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No Pushing In The Default Line, Please

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.

  1. Ed M
    January 30, 2012 at 11:12 pm

    Hi Mike. Great post as always. Two questions. 1. Why buy INFL when you can just do the options trade directly by taking a long position in TIPS and a short position in Treasuries with approximately the same duration. Is there an advantage in cost to buying INFL?
    2. Why choose out of the money equity calls rather than at the money calls?
    Eddie -NYC

    • January 31, 2012 at 12:35 am

      Ed – Good questions. INFL is accessible even to little folks. It’s not easy to short a Treasury as an individual, especially if you want to do it in an IRA or some other place where you don’t have to worry about the recordkeeping issues with TIPS. It’s definitely more expensive than doing the breakeven trade (or a swap) if you are an institutional investor.

      I said OTM calls rather than ATM calls because I don’t care that much about the gamma around current prices (gamma is maximized ATM), nor the vega. IN exchange for the higher gamma of ATM, you also get the higher decay! What I want is leveraged participation, limited downside, and slow time decay unless my scenario comes to pass.

      Thanks Eddie!

  2. onebir
    January 31, 2012 at 3:36 am

    “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?”

    I’ve been wondering why the ECB’s been sitting on its hands re Portugal, and this is the first sensible explanation I’ve seen. Thanks!

  3. usikpa
    January 31, 2012 at 3:42 am

    Michael, isn’t it just PCE, not core that the Fed papers referred to last week?

    Also I may be misinterpreting something here but given that we are already at 1.8% and the threshold is at 2 – 2.25%, if the rates are to stay low until 2014, just what kind of gloomy disinflationary economic scenario did Bernanke had in mind, and why would equities grow then?

    • January 31, 2012 at 7:38 am

      No, the Fed targets core PCE for the same reason they look at core CPI – the headline number is influenced too much by energy prices, so that if you tighten when it’s high and ease when it’s low, you’ll tend to tighten into energy spikes (bad idea) and ease when energy prices are dropping.

      In the Fed’s target-reporting exercise, they projected both PCE and core PCE. Not surprisingly, they had basically the same ranges since the Fed knows it can’t project energy prices. And for the “long-term” column, they only reported PCE (not core) because in the long run they’re the same if energy prices are mean-reverting (and they tend to be).

      BUT they won’t actually target headline. They’ll target core for the reason I just mentioned.

      You’re exactly right about the inconsistency of the Fed’s targets! It doesn’t make sense to project decent growth and steady to declining inflation. It could happen, but it’s unlikely especially with core inflation in an uptrend.

  4. onebir
    January 31, 2012 at 7:50 am

    ‘You’re exactly right about the inconsistency of the Fed’s targets! It doesn’t make sense to project decent growth and steady to declining inflation.”

    It makes sense if there’s a big output gap (&/ a lot of cyclical unemployment) & you think these will have a significant dampening effect on inflation (/wage growth). This is the BoE’s line I think.

    (Let’s not worry too much that most output gap estimates for developed economies over the last 5 years will have been substantially revised…)

    • January 31, 2012 at 8:03 am

      I guess I’d feel better about that if there had been any relationship demonstrated between the output gap and inflation! But you know how I feel about that……

  5. onebir
    January 31, 2012 at 8:12 am

    Hmm – I thought the relationships were OK for historical output gap data, but much more dubious in real-time due to revisions (mainly to GDP & capital stock data).

    (However, it’s been a long time since I looked into this, & I was steeped in economic orthodoxy back then 😉

    • January 31, 2012 at 8:28 am

      For small gaps and small inflation, there’s an OK fit but only if you ignore monetary variables. Fama pointed out in 1982 or so that if you add the monetary variables, the explanatory power of the output variables goes away – so that the output variables are likely proxying for the omitted monetary variables.

      In large inflation or large output gaps, the relationship vanishes (example being the most-recent recession, the biggest in 80 years, which didn’t cause prices to fall or ex-shelter prices to decelerate hardly at all).

  6. onebir
    February 1, 2012 at 2:07 pm

    Thanks to JStor’s iron grip on knowledge, I haven’t been able to look at the full 1982 paper (“Inflation, Output, and Money” ?) but that makes pretty good sense.

    My misgiving is that Fama assumed rational expectations, which generally boils down to including future data in the equations. None of the alternatives to rational expectations is particularly appealing, but I think taking a result based on rational expectations too literally is a bit of a stretch. (& for someone who was short equities for most of the last decade, I would have thought that was the case too 😉 )

    I guess the lesson (of the Fama paper and the recent episode) is that the impact of big enough monetary policy measures on inflation can dominate…

    As you’ve pointed out, that’s actually what the CBs want, but as the private sector wises up we’re likely to tend towards the Fama-predicted situation where monetary policy has no effect on the real economy whatsover.

    (Now that’ll be a victory for central banking :s )

    • February 1, 2012 at 2:22 pm

      Exactly! I actually was referring to his 1981 paper (I just looked it up) “Stock Returns, Real Activity, Inflation, and Money” but I’ll bet the theme is the same. I’ve got a JSTOR-purchased copy of that paper……….

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