Archive for January, 2012

The Weak Ahead?

January 31, 2012 2 comments

All in all, January wasn’t too bad. The S&P gained 4.4%. The DJ-UBS and SP-GSCI commodity indices rose 2.5% (USCI rose 4.9%). The 10y Treasury note yield fell 8bps. The yield of the July-21 TIPS fell 30bps to -0.43% – although, thanks to the roll, the current 10-year yield fell “only” 15bps.

The 10-year inflation swap rate rose 26bps to 2.53%.

So, basically, if you were long just about anything in the U.S., you made money in January. So then why was everyone so depressed? Consumer Confidence, which had been expected to rise to 68.0, instead dropped to 61.1. The “Jobs Hard to Get” subcomponent, which tends to move coincident with the Unemployment Rate, rose to 43.5 (see Chart, source Bloomberg). While that’s a 3-month high, it’s still well below the worst levels of the last few years although it should also be said that it doesn’t help the argument that Employment is on a steadily-improving trend.

Commodities prices being up is a good thing if you own commodity indices, it isn’t such a good thing if you don’t. Gasoline futures were up 7.5% over the month, and prices at the pump were up 15 cents (see Chart, source Bloomberg). Precious metals rallied 12.7%, but Industrial Metals jumped 10.9%. And I’m not saying these things are related, but M2 is up 1.3% (22.9% annualized) in the first three weeks of 2012, while European M2 rose 1.3% in December (15.2% annualized), the last data we have available.

Alas, this rising tide isn’t yet lifting all boats. The Case-Shiller Home Price Index fell -0.70%, more than expected. This takes the index perilously close to the lows from last spring, which optimists had believed were left behind us for good by summer. (The good news is that this will help restrain the inexorable rise in core inflation, so that central bankers bent on looking for an excuse to ease will probably get one if they don’t look too hard for what’s happening besides housing).

I should point out that the 61.1 reading in consumer confidence, and the weaker-than-expected Chicago Purchasing Managers’ report (60.2 vs 63.0 expected and my expectation of slightly better than that), while not cause for celebration, are also not disastrous. Taken together, they may shake the faith of economists predicting a smooth acceleration in the economy, but are not cause to reject a null hypothesis of a choppy, gradual, improvement in the economy.

That hypothesis will also not take much water if tomorrow’s ADP figure is 182k, which prior to last month’s best-ever print of 325k would have been regarded as quite respectable. Unfortunately, I suspect that there is some payback coming, and the figure will look weak. Prior to last month’s number, the prior six months had only averaged 136k. A modest improving trend to, say, 175k would suggest 150k needs still to be ‘paid back’ through revision or a shockingly low print tomorrow. I don’t expect that, but with the preponderance of the evidence on the labor market (including the Jobs Hard to Get number) indicating stability but not strength, I would be surprised if ADP exceeds expectations counting revisions.

Also out tomorrow is the ISM survey. The consensus of Bloomberg-surveyed economists is 54.5, but there’s a caveat here. The median estimate of economists who updated their estimate today after Chicago PM and after the ISM released new seasonal factors is 54.0. And frankly, that seems high. Last month’s number, which was originally reported at 53.9, has been revised downward to 53.1 and Chicago PM showed weakness. Be careful here, because a print of, say, 53.5 would look like a weak print to those who mechanically compare it to the consensus that includes stale data, but would still represent a slight strengthening trend.

I am anything but a bull on the economy at the moment, but that’s mainly because of the impending implosion of Greece and/or Portugal and/or who knows what other country. It is fair, though, to observe that the economy in the last few months is doing passably. It’s not strong enough to shrug off bad news from the Continent or meaningfully higher gasoline prices, but it’s also not collapsing. At the moment, anyway. Unfortunately, I think stocks are priced for much better than “an economy that’s not collapsing,” and are counting on the QE3 wind in their sales. Valuation is dicey here but I am reluctant to fight the Fed until the inflation numbers tick up a few more times.

After all, it doesn’t take as much hope to move the stock market as it once did. Today’s equity volume was the heaviest of the month at almost a billion shares traded on the NYSE. Note the word “almost”: the last month during which there were no pan-billion-share days was last April, but January’s volume is weak even compared to that (15.2bln shares versus 16.9bln last April). Prior to last April, I can’t find another month with no billion-share days to at least 2005 (which is the earliest data I have), and I suspect we have to go back into the 1990s to find one. Again, this isn’t very healthy.

And that’s why investors continue to flee into Treasuries and TIPS. That’s a very crowded trade at a very high price, and not a place I want to be. Bonds are in fact priced for depression. The 30-year TIPS yield has reached an all-time low of … wait for it … 0.60%. Think about that – if the economy grows at a feeble 2.1% for the next three decades, you are giving up 1.5% real growth versus just sitting around and participating pari passu in the economy.[1] With nominal 30-year bond yields at 2.94%, markets are also forecasting very weak long-term inflation.[2] Both Treasury and TIPS yields are going to go higher eventually, and not only will investors be selling them but so will the Fed, and all the while the Treasury will be trying to sell still more. I want to be on the side of the angels on that one, and am willing to risk the ‘Japan outcome’ (being carried out due to your bond short) to be short here.

[1] This isn’t technically exactly right, since TIPS are based on CPI. Since the GDP deflator is usually about 0.25% lower than CPI over time, CPI+0.6% is like PCE+0.85%. But you get the point.

[2] Again, not to get too technical, but there are two offsetting effects here. One is that breakevens (Treasury yields minus TIPS yields) isn’t the best way to look at expected inflation; inflation swaps are cleaner and don’t suffer from the funding disadvantage of being short Treasuries so they are a better indicator of inflation expectations. The offsetting effect is that the 30-year breakeven or inflation swap probably includes a risk premium due to the length of the structure – that is, you’re willing to pay a bit per year more for 30-year protection than for 10-year protection.

No Pushing In The Default Line, Please

January 30, 2012 11 comments

Europe continues to smolder, but it is about to burst into outright flame. The ‘private sector initiative’ (PSI) discussions, which were supposed to be completed the Friday before last, continue. The leaks of an imminent deal continue, and eventually I am certain that a deal will be announced because eventually we will be down to just one bondholder still represented by the IIF. It is pretty clear by now – or it should be – that the PSI is no panacea. The only ray of hope to that process is that the approval of a ‘haircut’ (in the same way that Hannibal Lecter gave haircuts) would give the EU a fig leaf to approve a deal to send good money after bad, if it could overlook the failure to implement austerity measures that currently has German Finance Minister Schaeuble in a tizzy.

It would be a colossal mistake to agree to another €130bln bailout, even if the chances of it actually being disbursed would be slim (after all, remember the PSI process is necessary for the disbursement of the past-due tranche of the current bailout). And, honestly, I think the only reason they are continuing the charade is to give themselves more time to ready the Plan B default and/or Euro exit.

However, the market may not give them the time. Today Portugal’s 10-year rate rose nearly 200bps (see Chart, source Bloomberg), likely triggered in part by a headline saying “ECB cuts off bond buying as pressure mounts.” 

It didn’t actually cut off bond buying, but it bought very little last week. It seems fairly clear that the limits of the ECB’s ability to sterilize the transaction are nearby, if they have not already been reached, and no doubt some cooler heads have pointed out that failing to have enough buyers for a 7-day ECB tender would be much worse than allowing bond yields to reach free-market levels. After all, what’s the difference to Portugal of 15% or 17% on 10-year notes? Neither level makes Portugal’s situation even vaguely sustainable.

Now, I still think that U.S. equities rally once Greece formally announces it is defaulting, after a knee-jerk selloff. That’s a harder call now than it was when I first made it October 4th with the S&P at 1124, though, and investors need to be aware that if Greece also leaves the Euro at that time (as is likely) then that creates a chance of the ‘unzipping’ trade I talked about here.  However, back in October the VIX was also at 41, and it’s now at 19.4. I think buying medium-term out-of-the-money calls on equities, especially with all central banks working the inflationary bellows, is a viable strategy here (and that’s coming from someone who has spent most of the last decade either out of the market, or short, to good effect).

In the near-term, be aware that Portugal is scheduled to sell 105-day and 168-day bills on Wednesday. The LTRO makes that operation basically risk-free for many banks, so the auctions will go fine (look at the Bloomberg chart below for one of the weirdest yield curves you have seen in your life, except for the fact that it’s becoming normal in much of Europe). And when the auction goes fine, the headlines will trumpet the fact that Portugal raised money around 5% or wherever and is doing just fine, thank you. You shouldn’t believe it, but some investors will use that as an excuse to relax.

Back in the U.S., our economy continues to do reasonably well. Personal Income beat expectations slightly with a +0.5% rise. The core PCE deflator (remember, that’s what the Fed targets) rose from 1.7% year-on-year to 1.8%. This was a surprise, as the consensus forecasts prior to the number were for the number to be unchanged at 1.7%. At 8:32ET or so, Bloomberg re-published the consensus as 1.8%. Wow, those economists are pretty good once they have the number. You can see below the chart (Source: Bloomberg) of the core PCE Y/Y (which is now just another inflation index that the Fed thinks is “contained”), which has just risen to three-year highs.

Today was a ‘risk-off’ day (I am so tired of that phrase), and so commodities suffered along with equities with the DJ-UBS down 1.1% with every category (softs, precious, industrials, etc) down. The dollar was up slightly. And yet, TIPS rallied yet again, with the new 10y TIPS down to -0.26%. Nominal rates continue to trade in my face, with the 10y falling to 1.85%, but absent an unzipping I am happy to remain short in an unlevered way (TBF) and to be long inflation through commodities (primarily USCI) and breakevens (via new ETFs INFL and RINF).

Tuesday’s data includes the Employment Cost Index for Q4 (Consensus: +0.4% from +0.3%) along with the Case-Shiller Home Price Index, the Chicago Purchasing Managers’ Report from January (Consensus: 63.0 from 62.2), and January Consumer Confidence (Consensus: 68.0 from 64.5). I expect to see the Chicago PM express some strength but would not be surprised to see the Consumer Confidence figure, which has risen rapidly over the last few months, fall short of expectations. Obviously, European actions are in the immediate picture more important once again.

Transparently Dovish

January 26, 2012 4 comments

Markets are finding it a little hard to believe that the Fed really said what it said. Stocks opened the day with a rally, along with commodities and bonds and especially TIPS. All of these markets leapt forward out of the gate, which is a completely understandable response. I was pretty clear in yesterday’s comment, but there were a couple of additional points that I either ignored or gave short shrift.

The first of these is that while I mentioned that Bernanke said “we’re not absolutists” about inflation, that really doesn’t capture the idea as clearly as he said it. Here is the full quote (and thanks BN for reminding me):

We are not absolutists. If there is a need to let inflation return a little bit more slowly to target to get a better result on unemployment then that is something that we would be willing to do.

It is hard to read that as anything except probably the single most-dovish thing that a Fed Chairman has said in eons. He explicitly states, essentially, that not only is employment as important as inflation in the FOMC’s consideration of its mandate, but that at this time inflation is actually subordinate to employment. This is essentially a vague form of the Evans Rule, which Chicago Fed President Evans proposed as a way to semi-formally declare that inflation doesn’t matter until (a) it’s out of control or (b) unemployment gets down to some certain level. Formally, it would read something like “the Fed will keep rates at zero and tolerate 3% (or 4%) annual inflation until unemployment is down to 7% (or 6%).” I wrote about this back in early November, never dreaming that it had a serious chance to become policy. It’s worse than policy now – it has a mushy informality that is guaranteed to make any ultimate decision to raise rates in restraint of inflation even more difficult. Back in November, I expressed my opinion of such a rule, and I must say I don’t disagree with this comment:

If they do take such a step, though, it is an unmitigated disaster for monetary policy and a sign to grab every real investment in sight. Because allowing 3% or 4% inflation has nothing to do with the Unemployment Rate, and moreover there is no sign that the Fed has anything like the kind of power they would need to lock the inflation rate at any particular level. Such a statement would mark a surrender against inflation in order to make a Quixotic charge on unemployment. If the world’s largest central bank goes that route, then bill-printers of the world unite! You have nothing to lose but your change.

It is inexcusable that I didn’t carry the “absolutist” quote to its full length and implication. But I also missed a small subtlety that is less egregious. The Fed, in stating formally that 2% inflation “is most consistent over the longer run with the Federal Reserve’s statutory mandate,”  already nudged the goalposts a bit. For some time it has been tacitly understood and occasionally communicated explicitly in speeches that the Fed operated as if it had a target of 2%-2.25% on core CPI inflation. The Fed has long preferred the core PCE Deflator as a measure of inflation, and the PCE deflator has generally run around 25bps lower than core CPI over time, so the 2-2.25% CPI target was really a 1.75%-2.00% target on core PCE.[1] By saying that the Fed’s informal target was 2%, the Committee (a) nudged the target up slightly from 1.75%-2.00% to just 2.00%, and (b) made clear that inflation can go at least another 0.3% higher before it even gets to the target, and probably wouldn’t alarm them until it was at least 0.8% higher than the current level. That would be a core CPI inflation rate around 3.0%, well above the current level. No wonder they aren’t alarmed at the strong, steady advance in core CPI!

Investors seem to barely believe their ears. While commodities ended the day +0.4%, stocks slipped into the red. Still, the equity chart to me bears an uncanny resemblance to the chart in the months following Bernanke’s Jackson Hole speech in which he essentially announced QE2 (see Chart, source Bloomberg).

Narrow ranges, steady advancement, and all on top of markets that were not cheap to begin with. Today’s selloff of a mere -0.6% doesn’t alarm me and I think equities will continue to climb, although commodities offer much more inflation “beta” at this stage of the cycle and with negative real rates.

In my view, this action is no less clear a sign that the Fed is going to continue to pump liquidity into the markets than Bernanke’s speech was in the summer of 2010. It is much more remarkable, in that back then core CPI was preparing to print a low of 0.6% and now it is 2.2% and rising, but it is not much less clear. After all, that has become the Fed’s game: transparency, transparency, transparency.

For a very long time (as in, more than a decade) I have been railing about how Fed glasnost is a bad idea with no real upside. It has generally been pretty lonely to have that view, since “transparency” seems like a good thing and in many areas of government we could use lots more. But I was pleased today to get news of a speech from former Fed Governor Warsh in which he said the transparency has gone too far:

Central bank transparency is good, but transparency that delineates future policy breeds market complacency. It threatens to undermine the wisdom of the crowds and the essential interchange with financial markets.

Now, I’ve said similar things in the past about transparency and market complacency – overconfidence breeds over-leverage; if you want to cause deleveraging then the Fed should start doing unpredictable, random things like moving the Fed funds rate 17bps one day and then moving it back the next day, or only making moves in prime numbers, or scheduling an FOMC ‘tea’ instead of a board meeting. Act crazy and investors will keep a bigger margin of safety, which means they will use less leverage. But Warsh raises another very interesting and important point that I haven’t noticed before: if the Fed is too busy telling the market what to do, it can’t be listening to the market to learn what to do. When you think about it, aside from arrogance this conveys a mistrust of markets that is a hallmark of liberal institutions. Failed liberal institutions.

In economic data today, Durable Goods and Chicago Fed came in strong, while New Home Sales was soft but at continued low levels which makes them irrelevant in any event. Initial Claims was roughly on-target (but we’re still in the choppy year-end waters during which Initial Claims can be ignored). But all of this is back-seat stuff if the Fed is pressing pedal to the metal.

Friday introduces another weekend filled with searing promise for solutions in Europe; and the weekend precedes a Monday stuffed with bitter disappointment. It seems to happen every week, and I don’t see any reason it should differ this week.


One quick note: in August 2010 I wrote an article called “The ‘Real Feel’ Inflation Rate,”  in which I discussed a paper I’d written discussing how economists might go about assessing quantitatively how inflation feels as distinct from how it is precisely measured. I’m pleased to report that the paper has finally been published in this month’s Business Economics, the journal of the NABE. It’s only available to subscribers, unfortunately, but membership in the NABE is only $150 per year online. (I am not a member, so consider this a public service message). I should mention that I am looking for a corporate partner who would be interested in developing the methodology and perhaps commercializing such an index – contact me if you are interested or know of someone who is.

[1] There are several differences between PCE and CPI. One important one at the moment is that the PCE deflator has a higher weight in housing, so it’s currently at 1.70% on core, but there are other differences as well covering the functional form, the items that are included or excluded for each one, and the weights for those. There may be a very slight reason to prefer PCE as a technically ‘better’ index, but there is a large reason to prefer CPI and that is that there is an explicit market price for inflation expectations in CPI form: inflation swaps. There is no such market price for PCE. So I don’t think the Fed has made the right decision anyway.

Intentional Ignorance?

January 25, 2012 2 comments

I want to state clearly at the outset that no one at the Fed was compensated in any way by me or my company for their words and deeds of today. While I am grateful at their gracious underwriting of the inflation biz, I neither expected it nor provoked it nor, to be honest, welcome the effects it will have on the overall economy.

The Fed is clearly the story of the day, in a way it really hasn’t been for quite a while. I think the consensus was that the “new communications policy” of the Fed was likely to be a near-term fizzle even if it provided long-term fireworks. But instead, the Fed made some fairly dramatic statements (albeit couched in code) about the way monetary policy will be conducted going forward. In retrospect, perhaps they wanted to make a big splash today so that attention would be drawn to the importance of the new communications regime; if it had caused nary a ripple (and it would have been easy to make it cause nary a ripple) then it would have belied the importance of the new regime.

The Fed released its normal statement at the conclusion of deliberations; the new component that was added was the release of a table of projections from the Fed Governors and regional Fed Presidents (both voting and non-voting) detailing their expectations for the likely paths of growth, inflation, unemployment, and the Fed funds rate for the next couple of years and for the long-term. The Fed released both the ‘central tendency’ (the range when you throw out a few highs and lows) and the actual point estimates themselves although not associated with the names of the contributors.

The first surprise of the day was that the Fed extended the projection of the period of exceptionally low rates from “at least mid-2013” to “at least late 2014.” Considering that recent data have shown a stabilizing of growth, this was a surprise. Moreover, the Fed removed completely from the statement the phrase “However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.” The message was crystal clear: the Fed is willing to be actively inattentive to the inflation risks so as to allow themselves to keep rates lower for longer and potentially to add more liquidity.

Bonds jumped on the news, but inflation-linked bonds jumped more (after a few hapless souls initially hit bids for some reason). Commodities rallied sharply, from down slightly on the day to +1.1% on the DJ-UBS commodity index. Crude Oil turned positive after having been negative. Gold rallied. Industrial metals leapt. Stocks, too, rallied with the S&P up 0.9% at the close.

The release of the poll of Fed meeting participants,  a couple of hours later (I am not sure I understand the delay, if the point is to help communication), muddied the waters a little bit because it showed that at least several Fed officials expected a rise in the Fed funds rate in 2014. If rates are to stay at 0.25% until “at least” late 2014, this makes no sense; ergo, at least some of the discussants figure that the “at least” isn’t definitive and depends on the state of the economy. Also, some discussants may have felt that “extremely low” rates could include an 0.75% Fed funds rate, which was not the market’s understanding of that phrase. But as Julia Coronado of BNP pointed out, those who favor earlier and more aggressive rate hikes “are not the drivers of monetary policy and their views can therefore be set aside.” I agree.

The other forecasts are interesting as well. Of the 17 members recording votes, not one expected less than 2.1% growth in real GDP this year. Not one expected the Unemployment Rate this year to tick up more than 0.1%. Not one expected core PCE inflation (currently at 1.7%) to exceed 2.0% in 2012, 2013, or 2014. The message is very clear: the Fed considers inflation to be no risk at all – or at least, they want us to think that’s what they think.

Here is my question: if no respondent forecasts a recession, or even very slow growth, on the horizon, then they cannot be considering that a recession will be restraining inflation even if they are using discredited Keynesian-based models. But they’re also forecasting continued extremely low interest rates, so they cannot be thinking that tight monetary policy will be restraining inflation. And yet, the central tendency expectation is for declining core inflation, or at worst only a slight rise in core inflation. How can this be? Here are the possibilities I can think of:

  1. The Fed plans to actually tighten policy by selling assets, even if they keep rates down. I think this is pretty unlikely.
  2. The Fed thinks that “anchored expectations” will hold down inflation. This is possible, and the Fed believes strongly in the idea that expectations anchor actual inflation even though the evidence for that proposition is “sparse” to be charitable.
  3. The Fed thinks that money velocity will fall, and doesn’t plan to respond by adding more liquidity. I doubt this is the case, although if you believe there is a natural deleveraging process going on you might make this argument.
  4. The Fed thinks housing prices will fall and therefore it is a smart bet to forecast falling core inflation even if they expect most prices to rise. This is sneaky, but possible, although I would find striking the irony of their confidence in forecasting housing price declines now when they couldn’t forecast them 30% higher.
  5. The Fed is trying to manipulate expectations. This is very likely. Bernanke said in his press conference that the Fed’s main tools now are “communications and asset purchases.” I don’t know how communications can be a “tool” of monetary policy, if you’re just telling the market what it already knows; if you’re telling the market something it doesn’t already know, it’s only valuable if on balance you’re better at forecasting than the market and that is decidedly not the case with the Fed.

The final possibility is that the Fed fully intends for prices to rise and inflation to accelerate, but seeks to define the mission (or leave it undefined) in such a way that they can argue they are being “credible” in sticking to the plan even though the results would prove it was the wrong plan. When the Fed first introduced the “mid-2013” shackles I suggested that could be one possible reason for intentionally limiting their options. By “lashing themselves to the mast,” they need not respond to the sirens telling them to hike rates and restrain inflation.

In addition to the statement and the table of projections, Bernanke also had his press conference. He commented that expanding the Fed’s balance sheet “remains an option” and said “we’re not absolutists” when it comes to inflation. That’s an incredible statement. It wasn’t so many years ago when Federal Reserve dogma was that employment is maximized in the long run when inflation is kept low and stable, so that the Fed was pursuing both maximum employment and low inflation if they just pursued the inflation goal. Now, Bernanke is saying very loudly that they can let inflation go a little higher, a little lower, as needed to address other economic imbalances. This sounds very much like BOE Governor Mervyn King’s comments yesterday in which he converted the 2% “target” rate into, effectively, a floor (be sure to read yesterday’s comment “A Funny Thing Happened On The Way To Deflation”  if you haven’t, as there are some very good charts in it).

Core inflation is in an upward trend around the world, and it has been so for nearly two years. With this backdrop, and a strengthening domestic economy, the Fed is extending its low-rate pledge and talking about doing more asset purchases because the economy and, especially, housing is so weak. Meanwhile, although I don’t necessarily take this at face value, the FHFA’s Home Price Index rose 1.0% month/month in November (data released today), the largest 1-month jump since 2005. Here is a question to ponder: does merely stabilizing home prices help the economy, since just as many mortgages will be under water if prices stay flat? There are three ways to solve the mortgage crisis. One is to distribute the losses from homeowners who have them now to taxpayers or to mortgage bond holders through defaults. One way is to jazz homeowner incomes so much that they can pay these losses (which become realized when they change residences and sell at a loss). The third way is to force nominal home prices up so that the losses go away. There is only one of these three that the Fed can do anything about.

The 10y Treasury today ended below 2% because the Fed declared it would keep on going with Operation Twist. But Twist has a natural limit in that once all of the short-maturity bonds are sold from the Fed’s portfolio, they can’t buy longer-duration bonds except outright. I would not depend on Fed purchases to protect my 2% yield. Unless growth collapses, I don’t think these low bond yields can be sustained. I am short bonds through the TBF ETF, and would add more if I didn’t think long commodity index exposure just got a lot more attractive today.

On Thursday, there’s a fair amount of data due. The December Chicago Fed Index (Consensus: -0.10 from -0.37), December Durable Goods Orders (Consensus: +2.0%/+0.9% ex-transportation), and Initial Claims (Consensus: 370k from 352k) are at 8:30ET. The first two should be supportive of equities; Initial Claims is still in the crap-shoot time of year and doesn’t mean much. New Home Sales (Consensus: 321k from 315k) is at 10:00ET, and the Money Supply figures will be released at 4:30ET.

A Funny Thing Happened On The Way To Deflation

January 24, 2012 3 comments

Markets remain mostly frozen while the news continues to flow. In a way, it’s Shiller’s revenge. Bob Shiller wrote in the early 1980s about the ‘volatility puzzle,’ the fact that the markets display far more volatility than is justified by the flow of news and the change in economic fundamentals. We now have the opposite situation: markets are showing far less volatility than is justified by changing economic fundamentals and news! (Could this be because investors are long volatility, so that they need to sell on rallies and buy on dips to delta-hedge? But that wouldn’t explain why all markets seem to be displaying a glassy-eyed countenance, including in markets where investing through options is less common).

Soc Gen and Credit Agricole were downgraded by S&P as a consequence of the sovereign downgrade of France. This makes sense, since it is fair to assume the French government would rescue any of its banking champions but the size of these champions makes it problematic for France to save them. The drop in rating to A from A+ should not have major implications for collateral arrangements, but the next notch or two could potentially make them nearly unfundable, or at the very least substantially unprofitable. They trade at somewhat low P/E ratios but I don’t see any margin of safety that makes me want to stick my neck out. BNP was maintained as a AA-, pays a dividend near 6% (the other two banks do not pay a dividend), and sports a similar P/E ratio. I know I prefer BNP to Soc Gen, and I wonder if the spread might be a proxy for French credit going forward since a notch or two on Soc Gen would have drastically more impact on its business than a notch or two on BNP from here.

In other news that should make you leery of European banks (and banks in general for that matter), Credit Suisse told employees that they will have part of their bonuses paid in bonds backed by “a diversified portfolio of derivative counterparty risks.” This is the bank’s way of sticking it to employees to show the rest of the world that they hate bankers too. It’s bad management. The firm’s leadership automatically loses some employee loyalty and generates “badwill,” and if somehow the bonds turn out to actually do well (as happened then they did something similar after the 2008 crisis – of course, stuff like this was lots cheaper back then) then they still get brickbats from the public when it is announced how well this all worked out for the “rich bankers.” A positive outcome won’t win back the love of the employees, either, since they will reasonably judge from intent rather than results. Now, maybe this is a desperation move to de-lever if they can’t find buyers for toxic waste and the stuff is too structured to finance at the ECB, in which case it would be necessary for firm survival – that might have been argued back in 2008 for instance – but I doubt the bank’s situation is that dire. More likely it’s just bad management.

What would a trading day be without Greek news? The cat fight there is turning ever-uglier as not only have the parties not reach agreement on a ‘private sector contribution,’ but it is beginning to look unlikely that they will even announce something just to save face!  The EU says the private lenders to Greece need to do more (but not the public lenders) and that Greece needs to do more with austerity. The private lenders say “We put an offer on the table and it remains on the table. All parties need to contribute to the solution.” And Greece says “So who’s paying for lunch?”

And none of this moves markets any more. The S&P was -0.1%. The dollar was unchanged. The DJ-UBS index was +0.3%. The 10-year Treasury yield rose 1bp to 2.06% and the 10-year TIPS yield fell 1bp to -0.01%. And all, as I keep pointing out ad nauseum, on weak volume.

I hear a lot that this is all part of the “deleveraging” process that is leading to deflation. And, as the chart below shows, deflation is clearly a threat.

Oh, wait. I think I had the chart upside-down? Right-side-up it looks like core inflation bottomed in the UK at the beginning of 2009, and in Europe, the U.S., and Japan in 2010. Only in Japan is the upward trend less robust (although no country bests the U.S. consistency of increasing year-on-year core inflation for fourteen consecutive months), but it looks quite clear to me in every case. This is Exhibit A for the case that inflation is at least partly a global phenomenon driven by common global factors. In this case, the common factor is flat-out liquidity provision, quantitative easing, and otherwise aggressive monetary policy. Not all of these markets shared the aggressively stimulative fiscal policies that the U.S. deployed in 2008, but we all share the liquidity that is sloshing around.

I can understand why central bankers want to tell us that inflation is contained, in fact it’s so contained that we have to worry about deflation. That position makes it easier for them to justify additional measures to “support growth,” while ignoring the inflation implications by telling themselves that they are helping to “anchor expectations.” For example, Bank of England Governor Mervyn King was on the tape today:

Bank of England Governor Mervyn King said slower inflation gives policy makers room to increase bond purchases to aid the U.K. economy and guard against a “renewed severe downturn.”

He goes on to say that they are ready to prevent inflation from falling below the 2% target (so…now the target is a floor?), but the real point is that a recession may have begun in the UK in Q4 and he’s looking for reasons to ease policy further. I think the chart above is fairly persuasive that deflation is nothing he needs to worry about just yet. And expectations aren’t exactly grounded, either. Here is a chart of 5y UK inflation swaps, and 5y inflation 5 years forward (Source: Enduring Investments):

While 5-year inflation expectations evidenced in the swap market are only around 3%, market participants expect 5-year inflation swaps to be around 3.40% five years from now. Those expectations are stable – investors are confident that Mr. King will keep prices rising smartly for a while. Not stable at all, however, are Euro inflation expectations, as shown in the chart below (Source: Enduring Investments):

Despite the obvious train wreck, investors are not fleeing into deflation insurance. Quite the contrary: since September, both spot and especially 5-year forward inflation expectations have been rising sharply. I think these investors have it right: as Mr. King makes clear, policymakers clearly will attempt to err on the side of higher prices rather than lower prices. Interestingly, while long-term Euro inflation markets have for a long time been close to 50bps lower than US inflation markets (a salute to the ‘Bundesbank DNA’ at the ECB), 10-year inflation swaps have been converging upwards to near U.S. levels since roughly the moment Mario Draghi took over for Jean-Claude Trichet at the ECB (see chart, Source: Bloomberg).

So, while we are continuously told not to worry , I have to conclude that given the pictures above that the people stepping to the microphone to say that are either naïve, drastically overconfident in their Keynesian models, or deceitful. Investors, who actually have money at stake, seem to agree and are beginning to recognize at least in Europe that monetary policy might actually matter.

Now, tomorrow the FOMC releases its projections for the next couple of years for the economy and the Fed funds rate, along with some measures of opinion dispersion at the Fed. I’m not really sure the point of this exercise. It’s as if a suspect in a crime (and here we suspect that their forecasts are very poor) decided to present the police with all of the evidence and hope for leniency. But no one has promised the Fed leniency in exchange, so I don’t see the upside. We all know that in those projections only one vote really matters, and that’s the Chairman’s; but by forcing the forecasts public there is a new behavioral dynamic in play: the other members of the Committee will feel ownership of their projections and defensive when they are challenged. We see that with economists all the time – they have a hard time reversing themselves when they are wrong, because everyone will now know they’re wrong. The projections released tomorrow won’t have names attached, but that doesn’t matter – the participants know what their forecasts are and that’s where the behavioral tendency vests.

There is also the question of what to make of the forecasts, if they don’t uniformly say 0.25% until mid-2013. As you recall, that is the pledge the Fed made on rates. It was not made conditional, although historical revisionists seem to think it was. The Fed has had ample opportunity to make the promise explicitly conditional either vaguely (making it contingent on continued economic sogginess) or precisely (an Evans Rule sort of formulation), and has not. I expect that we will see the central tendency still near 0.25% for June 2013, but I don’t think the bond market will react well if it isn’t. I actually think the FOMC will move to add liquidity somewhat aggressively if growth does slow (or if Europe implodes), but the Fed Table doesn’t illustrate that dynamism well.

Pressure is building on the bond market from the rising core inflation rates both domestically and abroad and from the rising amount of debt that needs to be rolled and the new money that needs to be raised. I expect equities to keep slowly inching higher (the narrow ranges and steady advance since December is oddly reminiscent of the same thing that happened beginning in mid-2010 in the leadup to QE2), commodities to outpace them, and bonds to suffer further.

Maybe Silence Really Is Golden

January 23, 2012 1 comment

It wasn’t the slowest day of the year so far, but that is only because of the extraordinarily weak start we have had to the year in terms of market volumes. I will have a little more to say about that, later, but for comparison today’s volume was lower than any day in the first three full weeks of December!

I thought, and I gather that others thought, that today might have been more interesting. The Greek PSI talks, which were supposed to be finished on Friday, were suspended temporarily and, while they have now resumed they have apparently done so with lines drawn in the sand. There is no way to construe the current state of that discussion in a positive way – even if agreement is ultimately reached, it probably is the last such agreement and it isn’t going to be enough anyway.

Those talks were supposed to be done before a meeting of EU ministers today, at which Germany suggested combining the ESM and the EFSF or letting them both operate at the same time. Until now, the plan has been for ESM to replace the EFSF; if both are kept open then it means the new guarantees associated with the ESM become additive to those guarantees still “untapped” in the EFSF, rather than replacing them. It’s not clear to me why other nations contributing to the ESM, who were told the ESM was a replacement for EFSF, would go along automatically with what amounts to an additional coerced contribution, but it’s today’s ‘happy thought’ from the Euro politicians.

The EU over the weekend also determined that indeed there will be an embargo of Iranian oil – they have heretofore dithered – starting in the summer. This helped energy markets, and commodities rallied again, with the DJ-UBS index up 1.62% as the dollar fell 0.5%. Natural Gas spiked more than 10% as Chesapeake Energy (the second-largest domestic producer of nat gas) said it will “cut output, idle drilling rigs and reduce spending in gas fields by 70 percent” according to Bloomberg. The combination of less supply and more demand if there is shifting away from oil at least among dual-source consumers turned out to be helpful for gas.

The stock market ended the day nearly unchanged after trying both a rally and a selloff and deciding that neither direction provoked activity from investors. Treasuries sagged again, with the 10-year up to 2.06% and near the highest yields since October. I think there is more coming to that selloff, but we might some modest support near this level. 10-year real yields are also at their highest levels in a while, back up to 0% although 13bps of that is the roll to the new TIPS issue (that is, the old guy is at -0.13%). TIPS yields also I expect to rise, although less so than for nominal bonds. Breakeven inflation remains quite inexpensive.

The VIX has fallen all the way back down to 18.7, a level it hasn’t been at since July. It is very hard to maintain options implied volatilities if the actual payoff to delta-hedging is virtually nil, and that’s partly what is happening. At these levels, it starts to make sense again to add equity exposure through options rather than through outright positions.

I didn’t say whether the position I would take here is a bullish one or a bearish one. I continue to be modestly optimistic that the economy can avoid a recession as long as Europe doesn’t implode; the problem is that is still looking quite likely. And equity prices are high, measured in reasonable ways, even if you don’t assume that margins will return to long-run means.

However, it occurs to me that one way to look at the current volume lull – an admittedly rose-colored glasses view, but perhaps not indefensible – is that this could represent the first stage of revulsion/exhaustion among investors. After more than a decade of putrid returns and plenty of volatility, it would not be surprising to see America’s love affair with the stock market finally tarnish. Frankly, it’s something that many long-term bears have been expecting for years. (I can’t claim credit for being one of those who declared that investors need to hate equities before we can have a long-term rally. But I thought they needed to stop loving the market irrespective of price.) For me, the connection with price is still important: loathing would be nice, but loathing ought to be accompanied by cheap prices before the low-risk “high margin of safety” opportunities are legion. I don’t think we’re there yet, so I don’t think the current rally is the beginning of a long-term upswing. But the next big selloff we get – say, at least 20% – might produce the revulsion that keeps markets down for a while, and sows the seeds of great opportunity.

As I say, that’s an optimistic view of the awful volumes so far this year. The more-pessimistic view is that this is a natural result of the legislative and regulatory assault on market makers. Darrell Duffie took this view in a recent paper called “Market Making Under the Proposed Volcker Rule,” in which he says:

The Agencies’ proposed implementation of the Volcker Rule would reduce the quality and capacity of market making services that banks provide to U.S. investors. Investors and issuers of securities would find it more costly to borrow, raise capital, invest, hedge risks, and obtain liquidity for their existing positions. Eventually, non-bank providers of market-making services would fill some or all of the lost market making capacity, but with an unpredictable and potentially adverse impact on the safety and soundness of the financial system. These near-term and longer-run impacts should be considered carefully in the Agencies’ cost-benefit analysis of their final proposed rule.

It is a very good paper, and worth reading in its entirety. I admit bias in that Duffie discusses the subject and reaches conclusions similar to those conclusions I jumped to initially (see for example my comments on the Volcker Rule proposals in May 2010 and September 2010), but he applies more thorough reasoning and more rigor. I doubt very much it will matter, since I suspect most Members of Congress can’t read.

And maybe Congressional revulsion is part of the process as well. Lower prices are a reward to long-term investors to provide liquidity when short-term buyers and market-makers are reluctant to – so perhaps this is all part of the process. The bad news is that I don’t think the process is complete yet, but at least it has (perhaps) started.


January 19, 2012 6 comments

The monthly price-a-palooza from the Bureau of Labor Statistics, coinciding with the auction of $15bln in new 10-year TIPS, also shared the day with Housing Starts and Initial Claims. Dispensing with those two details first: Housing Starts was 657k, which was a disappointing shortfall after the strong NAHB number on Wednesday. Initial Claims looked strong, at 352k, but this comes with two caveats that are really the same caveat. The first is that the prior week’s claims were over 400k; the second is that year-end seasonal adjustment to these figures makes them nearly useless. It is probably most-useful (which is to say, only barely useful at all) to think of the last two weeks together and figure that the current pace of Claims is “about” 375k, right in the middle. This would coincidentally be consistent with the level of claims prior to the year-end volatility (see Chart, Source Bloomberg).

Also out was CPI, of course. Headline CPI was unchanged on a seasonally-adjusted basis, but Core CPI came in as-expected at +0.1% keeping the year-on-year rate at 2.2%. “Stabilization!” screamed the pundits, but it isn’t yet so. Core CPI was actually up 0.145% before rounding, which means we were a mere 0.005% from what would have been considered a surprise for the cheerleaders on CNBC. The year-on-year figure, too, rose nearly a tenth, from 2.153% for the year ended in November to 2.230% for the year ended in December. Rounding giveth and rounding taketh away! Yes, a rise in the year/year pace of only 0.08% represents a modest slowing, but that would still add a full percent to core CPI over the next year were it to persist.

It probably will not persist, because housing is going to begin to act like ballast on the number over the next few weeks, but core ex-housing is already at 2.46% and I see few reasons to expect it to not continue its rise.

In any event, we should remember that the 1.6% rise in core inflation over the last 14 months is the fastest such rise since 1984. A little respect, please, for the inflation process. I know it doesn’t always act like an instant-gratification video game, but looking at the chart of 14-month changes, below, can you tell me that this advance is so shaky that stabilization is automatic from here? I didn’t think so.

Rolling 14-mo absolute change in core CPI


A chart of the current y/y changes and the previous y/y changes is shown below.

Weights y/y change prev y/y change
 All items




  Food and beverages
















  Medical care








  Educ & Communication




  Other goods and services




As you can see, Food & Beverages, Medical Care, Recreation, and Education & Communication, which collectively represent 34.1% of the basket, are still accelerating. Transportation (mostly because of energy), Apparel, and Other (24.4%) are decelerating. Housing looks like it is a wash, but it isn’t really, yet:

Weights y/y change prev y/y change








   Fuels and utilities




   Household furnishings & operations




As you can see, most of the apparent slowdown in Housing is also in the energy sector, while Shelter is still rising. If we put 32.4% as “accelerating” and 5.1% as “decelerating”, then we still have 2/3rds of the basket accelerating. Again, that won’t be the case for long, but it is early to call the end of the inflation rise. Note also that the Median CPI put out by the Cleveland Fed actually ticked up to 2.3%, so it is above core CPI (although for all intents and purposes, tied).

There is a reason that many models are calling for a flattening out of core “soon.” The most-honest reason is that some models establish an important role for “anchored” inflation expectations. I am familiar with the literature on inflation anchoring, and I find it completely unpersuasive. I also do not believe in poltergeists. Both theories seem to explain certain phenomena, but neither has compelling empirical data to back them up. While it does seem that poll respondents “anchor” their responses (and it seems they anchor them to the most-recently-released figure that all media trumpet), there is not any evidence that consumers and producers actually change their behavior at all because of that “anchoring.” However, if it’s in your model, it’s one reason you might think that core inflation above 2% ought to begin reining itself in.

The sneakier reason that some economists are calling for a flattening out of core inflation is that we all can see the conditions in the rental markets, and that follows the recent renewed downturn in housing prices which is due to the inventory overhang. So it’s easy to say “Core won’t reach 3% soon.” It would be remarkable if it did. Indeed, it’s remarkable it’s already this high given that it has the unwind of an epic bubble to deal with. The current 2.23% core rate is above what our models expected to see realized for 2011, because shelter inflation rose more than we expected. What’s more interesting is to forecast what is going to happen to core ex-shelter, which is already above the Fed’s target and rising.

Our models take note of the fact that 52-week M2 money growth is now at 10.71%, just slightly high of a one week peak above that level in January 2009. Before that, and a dramatic one-week spike in September 2001 (wonder what that could have been?), you have to go back all the way to 1982 to find faster year/year money growth. Unlike last year, too, it’s not all going into the vault – corporate credit growth over the last year is now up over 3% and still rising. So in my opinion, is probably too early to send the hawks back to the eyrie.

Remarkably, my measure of the spread of perceived inflation over actual measured inflation – I think of it as sort of an ‘angst’ index – reached an all-time low (going back 12 years) this month. The index is driven by, among other things, the volatility of price changes and the dispersion of price changes. In other words, inflation has been rising in a comparatively stealthy, orderly way, which tends to diminish our sensitivity to it. Not unlike a frog being cooked in water that is being brought slowly to boil, come to think of it.

And yet, with everyone telling us not to worry about inflation, with 10-year real yields negative, with dealer risk-appetites still low, and with headline inflation tumbling back down to only 3%, the Treasury today sold $15bln 10-year TIPS 3bps better through the screens at the bidding deadline. Dealer demand was strong, as was the overall bid:cover. Someone wants inflation protection here!

On Friday, Existing Home Sales (Consensus: 4.65mm vs 4.42mm last) is the only data. I think we are also supposed to hear about the private-sector cram-down from Greece. The word was that there was supposed to be an agreement “by the end of the week,” but come to think of it I guess maybe they didn’t say which week! In any event, conditions look good for a return of the 10-year yield above 2% (closed today at 1.97%). While calamity can strike at any time, a fair amount of calamity is already priced into Treasuries. Moreover, it’s only calamity of a deflationary kind, not a calamity of an inflationary kind…and it isn’t at all clear that that is the most likely kind of calamity here.

A Big Collection Plate; A Small Congregation

January 18, 2012 1 comment

Stocks rallied today (but no, trading was still somnambulant – volume is still some 250mm shares per day below last year’s volume to date) by 1.1%, largely on news that the IMF is going to raise $500bln to help troubled Europe. This sort of crazy talk normally only comes from the smelly guy on the subway, who mutters in between such statements. But in this case, it was said with a straight face (although the original discussion of $1 trillion was apparently seen as too crazy to be bought). The IMF is going to raise this money from the world’s economies, except Europe and the U.S. – the Obama Administration was quick to say that given our own rather messy finances, we would not be contributing to this passing of the hat.

So what that means is that half of the world’s GDP (the U.S. and Europe represent about half) is hoping for a bailout from the other half. The other half, incidentally, includes various nations with which we are at war or have deep ideological differences with, or are basket cases themselves. Of 2010 world GDP of about $63 trillion, subtract the EU, the US, Japan, Iran, Venezuela, Pakistan, Iraq, Libya, and Syria, and we’re down to $25.6 trillion. Let’s then subtract any country with less than, say, $40bln in GDP because we assume the IMF isn’t going to be calling Samoa to help out Europe. That takes us down to $24.5 trillion. Here are the only pan-trillion economies remaining in that group: China (5.9t), Brazil (2.1t), India (1.6t), Canada (1.6t), Russia (1.5t), Australia (1.2t), Mexico (1.0t), and South Korea (1.0t). Let’s hear it for Canada and Australia, everyone!

Seriously, who is fooled by this gambit? We all know who has bankrolled global growth. If those bankrolls are now inwardly-directed, does anyone really believe China will commit 8% of GDP to help out her pals in Europe? And in case you haven’t noticed, China has its own problems.

(Still, that wasn’t the stupidest thing said today. It was at least intended to cheer us up, with humor perhaps, and it did pump stocks up 1.1%. But the stupidest comment came from the President himself, who apparently thinks paying unemployment insurance creates jobs.  Quote: “However many jobs might be generated by a Keystone pipeline, they’re going to be a lot fewer than the jobs that are created by extending the payroll tax cut and extending unemployment insurance.” Yep.)

Now, there was some cheerful economic news today: the National Association of Home Builders sentiment index, which has been mired between 10 and 20 since late 2007, advanced to 25 today (see Chart, source Bloomberg). Now, this is a survey, but this looks like a legitimate improvement. Neutral on this index is 50, so it isn’t all wine and song, but it’s another one of those little indicators that things are getting slightly better. The question, of course, is whether any of this will stay on track when Europe finishes going off the tracks. And that seems unlikely.

Capacity Utilization also reached 78.1%, tying the highest level since June of 2008. Many years ago, economists thought that 80% was where the economy would experience capacity of scarcity that would push up inflation. Then Capacity Utilization remained above 80 almost uninterrupted between March of 1987 and December 2000, and while core inflation rose from 1987 to 1990…it then fell for 9 straight years. So another sacred economic cow was gored. Accordingly, while the rise in Capacity Utilization is a measure of good news for the economy, it doesn’t really tell us anything about inflationary pressures.

Speaking of inflationary pressures, on Thursday along with Housing Starts (Consensus: 680k from 685k, but probably okay to expect something higher after the NAHB number), Initial Claims (seen unfortunately falling to 384k from 399k, thus killing some of those jobs Obama is talking about), and the Philly Fed (Consensus: unch at 10.3) we will get CPI.

The consensus for CPI is +0.1% on the headline number and +0.1% on core, bringing the year-on-year figures to +3.0% and +2.2%, respectively. I find the reasoning behind the low forecasts a little suspect; one primary excuse being given is that inflation should be low on “discounting.” Well, folks, that’s why we have seasonal adjustment factors. Discounting happens every December, at least in the U.S., so the seasonal factors expect something like a -0.2% decline in the non-seasonally-adjusted figures. There didn’t seem to me to be an unusual level of discounting this holiday season. Indeed, my own anecdotal observation is that airfares (a mere 0.82% of CPI, however) were dramatically higher this Christmas than last. When the seasonal pattern is looking for declines, the anecdotes that matter are the ones that point out unusual increases. That is, if anecdotes matter at all, and they probably don’t although they’re fun to write about.

I do think that core inflation could well print another 0.2% “surprise” this month. Recall that last month, much was made about the ebbing of headline inflation despite the fact that core inflation surprised higher. But as I wrote last month in the article “The Inflation Trend Is Not Yet ‘Tamed’”, most of the consumption basket is still accelerating. While the Transportation subindex declined because of the drop in energy prices, what is more important is the breadth of the acceleration:

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.

The conundrum continues to be housing. The Housing subindex, which is about 42% of the CPI, rose over the last year at a 1.9% pace despite the still-high level of housing inventories. I expect this to continue this month, which could help produce another “surprise.” Going forward, housing inflation should begin to ebb in the next quarter or two as those inventories and the renewed drip lower in owner-occupied housing that they have caused start to be felt in the rental markets. The chart below shows the Quarterly Survey of Apartment Market Conditions Market Tightness Index (that’s a mouthful!) against the year-on-year rise in the Owner’s Equivalent Rent component of CPI, lagged 4 quarters. Note that the QSAMCMTI just fell sharply, which leads me to expect a slowing in the housing component of core inflation fairly soon.

Unless CPI is a big high-side surprise, most of the data tomorrow should be cheerful. Equity investors ought to make hay while the sun shines, because what is rolling downhill from Europe is still pretty ugly. For now, though, we can imagine what might have happened to the economy in a world without the Euro straitjacket. Pressure should start to build on bond yields (higher).

Yee-Haw News And Ho-Hum Trading

January 17, 2012 5 comments

Tuesday was another day of ho-hum trading following yee-haw news.

Anyone expecting a bloodbath following the ratings downgrades clearly has not been paying attention as the market sleepwalks through 2012. Stocks gained 0.4%, 10-year note yields ended virtually unchanged at 1.86%, and TIPS yields fell 2.5bps despite the proximity of a $15bln 10-year auction, now only 2 days away with 10-year TIPS yields at -0.22%.

The dollar slid somewhat, and commodities rallied. Indeed, the only market with a reasonable level of excitement was the Nat Gas market, where prices fell to levels not seen since 2002 (see Chart, Source Bloomberg). It is useful to remember that a significant part of commodities futures returns comes not from movements in the spot price, but from collateral return, normal backwardation, expectational variance, and a couple of other sources.

Natural Gas front contract. Spot gas has gone basically nowhere in a decade as supply responded to price.

Of course, Nat Gas also had the worst fundamentals of any commodity. Coming into the month, the mild winter and the added supply from frackers had combined to make NG the fourth-most-contango commodity (a commodity in contango is one which has deferred contracts at higher prices than nearby contracts, implying a negative roll return), with the worst momentum, among the universe of normal commodities. That combination means that it was not selected this month to be one of the commodities in the USCI basket. And that, in turn, means that USCI has appreciated by 3.79% this month while DJP, an ETN that tracks the DJ-UBS Commodity Index, is up only 0.02%.

European bonds closed mixed, with small gains in Greece, Portugal, Ireland, and Italy on the back of successful sales of short bills in Spain, Hungary, Belgium, and by the EFSF. But it isn’t very surprising that these sales of 3-month to 18-month bills were well-received, considering that the ECB has made hundreds of billions of Euros available virtually free to banks, which can earn an easy spread in this way. Let me know when Spain sells a 5-year note. Portugal also bounced a little today because the huge move yesterday was caused by Citi removing the country from its European Bond Index after its downgrade. Some investors who systematically wait for these “forced” moves to take the opposite side of figured to be getting a mild bargain. For a little while, anyway!

Fitch tried to grab the headlines back from S&P by saying that Greece is insolvent and will default.  Really, though, at this point it’s about the over/under on when, not if, Greece defaults. Markets did not react to this news, nor to S&P’s statement that it will take ratings actions on European banks and insurers within the next month, some as early as the next week. This is potentially a bigger deal than the original downgrade itself. While a sovereign rating is a strange beast – since many investors will treat the sovereign as the closest thing there is to a risk-free investment in a particular country, no matter what its rating – ratings of financial companies affect actual contracts, collateral covenants under a CSA (collateral support annex to an ISDA), and credit lines. It was a downgrade to AIG that triggered one of the big failures in 2008, when the additional margin demanded by CSA agreements could not be met by the firm. And the problem for investors is that unless you’re the guy holding the CSA that has the rating trigger in it, you won’t know about the problem until it’s too late. Not that investors need any more reason to avoid financials than that their business model is irremediably destroyed and ROE will be permanently lower in the future, but the silent-but-violent nature of the blowup events means the only person holding the credit that is about to go under will be the person who is the last to hear about margin calls.


By now, I suppose we all recognize that one of the precipitating factors for this crisis, if not the precipitating factor, was the rise in leverage and in particular private leverage. There has been a lot of ink spent about the ‘deleveraging’ that is going on; as I have written several times before (most recently in “Scrooge Businesses”) the data say this is largely a myth. Domestic financials are deleveraging; Households are deleveraging slightly; Businesses are now re-leveraging. And of course, this is all occurring with the backdrop of the great increase of leverage that the federal government is generously taking on our behalf. I think that many of us feel that society must be deleveraged broadly in order to build the foundation for robust future growth. I want to take a quick moment here to talk about the difficulty of actually reducing overall leverage.

John Mauldin recently wrote (and he has written many times before on this topic, as have others):

“…a country cannot reduce private-sector leverage, reduce public-sector leverage and deficits (balance its budget), and run a trade deficit all at the same time…ultimately, there must be a trade surplus if leverage and debt are to be reduced.”

The statement is true from any given country’s perspective; Mauldin’s argument is that we can’t all run trade surpluses. That’s not quite true: emerging market countries are in general drastically less-leveraged than are the developed countries, so if we could just persuade them all to run large trade deficits to the developed world, we could shift our indebtedness to them. Let’s assume for the sake of argument that isn’t a serious alternative. What, if anything, do we need to do to reduce ALL debt and leverage?

It may seem easy. Each of us needs to save, pay down credit cards, and so on. We all know people who are doing this. And yet, the numbers say that in aggregate, it’s not happening. That’s because when Person A sells his house to person B, one is delevering but the other one is levering. When Person A defaults, he delevers but the bank who lent him the money increases its leverage. If Person A defaults and the government injects capital into the bank, then the government is taking on Person A’s leverage.

What the numbers tell us (see the charts in ‘Scrooge Businesses’ referred to above) is that the government’s increase in leverage is simply balancing out the decrease in the banks’ leverage, and households and businesses are just trading around leverage and not doing much. Is there anything we can do, absent borrowing lots of money from EM?

It turns out that there is one thing we can do, and you may be able to guess what it is by the fact that it has been the last refuge of heavily-indebted governments for many generations. Leverage is, notionally, the dollar value of debt divided by the dollar value of assets. Back in the 1970s and 1980s, one reason that overall leverage wasn’t growing too fast is that the real value of debt evaporated pretty quickly. That is, you paid off your mortgage with dollars that were worth a lot less than when you took out the mortgage, and the house was worth a lot more. This happened because the value of a mortgage is a fixed number of dollars. Inflation helped keep leverage in check by eroding those claims. As a society, we became used to this effect, and when inflation went away in the 1990s and 2000s, we continued to draw as much debt as we had been (and more) but when we went to pay it back, it was still a lot of money! Much more debt got rolled and refinanced, and the debt numbers climbed.

The solution to the debt/assets ratio is inflation, unfortunately. While many assets will not keep pace with inflation, some will. Below is a chart (Source: Enduring Investments) that I use in presentations in a different context – illustrating how a corporation’s capital structure drifts (to non-optimal levels) over time if debt is nominal. But the chart has meaning in the context of this discussion. The curves show how rapidly your leverage decreases under different inflation assumptions, assuming that you start at 100% leveraged, your assets keep pace with inflation and your debt is nominal. So for example, if inflation is 1%, after 10 years your leverage is down to 78% or so; if inflation is 7%, then your leverage is down to 45%.

Inflation isn't all bad. If you're a debtor. And aren't we all?

Note that this has nothing to do with amortizing the loan. We are assuming no amortization here. So all you do is pay the interest, and in 10 years your leverage drops 150% more (55% instead of 22%, roughly) with 7% inflation.

So, do you still think the Fed is neutral on inflation? Do you still think the Committee really wants inflation pegged at 2%? At the very least, the FOMC wants inflation to be at the upper end of the band that allows it to retain its credibility. And, if push came to shove, I suspect they might allow an “oops” to happen if they thought a little more inflation might help delever society.

And it might. It just might.


Speaking of inflation, the next two days see PPI (Consensus: +0.1%/+0.1% ex-food-and-energy), which isn’t important, and CPI (Consensus: +0.1%/+0.1%), which is. I’ll have more to say on CPI tomorrow.

Rolling, Rolling, Rolling…Keep Them Lenders Rolling

January 16, 2012 1 comment

Either the strategy of releasing downgrade announcements for Europe at 4:30 ET paid off, or sovereign ratings have become largely irrelevant. On Monday, albeit a market holiday in the U.S., bond markets ignored the downgrades and equity markets rallied in the U.S. (via futures) and in Europe.

Except for Portugal. Portuguese 5-year note yields rose 193bps to 16.13%; 10-year note yields rose 125bps to 13.17% (see Chart, source Bloomberg).

Portugal seems to be saying 'we got next.'

Why Portugal? Why not Spain, or France? It’s understandable why Greece, which everyone already assumes will default, didn’t sell off further; Portugal, it seems, is considered next in line. I still would have expected the other countries in the queue to have moved up as well, since they are getting closer to the front of the line (and, as I said on Saturday, there is always a chance that the dominos all fall at once in a big unzipping).

Volumes were lighter, of course, with most U.S. traders out for the day, and we may see more of a reaction on Tuesday, but honestly I don’t expect much of one. We did get a tiny bit of additional information on Monday, and that was that the European Financial Stability Facility (EFSF) also, unsurprisingly, had its rating cut from AAA to AA+ as a direct consequence of the downgrading of many of the constituent members.  This downgrading happened even though the EFSF is technically ultimately backstopped by only the AAA members…the problem is that those AAA guarantees are only worth €271bln now rather than €451bln. There will be an immediate test of the new rating, although a mild one, as the EFSF goes to market tomorrow to sell 6-month bills (because, you know, 3 months might not be enough to completely solve the crisis I guess).

Speaking of tests of a rating, here’s your scary chart of the day. Looking back to the U.S., where Treasury yields are below expected inflation for 10 years, the distribution of US debt looks like this:

Ouch! The employees of the Treasury are certainly earning their pay these days.

Yes, that’s $2.7 trillion the Treasury needs to roll this year, not including the new money to cover this year’s deficit. About $1.9 trillion of that is in the first half of the year ($1.3 trillion of which are Treasury Bills). I sure hope we can keep rolling a trillion or so T-Bills every quarter! What could go wrong?

Now, the Treasury had a similar, if somewhat smaller, problem last year. But last year, the Federal Reserve was generously vacuuming up hundreds of billions of dollars of the issuance. Right now, investors fleeing Europe are filling in for the Fed. What happens if the crisis in Europe really does recede?

All of these things are hopelessly intertwined. Like two trees which have grown together, the banking and sovereign crises in both Europe and the U.S. may have become inseparable – saving one may imply killing the other. It may be that only way that the U.S. can fund itself is if money continues to flee Europe!

The Treasury will sell $56bln in T-Bills tomorrow, and $15bln in new 10-year TIPS on Thursday. There shouldn’t be any problem with these auctions, yet. Empire Manufacturing (Consensus: 11.00 from 9.53) for January is also due out, along with revisions, but shouldn’t move markets. We will instead react carefully to news out of Europe, and more particularly our markets will respond on the basis of how their markets are responding. The reviews from Monday suggest our bonds could lose some flight-to-quality sponsorship, but it’s early yet.

Categories: Europe Tags: ,
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