Archive for January 24, 2012

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.