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The Basket Is On Fire

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?

  1. Jim H.
    December 15, 2011 at 8:16 am

    ‘Commodity price inflation … is not yet happening, but … 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.’

    How can one disentangle the effects of financial deleveraging on commodity prices from those of global economic deceleration? Or should one even try, since the two phenomena often occur together?

    In relation to an idealized economic cycle, commodities’ massive smash from July to Dec. 2008 started a bit late (seven months into the U.S. recession), but was consistent with the empirical observation that commodities deflate during late recession. In severity, it was like nothing since the unaesthetized cold-turkey wring-out of WW I inflation in 1920 — OUCH!!

    ECRI is pounding the table that the U.S. is headed for a fresh recession in 2012. While I’m agnostic about that (the economy is even harder to predict than financial asset prices, especially in the future!), commodity-intensive developing economies in Asia and LatAm definitely seem to be decelerating. So I have a hard time feeling sanguine about commodities’ prospects, at least in the first half of 2012. To paraphrase the late thousand-man, the serious printing starts in the darkness just before dawn.

    As for turning friends on to your blog, I occasionally post brief quotes of yours at Naked Capitalism. It’s not as market-oriented as E-piphany, but takes a consistent interest in the euro currency crisis, and seems to attract a quality readership of Influentials. Cheers …

    • December 15, 2011 at 8:39 am

      Yes, Jim, I get the pingbacks and sometimes check and see where the column was mentioned, so I’ve seen some of your kind posts there. I appreciate it!

      Thinking about commodities and economic recession…my response to many things inflationary is “what about the 1970s?” There was broad increase in commodity prices despite a decade-long malaise. Why? Simple answer is that real growth doesn’t matter very much when monetary conditions are changing. When monetary conditions are tightening, such as when real interest rates are high, commodities historically do poorly; when monetary conditions are easing, they do well. Short-term, the market tends to focus on growth prospects, but I think that only works if monetary conditions are stable.

      In 2008, monetary conditions were tight, and that helped set the stage for the rinse. But economic growth was still awful in 2009 and commodities rallied 30%!

  2. usikpa
    December 15, 2011 at 9:19 am

    Wouldn’t it be a great holiday gift to your friends to turn them onto this blogger?

    Absolutely, Michael.

    Thank you very much for your blog

    • December 15, 2011 at 9:28 am

      …and thank you for your frequent contributions! You know that the feedback and counterpoint is the reason I do this.

  3. Jim H.
    December 15, 2011 at 11:39 am

    Commodities’ response to Seventies stagflation … or to take a more extreme case, runaway prices in Zimbabwe as its economy shrank drastically … shows that commodity prices aren’t as closely linked to GDP growth as simplistic supply-demand analyses often suggest.

    Unquestionably, currency’s falling purchasing power dominates in the long run. In the short run, though, the murky territory of whether monetary easing is ‘getting traction’ becomes important. Major central banks’ balance sheets have roughly tripled since 2008, but CPI hasn’t risen proportionally. Partly this is lag effect, and partly it’s that vast excess reserves aren’t driving inflation for now.

    Until real-world monetary processes are better understood, I despair of being able to reliably forecast commodity prices. Gorton and Rouwenhorst, in their 2006 paper ‘Facts and Fantasies About Commodity Futures,’ made a case for commodities as a passively-held asset class with equity-like returns (from the combination of yield on 100% T-bill collateral, plus rebalancing returns on the futures positions) — no forecasting required.

    Victor Sperandeo’s Diversified Trends Indicator, now licensed by S&P, uses a purely momentum-driven (and fully disclosed) algorithm to generate positive, uncorrelated returns.

    For now, such passive approaches are my main interest in commodity strategies, since I absolutely suck at forecasting!

    • December 15, 2011 at 1:45 pm

      Yep, and G&R (maybe it’s just R) designed the methodology behind USCI, which is currently the only way I invest in commodity indices! Problem right now is 0 collateral return, but the rebalancing return ought to be quite robust – but that becomes more powerful with time.

  4. Jim H.
    December 15, 2011 at 2:44 pm

    Zero collateral return is ugly … but it reduces contango in products such as stock index futures and gold, so there could be offsetting benefits in roll returns.

    Rebalancing return is a fascinating subject — Erb and Harvey call it ‘turning water into wine’:


    This phenomenon — in which the portfolio return can be materially higher than the return of its constituents — probably deserves a whole book. Erb and Harvey go so far as to call it ‘the one free lunch that can raise a portfolio’s geometric return.’

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