained, and so they are beginning to obsess about the parts of the price index that appear contained even if they are not the important parts of the index.

Meanwhile, core inflation rose +0.173%, bumping the year/year rise in core inflation to 2.153%. Both were above expectations. Look at the chart of core inflation, below, and objectively try and decide if that looks like a “tamed” inflation trend. To me, it looks like a trending trend.

Tame? Only if you're already assuming the trend stops.

The last time year/year core inflation was 2.2% was in October 2008. It took exactly 2 years to decelerate to a low of 0.6% in October 2010. It took 13 months to return to the level. And as the chart makes clear, it has been a straight shot. Year-on-year core inflation has not fallen in a single month since October 2008.

It isn’t as if this rise is being caused by wages, or by medical care, or by fuel. While the second story below takes pains to blame it on “higher medical care and clothing costs”, in fact most of the basket is accelerating. The table below shows the eight major subgroups.

Weights y/y change prev y/y change 1y ago y/y change
 All items





  Food and beverages




















  Medical care










  Education and communication





  Other goods and services






From last month, acceleration in the year-on-year rate happened in Housing, Apparel, Medical Care, Recreation, Education & Communication, and Other, totaling 67.9% of the basket, while Food & Beverages and Transportation (mostly due to energy), 32.1% of the basket combined, decelerated. And, from 6 months ago (shown below), every major group has accelerated its year-on-year trend except Transportation (again, because of energy prices) even though the headline inflation rate itself has fallen.

Weights y/y change 6m ago y/y chg
 All items




  Food and beverages
















  Medical care








  Education and communication




  Other goods and services




This bears repeating. There has been a 5% fall in the year-on-year rate of inflation in 17.3% of the basket. That causes an 0.88% drag on the headline number. But the headline number only dropped from 3.569% to 3.394%, because every other major group accelerated.

You can call that “tamed” if you want to. I will say that it is surprising our models, which a year ago only expected core inflation to be in the 1.6%-1.8% at year-end 2011. Housing inflation in particular has remained surprisingly high despite inventories which should be pressuring rents and home prices. And yet, prices are rising. There is just no sign of deceleration in core inflation at this point, although core inflation ex-housing rose only to 2.37% and will probably only be around 2.6% by year-end, a trifle lower than we were expecting two months ago.

This is not a growth story. While economic data on Thursday was better-than-expected, with another eyebrow-raising decline in Initial Claims and better-than-expected readings from Empire Manufacturing and Philly Fed, recovery today (such as it is) doesn’t affect inflation today. Inflation, if it responds to growth at all, is supposed to respond with a lag. So that’s not what is happening here.

The best candidate continues to be money and lending. M2 on Thursday night bounded ahead again, pushing the 52-week change up to +9.6%, and the 52-week rise in Commercial Bank Credit reached 2.5% for the first time since November 2008. The chart below shows both the rise in Commercial Bank Credit and the contemporaneous rise in CPI for the last few years. CPI seems to respond to changes in credit with a 6-12-month lag.

Commercial Bank Credit vs Core CPI - related, or at least both related to a third thing.

Well, I am not saying these things are necessarily causally related because if we trace this back to the early 1980s the fit is less persuasive, but I suspect there is a causal link which becomes more apparent when other factors are muted. It certainly fits with theory that money and lending should impact prices.

Assessing all of the data, I cannot see how a neutral observer can look at current price trends as being “tame” or “stagnated,” and I can easily see how inflation might become a cause for concern…even if it isn’t already.

The Basket Is On Fire

December 14, 2011 7 comments

Italian yields rose again today. The take-up of the 5-year tap was not awful, but obviously less than what the market was hoping for. Meanwhile, the Treasury auctioned 30-year bonds at a record low yield of 2.925% and a bid-to-cover ratio over 3.

And that’s where we stand today. The status quo is that U.S. bonds have a bottomless bid and European securities are consistently offered. I suspect that is partly a response to the approach of year-end, and some of that trend will reverse after the end of the year, but I suspect that investors with long-dated liabilities, like pension funds, probably see the U.S. long bond as probably a much better source of duration than long bonds from European sources.

After all, the notion that the Euro might not survive in its current form is finally…uh…gaining currency. While a narrowed Euro should probably be a stronger currency, the uncertainty associated with a splintering bloc – who will be in it, or will the Euro simply evaporate altogether? – deters investors from keeping as many eggs in that basket. The basket is on fire.

For all the wailing about the Euro’s decline below $1.30 today, to near the lowest levels of the year, Armageddon it is not. The chart below shows the Euro/USD exchange rate over the last five years. Clearly, the Euro does not look strong. But neither is this alien territory, at least not yet.

Source: Bloomberg. Euro is weak, but it isn't exactly in no-man's-land.

I am tempted to call the dollar the least-ugly stepsister, and say that the weakness of the Euro/USD exchange rate is all about weakness of the Euro rather than dollar strength, but today the dollar was very strong against the constant candle of commodities. While yesterday commodity indices were strong despite the dollar weakness, today virtually every commodity fell. Precious Metals fell 5.2%, led by a thrashing of Silver; the Energy group was also down around 5% and the DJ-UBS Commodity Index as a whole lost a whopping 3.6%. So were investors right yesterday when they bid commodities up, or right today when they cratered them? My personal view is that they were closer to right yesterday, but again this may be so much year-end noise. Raising liquidity by selling commodity futures-backed investments is easy to do, and the commodity trading business is a capital-intensive one for banks at a time when capital is increasingly scarce.

Unsurprisingly, with commodities down that much and the Treasury auctioning $12bln 5-year TIPS tomorrow, breakevens and inflation swaps were weak.  Inflation swaps fell 5-15bps. TIPS were unchanged to lower, while nominal markets rallied with the 10y nominal Treasury down to 1.90% and the 10y TIPS still at -0.08%.

Yesterday I showed a fairly violent chart that illustrated how European real yields have risen relative to U.S. and UK real yields. In contrast to the violence of real yield movements, the movements in inflation expectations have been sedate if not stately. This is because an important part of the movement in European real yields is due to the deterioration in the perceived credit quality of the underlying bonds. Inflation swaps tracking inflation in different economies, however, have the same underlying credit (you face your counterparty on a fully collateralized basis) so the relationships are much more stable. For a long time, UK expected inflation (RPI) has been higher than US expected inflation (CPI) which has in turn been higher than Euro expected inflation (see Chart).

Source: Enduring Investments. The general configuration of inflation markets has been static for some time.

Now, you would think that, all else being equal, the recent debacle in Europe would imply much lower inflation on the Continent. In fact, European inflation expectations have risen and are now trading as close to US inflation expectations as they have since the inflation swap market began, other than the late-2008 to late-2009 period when the US was the country in crisis. In late 2008 and for parts of 2009, 10-year inflation swaps in the US actually traded as much as 80bps below 10-year inflation swaps in Europe.

But why should the spread tighten when the US is in crisis, and also when Europe is in crisis? The answer is that in both crises, the dollar strengthened versus the Euro. A change in the foreign exchange rate has the effect of importing or exporting inflation from one country to the other. When the dollar is strong, US inflation declines relative to European inflation. When the dollar is weak, the opposite holds true.

However, the currency has nothing to do with the overall level of inflation (call it “global inflation”). Both inflation rates can rise, or both can fall, based on other causes, while the currency determines which one rises or falls more relative to the other. One such cause, and frankly the one that is far and away the most important effect, is the collective action of central banks.

In 2008, central bank intervention was far less coordinated and initially it was quite substantially behind the curve since central banks had been in tightening mode just prior to the crisis; also, we had a not-insignificant fall in money velocity and the dollar, being thus more scarce, strengthened relative to commodities prices (that is to say, commodities prices declined). In the current circumstance, central banks arecoordinated and are easing much more aggressively; moreover, bank lending is not plunging like it was in 2008. I believe that European inflation should rise relative to US inflation temporarily while the greenback strengthens, but that both should rise relative to commodity price inflation. The latter, clearly, is not yet happening, but you can still see in the chart below that commodity prices are falling much less dramatically than they did in 2008, and the crisis now I think is at its root even more severe.

Source: Bloomberg. Commodities prices are falling but much less-dramatically than in 2008.

The severity of this crisis is not in terms of the pace of economic growth (which I don’t think is likely to contract, in the US at least, as dramatically as it did in 2008) but in terms of the long-term damage being done to financial intermediaries and sovereign credit. No countries fell in 2008, and the banking sector in the US continues to function today. The damage was very large, but it was diffuse. In 2012, we are likely to see some more banks nationalized, and the European financial sector which is already significantly dormant is likely to look very different at year-end from year-beginning. Greece will default and some other countries likely will as well, and there is a reasonable likelihood that the Euro will have a different constituency. But central banks will continue to create liquidity. Oh, will they create liquidity. And so I want to be long commodity indices.


Data tomorrow, while still not of prime importance, is likely to continue to recent trend of mildly positive releases. Initial Claims (Consensus: 390k vs 381k), if it achieves the consensus number, will drive the story about an “improving labor market” further along. Empire Manufacturing (Consensus: 3.00 vs 0.61 last) and Philly Fed (Consensus: 5.0 vs 3.6) are expected to be essentially unchanged. Industrial Production/Capacity Utilization (Consensus: +0.1%/77.8%) are to be roughly flat. (Ignore PPI, which is expected to be +0.2% and +0.2% ex-food-and-energy, and wait for CPI to get a useful measure of inflation). I will say that the Citigroup Economic Surprise Index, near a record level last reached in March, suggests that we should begin to brace for some disappointments, but I don’t think these forecasts represent economists getting too far “out over their skis” and I don’t expect big disappointments.

Equities should remain heavy, but one other point I want to make (and keep making) is that these December moves ought to be taken with a grain of salt. The moves will be more dramatic simply because it’s year-end, and sometimes big moves will happen for no other reason than that one big player needed to liquidate a position. We little people can’t know much about those moves, so work hard to avoid overreacting. By now you should already have the position you’re comfortable holding until January, and very little should cause you to change that.


The holiday season means that only a few more of these articles will be published before the end of the year. But there are still some to come, including my year-end piece with updated long-term asset projections and a portfolio allocation exercise. Wouldn’t it be a great holiday gift to your friends to turn them onto this blogger?

Autopilot Through the Andes

December 13, 2011 1 comment

Tuesday’s bright start to equities was tarnished by selling in the last couple of hours. Overnight, the market had moved higher on the usual reasoning about how the market is oversold, undervalued, unloved, and that everyone is too bearish even though most people are telling the bullish story. Sunshine disinfects, though, and the highs for the day were set during the optimistic first half-hour.

Neither stocks nor bonds responded to the modest shortfall in Retail Sales from expectations. The print of +0.2%, +0.2% ex-auto, was the second-weakest reading of the year, and a mild surprise; however, as has been true for some time economic data was ignored. The focus was ostensibly on the Fed and a result that few thought would be surprising. That’s why it was curious to see currency markets trading rather sharply. The dollar index rose to nearly the highest level of the year, with the Euro off nearly four big figures since Friday. What is more, despite the dollar strength and equity weakness, commodities rallied. This is an unusual combination. In fact, the last time that the S&P fell at least as much as it did today (-0.9%), the dollar index rallied at least as much as it did today (+1.0%), and the DJ-UBS Commodity index rallied at least as much as it did today (+0.6%) was in February 2009.

There was some speculation that the odd mid-day timing of the Euro breakdown might have had something to do with the S&P downgrade announcements, which are due any day now. Apparently, under the new rules controlling rating agency behavior in Europe, they are required to report ratings changes to regulators twelve hours before formally announcing the change (I hadn’t known this), and there was suspicion that there was a leak. We’re all pretty sure which direction the changes will be in, but the actual report will still cause some ripples in an illiquid year-end market.

As of this writing, S&P has made no announcement, but we have all night.

I think this is a more likely explanation for the market action than attributing the moves to the FOMC announcement. There were no surprises in the statement or lack of action. Personally, it seems to me like the Fed is trying to coast on autopilot through the Andes Mountains, but no one was seriously expecting any change in policy; at most, some people expected a statement about how the communications policy will change going forward. So I don’t think that’s why the markets were moving (besides, the bond market rally was at 1pm, and nominally charged to a strong 10-year note auction, while the Fed statement wasn’t until after 2pm).

Equity volume was a bit higher than recent standards, but liquidity is going to be an issue if there are any surprises over the next couple of weeks – for example, if Italy’s auction on Wednesday is not well-received or if S&P downgrades France the full two notches rather than only one. This is mostly a year-end issue, but as I have pointed out all year, equity volumes this year have been consistently lower than in prior years. The following chart shows cumulative NYSE Composite Volume through the first 240 trading days of the year. The volumes leading up to and since the Volcker Rule assault on dealer market-making abilities (aka “proprietary risk taking”) have been demonstrably lower than in the four years prior. I am sure there are other secular pressures on equity volumes, but in any event it seems obvious that we are in an era of less volume and diminishing market liquidity. (This should by the way favor small investment managers, who have lower market-impact costs of trading…which is another trend I see continuing.)

Source: Bloomberg. Equity volumes have been consistently weak all year.

10-year real yields are at their lowest levels ever (-0.087%), save for a spike down back in August. And that’s happening despite the fact that a TIPS auction is only two days away and we would ordinarily expect prices to be backing up (especially with year-end liquidity!). But the chart below explains part of the dynamic. As European inflation-indexed bonds are being beaten up because of credit issues, TIPS are clearly deriving some support. Actually, although French real yields around 1.5% are not exactly cheap, they’re pretty cheap if France is only downgraded one notch to match the U.S. rating. A few days ago they were over 2%. Once the French downgrade announcement is actually made, that is one place I would look to add exposures. I would, however, continue to avoid Italy at 6% real yields. Greek 2025 inflation-linked bonds at a 21.5% real yield and a price of around 20…if the prices on Bloomberg mean anything…actually might be worth buying for the negative miracle.

Source: Enduring Investments. 1.5% real yields in Europe doesn't sound so bad, especially for a US investor who doesn't currency-hedge.

The economic calendar on Wednesday is thin, so keep an ear out for pings from S&P and otherwise, enjoy the seasonal cashews.

Priced For Omnipotent Central Bankers

December 12, 2011 1 comment

It seems that, over the weekend, some investors had a case of indigestion after the cookie exchange late last week. Moody’s did, and announced a review of EU sovereign debt ratings. Fitch followed later in the morning on Monday, so now all three major rating agencies are in agreement that the Euro summit was significantly less than decisive (at least, less than decisively positive). It is now quite probable that at least a few sovereigns will have ratings cut. Intrade ( has a market on whether France will lose its AAA rating by June 2012; as of this writing, the last trade is at $7.70 (meaning the market sees a 77% chance).  In other markets, Intrade participants put a 69% chance on Greece being rated as in default by Dec 31, 2012, with a 28% for Italy and a 20% chance for Spain. These numbers would surely be higher except for the technicality that we have all recently discovered, that a country could be effectively in default and not rated in default due to arcane rules that are carefully managed around by politicians.

And all of that assumes that the summit deal at least limps towards ratification by the main players. This is obviously far from assured for many of the countries involved, but even France’s participation is less than clear. Grand-Plan Architect (and French President) Sarkozy is up for election in April (and May, as there are two rounds), and the candidate he is comfortably trailing in the polls said on Monday that if elected he would seek to rework the deal or simply not ratify it at all.

The partial thaw of last week’s optimism trimmed around 3% from European stock markets, and sent the S&P down -1.5%. The dollar, not surprisingly, shot higher, and is again not far from 1-year highs. Commodities, which these days mindlessly follow equities, fell about -1.6%. Precious metals were the worst performers, which is especially odd when you consider their reputation as safe havens in banking crises.

The odds of a full-fledged banking crisis rose, along with bond yields in Italy where the 10-year is again up to 6.5% (see Chart). Remember how, when the global central banks cut swap lines on November 30th, observers noted that the direct impact of the rate cut would be small since the swap lines were only lightly utilized? Well, last week the ECB took some $50.7bln on those swap lines, up from $400mm right before the swap line rates were cut.

Italian yields heading back up?

The rate is still less important than the availability of the line, and so the signaling significance is still the dominant reason to care about the concerted central bank easing – but it now appears that some of those rumors of banks having trouble accessing funding may not have been entirely spurious after all.

Long TIPS rallied despite the decline in commodities and the decline in yields, thanks to the Fed’s buying of $1.378bln TIPS. Inflation swaps increased, but remain comparatively sanguine about the central bank’s ability to peg inflation just about exactly where it wants it. The chart below shows the inflation swap curve at Monday’s close (Source: Enduring Investments).

US Inflation Swaps

I suppose that this is consistent with the current level of yields and the generous equity market valuations (a Cyclically-Adjusted P/E at today’s close around 20.3). The inflation market is pricing near-omnipotence from global central bankers. I guess if you believe that, then why shouldn’t equities be valued with a thin margin for error? What is potentially most remarkable is that looking at the central banks’ actual record of achievement over the last couple of decades, they still have such credibility.

Speaking of central banks, tomorrow the Fed meets. Market participants expect no major change in policy, although some observers think the Committee could indicate its new communications strategy. The stronger recent economic data could deter them from making any overt move towards QE3 until the end of January, but I would be cautious about this assumption. If the Fed wanted to move markets dramatically, a December action is much more valuable than a January action. Moreover, since the European summit fizzled it may be that the FOMC perceives a lot of risk over year-end and the next six weeks. And let’s not forget that the Fed doesn’t officially know who borrowed the $50bln that they swapped with the ECB, but they almost certainly know unofficially whether it is something to be worried about. In short, while a surprise Fed move on Tuesday isn’t my base case, I don’t think it’s the long shot that many observers think it is. How do you play it? I’d consider selling the dollar into the announcement.

Also on Tuesday, we’ll get November Retail Sales (Consensus: +0.6%/+0.4% ex-auto vs +0.5%/+0.7% last). Ex-auto Retail Sales have been remarkably stable for about a year now, with a little bump in the spring and a little dip in the summer. The consensus estimate actually looks slightly conservative given recent trends.

Categories: Europe, Federal Reserve

Cookies and Zilch

December 10, 2011 15 comments

One of the frustrations of the Christmas season, for someone trained in basic mathematics, is the tradition of the holiday cookie exchange. In this tradition, a collection of friends and/or acquaintances comes together for a night and exchanges cookies they have prepared for cookies that others have prepared. This results in every person who came with cookies of one type leaving with a rainbow of cookie types. And thus, we illustrate the “gains from international trade” to the masses.

One of the reasons the cookie exchange tradition is frustrating is that there are always several participants, and often the organizers, who seem never to understand a basic principle: cookies are not created in the exchange. I remember an incident a few years ago when an exchange participant was enthusiastic about one particular event because she said ‘this way I can get so many cookies!’ How many cookies are you bringing? I asked. Two dozen, came the answer. How many do you expect to leave with? ‘I don’t know…maybe three, four dozen!’

This obviously can’t work, and it’s easy to illustrate. Suppose only one person comes to the cookie exchange, and he brings 10 cookies. In that case, he obviously leaves with 10 cookies. Suppose two people come to the cookie exchange, and they each bring 10 cookies. Then they switch cookies, and each person leaves with 10 cookies. Suppose four people come with 10 cookies. Each hands 5 cookies to the person on his left and 5 cookies to the person on his right. They all receive 5 cookies from the person on the left and 5 cookies from the person on the right, and they all leave with 10 cookies. We can generalize this: if n people bring q cookies to a cookie exchange, then on average (assuming no one eats any), each person will leave with q cookies. The n doesn’t matter.

Which brings us to Europe.

What Europe has is the cookie exchange, but they don’t understand how it works. Each country is showing up with 5 cookies and expects to leave with 10 cookies. It doesn’t matter if they route the cookies through the IMF: the number of cookies is fixed. You either need someone to bring a truckload of cookies which are distributed to everyone else (with Germany the driver of the cookie bus), or else everyone gets roughly the cookies they came with. There is no “cookie leverage.” Now, if some people show up with just a few cookies, and some with big bags of cookies, but they all leave with the average amount, then obviously some participants will enjoy this socialism and some will not (in the real-world cookie exchange, this takes place when all cookies are treated as equally valuable. The person who showed up with three dozen macaroons leaves with chocolate-chip, peanut-butter, snickerdoodles, ginger snaps…and the person who brought chocolate-chip cookies goes home with at least some macaroons. Where is the justice? Shouldn’t macaroons trade at a discount?[1] Those who bring great cookies end up losers while those who bring lame cookies end up winners.)

Strip away all of the structuring, and that’s fundamentally the problem. There is not enough money to service all of the debt, and no amount of shuffling money will solve that problem. And Germany’s decision to make is whether to bring dozens of chocolate-chip cookies and leave with macaroons, gluten-free rice-crispy treats, and that nut-flan-custard thing Grandma developed during the War.

So it wasn’t a huge surprise when on Friday there was nothing of substance announced to come out of the European summit. There were lots of statements given to the press. There was nothing there. Equities rallied (S&P +1.9%) because investors couldn’t really believe that was it. All we got from the summit we’ve been promised for weeks is a decision to move the ESM forward, although we don’t know how, and a reassurance that maybe some of the Eurozone will effectively cede fiscal sovereignty to the big guys, although we don’t know why?

When Monday comes, with no more headlines (unless the rating agencies go ahead and start downgrading sovereigns, as is almost assured now), I think there will be some selling pressure in the European equity and bond markets, and probably some spillover here in the equity side.

The other news on Friday was not good. Moody’s downgraded the French banks, and the ECB announced that it would limit its sovereign bond buying at €20bln per week (although it is still not clear they can do that for very long and continue to sterilize the purchases effectively).

I don’t think I am the only one who ended the day on Friday shaking my head in disbelief that there was no earth-shattering announcement. I didn’t expect any substance, but I thought they would make a better show of it. This is going to get ugly, and I have seen nothing that truncates the possibility that it could get epically ugly.

I guess that’s the way the cookie crumbles.

[1] I always thought this would be a great trading game – a tote board with bids and offers for, say, the gingersnap-snickerdoodle exchange rate.

Categories: Economy, Europe, Good One

Any Fireman Will Do

December 8, 2011 2 comments

Thursday’s spotlight turned out not to be on the European summit but on the ECB. As expected, the central bank cut rates 25bps (although some expected 50bps) and loosened collateral criteria so that banks can pledge dicier assets at the ECB.

By the way, although this is a bad idea it becomes necessary because the best-quality collateral – sovereign bonds – are the securities causing all of the problems, so if a bank wants to rid itself of toxic sovereign bonds it also rids itself of a lot of collateral. So banks were doing “collateral swaps” (a good explanation is given by the Financial Times here) in increasing amounts, which in turn has the effect of creating a great contagion possibility if banks falter.

The Danish Central Bank also cut rates, to 0.80% from 1.20%, in case you’re keeping score.

But the real fireworks came when new ECB President Draghi declared that the ECB wouldn’t lend to the IMF to re-lend to sovereigns in need of aid, noting that the capital-T Treaty prohibits the ECB from financing member countries (and cute optics aside, that’s plainly what the plan was). Equity investors were shocked. The Gordian Knot of treaty obligations and limitations was supposed to be subordinate to “whatever needs to be done,” wasn’t it? After all, in the U.S. the Federal Reserve in 2008 was, um ‘flexible’ about its interpretation of its legal limitations.

If EU ministers were unified, that Gordian Knot could be cut. But the knot was tied that way on purpose; it was supposed to be problematic to circumvent because smaller countries needed assurances that their will would not be circumvented. For example, Finland’s Grand Committee of parliament today rejected the notion put forward by Merkel and Sarkozy that financial rescues conducted by the ESM needed to be fast-tracked and approved by a “qualified majority” rather than requiring unanimity. Finland pointed out that the treaty requires unanimity, and they (quite reasonably) intend to resist weakening that protection of their sovereign prerogative.

So the probability of having something awe-inspiring emerging from the European summit…something which would save the ratings of many of the Eurozone members…is very obviously decreasing. The rules are constraining the options, as they were meant to.

Stocks dropped 2.1% on this dawning realization, as well as the notion that the ECB isn’t ready to pull the “Quantitative Easing” lever as rapidly as investors were expecting them to. Inflation-linked bonds were very weak, with inflation swaps down 6-10bps despite a rallying bond market (the 10y nominal yield fell to 1.98%). Commodities were somewhat weak (DJ-UBS -0.8%), but not too bad compared to what happened in inflation markets.

This was probably partly due to some investors getting cold feet when the ECB didn’t come forth with a fountain of cash. I don’t think Draghi was as intransigent on this point as he was made out to be, and I think the ECB will continue to buy bonds until they simply can’t sterilize them all and they back into QE. But let’s suppose that the ECB really was immovable on this point, and central bankers determined that more was needed. In that case, I think it increases the chances of the Fed doing QE3. Liquidity is liquidity, as last week’s example with the coordinated action on swap lines reminds us. It’s more awkward to print dollars if Euros are needed, but there is a way to change dollars into Euros!

This is why inflation is substantially a global phenomenon, with something like 2/3 of the inflation in developed nations coming from a common global factor. You can’t just watch the Fed, although the Fed moves the needle the most. You have to watch the global tide of money, which (it hardly needs to be said) continues to rise.

While all eyes are turned on Europe, few cared about the somewhat stronger-than-expected Initial Claims (381k) today. And in the U.S., it seemed that few noticed that Japanese data has taken a serious turn for the worse. Japanese data last night (Our Wednesday night) was awful. October Machine Orders were -6.9% versus expectations of +0.5%, and that follows -8.2% in September. Don’t look now, but that’s the worst consecutive months of orders since Nov/Dec ’08. Somehow Japan’s fiscal situation has escaped notice, even though this AA-rated nation has a debt-to-GDP ratio of 200% (as of 2010 according to the CIA Factbook), which is substantially higher than Greece’s (143% in 2010) and Italy’s (119% in 2010).  But let’s not think about that right now…

Choppy trading will continue on Friday and it will probably stay that way even after the summit ends, at least until the end of the year. It seems to me that stocks are more vulnerable to the downside due to optimistic positioning, especially with a weekend looming and every indication that big solutions are unlikely to come out of this summit. But I am happy to keep my hands off the trigger.