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Don’t Surrender the CAPE
The linear uptrend in stocks this quarter, which has only recently stuttered for a week or two around S&P 1400, has lifted that index at a 46% annualized pace (11.58% for the quarter-to-date). It seems unlikely that the last day of the quarter will see a further rally just because of ‘window-dressing’ (or the more-slimy tradition in which hedge funds push up thinly-traded names to get better marks for the quarter), but it may well see a further rally because, well, it’s just another day of easy money and few compelling investment alternatives.
Oddly, that same argument works much better for commodities, which tend to have a high inflation ‘beta’ and have historically had strong performances when real interest rates are low (as they are now), and yet after today’s agriculture and energy-led selloff the DJ-UBS commodity index is actually -0.52% on the year. The forward performance gulf continues to grow, while those of us who have favored hard commodities over soft hopes that equities can continue to grow to the sky are left gasping in the dust pounded up by the stampeding equity bulls.
I often look at the cyclically-adjusted P/E ratio (CAPE), which compares the inflation-adjusted price of the market (in this case, the S&P) against the 10-year average of the inflation-adjusted earnings per share. That ratio is currently at 22.4, against a long-term average of 16 (the long-term average is more like 15 if the 1999 bubble is removed). This measure echoes the indications of Tobin’s Q: they both say that the equity market is woefully overvalued not with respect to the current interest rate – comparing to see which bubble is less, and going long that bubble, doesn’t seem a winning strategy to me – but with respect to historical cycles of value.
However, I believe in questioning assumptions so I recently began to wonder whether the fact that we have had two deep recessions in the last ten years might have biased this number higher; if so, then as the first of those recessions rolls out of the 10-year window the CAPE ought to slip gently back to earth without a price effect, and the market might arguably not be as overvalued as this indicator suggests.
While the recession of the early 1990s did not cause a big decline in after-tax earnings according to the Federal Reserve’s Flow-of-Funds report, it did cause something of a dip in reported earnings per share (see Chart), and this is what the CAPE calculation uses. So, there is at least some argument to be made that CAPE may be exaggerated a little bit because it includes two sizeable recessions, when a normal 10-year window is unlikely to have more than one.
The counter-argument, though, ought to be considered. The counter-argument would be that looking at reported earnings, whose quality has probably never been worse (more manipulated) in history, is a convenient measure but perhaps not the best measure. It could be argued that the profits measure from the flow-of-funds report would make more sense.
I am not here to propagate that argument, but while I have the data for corporate profits out you should consider another argument from the bears. Investors who feel the stock market is likely to perform poorly in the future (among them the august Jeremy Grantham) point out that the level of profits as a share of national income is near extreme levels (see Chart).
So, investors who expect good returns from stocks going forward need to have one of these things happen: (1) profits as a share of national income stay near record levels, or (2) a rise in national income, rather than a fall in profits, causes the reversion to the mean. I suppose it could also happen that profits fall, but P/E ratios rise; this, however, seems to me to be wistful thinking akin to assuming that “prices will stay high somehow.” Personally, it doesn’t appear that the populism sweeping the nation in the form of the “99%” supposedly represented by the Occupy Wall Street crowd, the “Buffett taxers”, and other phenomena represent fertile soil for continued robust corporate profits in the face of weak personal income growth.
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There is also the possibility that the recession that is rolling out of the 10-year data window could be replaced by another recession. So far, there is no sign of that, but it also appears that the strong recent data may owe some credit to the warm winter weather in January and February. Today’s Initial Claims (359k) was the lowest in a long time, but only because the lower figures in February were revised sharply higher in a benchmark revision process. The labor market seems to still be improving, but it doesn’t look like the engine has fully caught yet.
For my part, I remain leery of both stocks and TIPS and am actively avoiding (or shorting) nominal bonds. I see commodity indices as the only undervalued asset class. While they will surely get pummeled unfairly if nominal growth slows, the fundamentals for commodity price increases remain in place, and I remain heavily committed to that market.
Odds In The Skeptic’s Favor
Friday’s shocking news was that new home sales are weak!
I would say that sometimes I don’t understand market reactions, but the fact is that I fully understand them much of the time; I just can’t understand how investors can be so myopic. New Home Sales came in at 313k, below the 325k that had been expected. The stock market initially didn’t take the news well, and bonds rallied. But look at the chart below – what number, short of 500k, would have been great news?
And in fact, there was some good news in both the New Home Sales data and the Existing Home Sales data from Wednesday, and that is that the inventory of homes continues to decline. While it’s certainly true that there could well be “shadow inventory” of existing homes to come on the market, the actual inventory that is out there now is near the lowest level it has seen since 2005, and in somewhat of a ‘normal’ range (see Chart). The inventory of new homes, already at multi-generational lows, fell further. Both of these facts speak to the likelihood that we are not likely to see a new leg lower in home prices soon, although the fact that there probably is some shadow inventory means home prices might continue to lag inflation a bit on the upside (thereby falling in real price terms).
Friday trading volumes were light, and stocks rebounded to close with small gains with the S&P just shy of 1400 again. Treasury bond yields fell again, by a smidge. But gasoline prices, now at a $3.89/gallon nationwide average price at the pump, continue to roll higher as the front Gasoline contract rose to a new record for March ($3.3852). Support for energy prices was partly due to a report that Iranian crude exports declined this month – again, in a shocking surprise since Iran has been saying they are cutting exports.
But for myopia, it’s hard to beat economists. The Atlanta Fed macroblog on Friday had an article by research director Dave Altig that is worth reading even though I am about to focus on something about it that annoyed me. Most of the posts on the macroblog are fairly interesting, but in some cases they are interesting in the same way it is interesting to look at tree sloths at the zoo. You can gaze at economists behind the glass and muse “they really aren’t like us, are they?”
In this case, Dr. Altig shows a number of intriguing charts showing the weak pace of job growth in this recovery, before raising the good question about “whether historical standards represent the appropriate yardstick today.”[1] Then he goes off the rails a little bit:
“In other words, is the correct reference point the level of employment or the pace of improvement in the labor market from a permanently lower level? For the proponents of the latter view, the bubble chart might very well look like a return to normal, despite the fact that employment has not returned to prerecession levels.
“One way to adjudicate the debate, in theory, is to rely on the trajectory of inflation. If there remains a significant amount of slack in labor markets, as the conventional interpretation of things suggest, there ought to be consistent downward pressure on prices. The case for consistent downward pressure on prices is not so obvious…
“There may not be much evidence of building disinflationary pressure, but neither is there building evidence of an inflationary push that you would expect to see if the economy were bumping up against capacity constraints. Obviously, the story isn’t over yet.”
Readers of this column know that I’ve pointed out a number of times that the failure of the growth-causes-inflation theory in this recession – the worst recession in eighty years didn’t cause prices to fall on a year-on-year basis even a little, or to even get very close; moreover, if you exclude the imploding cost of housing, inflation didn’t even slow very much at all – ought to more or less end the debate over whether growth (or recession) causes inflation (or deflation). It takes a Herculean feat of open-mindedness to say “the case for consistent downward pressure on prices is not so obvious” when core prices have accelerated for 15 of the last 16 months.
But Altig actually it trying to resuscitate the moribund theory by suggesting that perhaps what is wrong isn’t the theory, but rather the estimate of how much slack there is in labor markets. In other words, the theory is still good, but they were just completely wrong about what the limits of productive capacity were. My question is, if the theory’s parameters can be so wrong, is it useful as a theory? And the Occam’s Razor explanation is that…the theory is wrong.
I find the continued resistance to that possibility, despite the accumulating evidence that it is the case, almost incredible. I think it is probably a consequence of the way we try in college to teach the current state of knowledge as the ‘right answer’ instead of ‘our best guess right now.’ Students think they are learning the answers, and therefore they don’t need to question the answers. This is a sad state of affairs. We should be always looking for ways the prevailing theory is wrong, rather than just assuming it is right, because we find over and over and over again, in almost every category of knowledge from physics to astronomy to economics, that the prevailing theory is, in fact, wrong. The odds are in the skeptic’s favor!
And that is one reason that true contrarians (as opposed to those people who want to be just like the other contrarians) tend to do well in markets.
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I will be in San Diego for the next few days, where I am speaking at the IMN Public Funds Summit on the topic of innovations in inflation hedging and trying to make contact with potential clients in the public funds space. Accordingly, there will be no commentary produced until Thursday evening (and an article at that time will depend on work load!).
[1] Note that this isn’t the place to argue the demographic (baby boomers retiring) angle because the Unemployment Rate, which is based on a survey which incorporates job seekers’ intentions, still shows a very high rate. This debate is on the jobs-creation side: have jobs been permanently destroyed here, so that we are rebuilding the economy from a lower plateau rather than restoring lost jobs? I think that’s fairly likely, given the depth and length of the recession.
Son Of “Risk Off”
Although the last few days’ worth of trading is consistent with the type of trade we have periodically seen over the last year or two, referred to with the hackneyed description “the risk-off trade,” it isn’t much risk and it isn’t far off.
After a 21% rally in the S&P since November, prices now stand a whopping 1.2% off the highs. Wow, time to get in!
After 10-year note yields rose 45bps in two weeks, they have now fallen 10bps. Be still, my heart!
Spanish 10-year yields, down from 7% in November to 4.8% earlier this month, have reversed the February rally from 5.41% to 4.80% to return to 5.47% – only 153bps below the high yields. Calamity!
Ten-year inflation swaps, which began the year at 2.25% and closed at a high of 2.75% two days ago, drooped all the way to 2.68% today. Tantamount to deflation!
Hey folks, cool it. Nothing much has changed, yet. Initial Claims today was 348k when 350k was expected. Housing Starts on Tuesday recorded 698k rather than 700k. Existing Home Sales showed 4.59mm rather than 4.61mm. There are disappointments, and then there are disappointments. This is the disappointment that sends a stock lower if the company doesn’t beat the “whisper number,” even if the earnings are still great.
Markets will, though, probably get a boost from the comments of Chicago Fed President Evans, who commented in a speech after the markets closed that “clearly more accommodation would be appropriate.” I assume he is speaking about monetary policy and not the size of his hotel room, and if so then it’s a remarkable statement to be made about an economy that’s growing at or above a 2% rate of growth. Dallas Fed President Fisher, on the hawkish side of the spectrum, says on the contrary that he won’t support further quantitative easing, but that’s not really a surprise. In any event, there’s clearly disagreement at the Fed about further QE. That’s almost mind-blowing to me given that we are not in a state of crisis, most policymakers tell us we shouldn’t worry about a resumption of financial crisis, and economic growth is doing fine (although it’s not booming!) with the exception of some clear signs of inflationary pressures. If they can’t get fair unanimity about holding off on QE3 now, then either they know the chances of further disaster are not as remote as they say, or QE3 will be on the table forever.
This was, in any case, roughly the right place for the bond selloff to take a pause. The chart below gives the very-long-term monthly closing chart of the secular bull market in bonds. As with any long-term chart of a series bounded by zero, as nominal yields are, the chart makes the most sense logarithmically. The very regular decline in yields had a false breakout in 2008, a re-test of the lower line (which I took at the time as the turning point of the whole bull market, incorrectly), and then a more-durable breakout over the last year.
The selloff so far has taken us slightly inside the lower trendline, which is an unstable position. Either yields should move somewhat higher from here, exiting the area of the trendline, or this should represent just a re-test of the breakout and lower yields are to persist for a while. My view is that the selloff we are currently experiencing, which is in line with normal seasonal patterns, should result in no less than a return to the channel and a migration back slowly towards 3% 10-year yields. However, we have to keep in mind that the breakout from the natural, secular decline corresponds to the Fed’s direct and almost unprecedented manipulation of long-term interest rates (I say “almost” because the Fed back in the 1940s pegged long-term interest rates, but the market was much smaller then).
This chart, as much as any other, shows how unnatural the intervention has been, in disturbing the market’s natural rhythms. That also means that the Federal Reserve is rowing against the tide, but so far they have been successful. I can’t rule out the possibility that a QE3 might hold rates near 2% (although it is hard to see them much lower than that, in any case, while there are massive deficits and rising inflation), but I take the bearish view.
Although TIPS remain expensive, they are nonetheless still cheap to nominal bonds. Now that breakevens are 35bps wider they aren’t as cheap as they were, but I still vastly prefer to own TIPS at a -0.10% real yield than nominal Treasuries at 2.28%: what could well end up being a much worse real yield.
A Couple Quick Words About Commodities
The market is back to casting about for the next source of fear. Today, it was China. Fears that the Chinese economy may be slowing pushed both stocks (-0.3%) and commodities (-1.5%) down. The Chinese economy, although only 1/3 as large as the US economy, is a disproportionate share of global growth and so the fear is that a meaningful slowdown in China could cause the demand for raw goods to drop significantly.
There are big problems in China, starting with the banks. A discussion of the weaknesses of China’s economic situation is beyond our purpose here (as well as being beyond my expertise), but what should be kept in mind is that an implosion of the Chinese economy is quite unlikely. China does not have a capitalist system, and preventing a run on banks is much easier in a nation that doesn’t face the rigor of free markets. And if you thought printing money proved too easy in the “open” economies, how much easier is it in the “closed” economy? I think the forecasts of Chinese economic hegemony in the foreseeable future are more misplaced than the forecasts of Japanese hegemony were in the mid-1980s, and we can see how that worked out. But I also suspect that we will not see a “crisis” in China very soon. Again, it’s not my core expertise so I may well be wrong.
But I think that in any case, people who are thinking the slowdown in the Chinese economy will cause a sharp fall in commodities prices are unlikely to be right, for several reasons. First, absent an actual recession in China it seems to me that the worst case is that demand will rise less than it otherwise would have, but a global commodity supply glut seems unlikely as long as the country continues to grow.
The second, and more important, is that the notion that slowing growth ought to hurt commodities significantly represents partially a confusion of real and nominal quantities. The chart below shows the common thought process, and seeming empirical support for it. The chart shows Real GDP versus the SP-GSCI Non-Energy Spot commodity index (that is, the level of commodities, ex-energy commodities, ignoring collateral return and other sources of excess return to a commodity index). The fit is striking: when real GDP goes up, so does the commodity index; when real GDP goes down, so does the commodity index.
The only little problem is that this is clearly comparing apples to organges. Real GDP is measured with constant prices from a base year; commodities are priced in current dollars. The chart below is the right comparison – Nominal GDP versus spot commodity indices – and the fit, while still fine, is definitely worse.
Oh, and by the way these charts only look kinda good because of the massive ripple in 2008-09. If we take a longer view, the relationship breaks down. It doesn’t matter if you look at 1990-2012 (shown below) or 1970-1990, the fit in either case is useless. Not even close. The best you can say is that they both went up in the long run.
What is missing in these charts is a sense of the tightness or looseness of monetary policy, but in this third chart you can sketch some broad themes. When domestic GDP growth is relatively quick, compared to money supply growth (that is, policy is tight or neutral), then the commodity index moves lower. The early 1990s saw weak money growth; the late 1990s saw better M2 growth but the economy was growing at a much more rapid clip as well. In the 2000s, weaker growth as a function of several recessions corresponded with rapid money growth, and commodities rose significantly. It’s difficult to construct a fair-value metric that balances these factors and takes into account the fact that commodities are often priced in dollars but obviously not all consumed in the US. But the 2001-2008 and 2009-2011 experience is telling: if slow growth in the world’s largest economy didn’t restrain commodity growth, then slow growth in an economy one-third the size probably won’t either.
And yes, I understand that China also consumes much more in the way of commodities than its GDP would suggest it should, relative to the US. A collapse of the Chinese economy might give me pause. But rapid growth of the global money supply appears to me to be a much stronger effect, judging from Chart 3.
Incidentally, I think one way you can tell that the average age of portfolio managers and traders is under 50 is that it is very easy for these investors to sell commodities at the first sign of weakness – because, after all, that has been a good trade for most of the last 30 years, until 2005 or so. There are not very many practicing institutional investors who clearly remember the last good bull market in commodities! The same statement applies to bonds, to a lesser extent, but at least bonds have a connection to fair value that we think we understand better, and they teach fixed-income mathematics in schools. No one talks about Lean Hogs.
I continue to think that commodities are undervalued relative to the significant increase in the money supply, and I continue to hold a significant weight in commodity index ETFs.
Has Inflation Really Turned, As The Fed Expected?
If 15 months of rising core inflation did not a trend make, then surely one month of declining core inflation also does not. Nevertheless, with confirmation bias doubtless in play, the decline in ex-food-and-energy CPI to 2.177% from 2.277% probably brings QE3 back into play.
Confirmation bias, for readers unfamiliar with the term, is the behavioral tendency for people to emphasize information that confirms what they already believe and to dismiss contrary information. So, for example, an economist who is forecasting that inflation will slow (and who has been forecasting that for months now, perhaps also not having forecast the fastest rise in almost 20 years of 1.7% over the prior 15 months) will see in today’s number a confirmation of his/her beliefs, but never questions why there were so many prior misses. In this way, a bad economist is like a good cornerback – they both have short memories!
So here is the market implication of today’s slip: the hawks on the FOMC had been gaining ground in persuading the doves to hold off on QE3, partly due to economic recovery but also due to the fact that inflation looked to be accelerating uncomfortably. Chairman Bernanke seems to have an itchy trigger finger on QE3, but the argument for it weakens considerably even if there is somewhat weak growth unless inflation also slows. Since FOMC members are as subject to confirmation bias as are any other humans, I think this single number puts QE3 back into play (especially with bonds weakening lately).
Not wanting to be accused of confirmation bias myself, let’s look at today’s inflation release critically. Most of the major groups decelerated: Food & Beverages, Housing, Apparel, Medical Care, Recreation, and Other. Those groups account for about 78% of the CPI; accelerating were Transportation (mostly due to fuel) and Education/Communication.
To have three quarters of the basket decelerating is a big change from the recent tilt the other way, but it isn’t quite as obvious as that. First of all, within the Housing major group Owners’ Equivalent Rent was flat, “Rent of primary residence” rose, and “Lodging away from home” rose. The primary cause of the decline in the Housing major group was the sharp fall in “Fuels and utilities,” driven by large declines in Fuel Oil, Propane, kerosene, and firewood, Electricity, and Utility (piped) gas service. In other words, the 5.27% of the CPI that was “Fuels and utilities” under “Housing” ought to go in the declines column while the other 34.95% that is Housing ought to be in “accelerating.” That moves the tally to 41.85% decelerating, with 58.15% accelerating, which is much closer to the prior diffusion. So this decline isn’t as dramatic as it looks at first blush.
Another component where there was a sharp fall was Apparel. Last month saw an 0.9% rise in Apparel prices; this month we got an 0.9% decline. Confirmation bias kicks in, and virtually every economist pointed to “payback from a surprising increase in Apparel.” I don’t see Apparel’s increase as so automatically surprising (see my comment on Apparel last month here). It seems to me, even with this correction, that Apparel is looking a lot more like it did pre-1993 than since then (see Chart).
The +0.9% followed by -0.9% is more likely to be a seasonal glitch than a reversal in trend – the non-seasonally-adjusted data show a sharp fall in January and a sharp rise in February. In other words, the seasonal adjustment factors expected a sharper decline in January apparel prices, which usually accompanies post-holiday clearance sales, than actually happened in January. This is probably a weather effect, and I’d expect Apparel to resume its rise next month.
Aside from the minutia, let’s look at the bigger picture and let me extend my comments from yesterday about the expansion of commercial bank credit. A reader asked me why commercial bank credit matters, and whether the recent decline in monetary velocity to levels never seen before is a more-dependable precursor to deflationary doom, as no lesser pundit than Ambrose Evans-Pritchard seems to believe.
Should we worry about the decline in the velocity of money? Of course we should, and that is why the Fed did QE1 and one reason they are considering QE3. But remember that we don’t measure money velocity directly. Money velocity is a residual value from the equation MV≡PQ, where we calculate M, P, and Q and therefore derive V. Since we don’t measure velocity directly, we have to rely on signs that velocity is changing. The collapse in bank lending during the crisis was a terrific signal that money supply growth would not be immediately inflationary, because velocity was clearly plunging (velocity is, coarsely, how many times a dollar gets spent in a year, and with the banks sitting on every dollar that came their way, they couldn’t get spent as many times!).
The return of lending to something like its normal range is disturbing, in one sense, because a return of velocity to its normal range would be worrisome with the money supply itself still growing robustly. But is there really such a link? I asserted it, but I didn’t show it. So let me show it.
The chart below shows the 2-year annualized growth of Commercial Bank Credit, in red and measured on the left axis, versus M2 velocity, in blue and measured on the right axis. Since 1990, the quarterly correlation is an impressive 0.51, and I am sure with some further massaging I could improve the correlation further.
The last point on the chart is from December. If the quarter ended today, the 2-year compounded rise in Commercial Bank Credit would be 1.9%.
Let me illustrate how much a rebound in velocity would matter. Over the last four years ended in December, M2 rose about 28.5% and velocity has declined 16.2% (so M*V rose 7.7%). GDP has risen 0.8% (that’s a total of 0.8%!) in constant dollars and the core PCE deflator rose 6.5% (so P*Q rose 7.4%).[1]
Now suppose that over the next two years, velocity rebounds to 1.9 (a rise of about 20% from the current level) and money supply growth slows to only 8% per year. That puts M*V +40% in two years. Let’s assume that real GDP soars, because of wise leadership and surging consumer confidence — stifle the laughter, this is a thought experiment — at +5% per annum. That means prices would rise by roughly, um, 27% in two years [1.4/(1.05^2)].
So yes, velocity matters. And yes, the recovery in commercial bank credit probably tells us something about what is going to be happening to velocity now, and in the near future.
So no, the 0.1% decline in year-on-year core CPI doesn’t change my view.
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I promised myself I wouldn’t make any snide comments about the wisdom of the Fed going all social-media on us by opening a Twitter account. However, it depresses me that I have been tweeting for a couple of years at @inflation_guy and have only 352 followers, but @federalreserve already has 15,658. So come on, help me catch up! We can do it! Note that this comment is released on Twitter, and also note that if you are on Bloomberg and can’t get Twitter behind your compliance wall, you can still get my tweets (such as they are) by typing NH TWT<GO> and then searching for Michael Ashton.
[1] I should use the regular PCE, but I’m not trying to make a point about energy prices, and as you can see it’s still the case that DMV»DPQ using core.
The Downside Of Healthy Banks
For the third day in a row, equity volume was passable, near 800mm shares. That’s the best 3-day performance, volume-wise, since early February. What does it mean, on a day that stocks rallied another 0.6%? Bulls will say that it is supportive, showing that the rally is gaining adherents and some of the sidelined cash is returning to the market. Bears will say that it looks like retail is finally chasing the market higher.
I don’t know which (if either) of these is true, but either way the market has the support right now of solid, if unspectacular, economic fundamentals. Empire Manufacturing came in at 20.21, Initial Claims fell to 351k, and Philly Fed printed 12.5: all three releases were as good or better than expectations.
Bonds had sold off in the overnight session before rallying back and managing to fall only a smidge, with yields +1bp on the day.
Commodities were generally strong, but the energy sector fell with gasoline off -1.8%. Energy traders were a bit rattled by a Reuters story that the UK and the US had agreed to coordinate releases from strategic stockpiles. Spot Crude dropped $2 instantly. In a way, it is an odd reaction because there are only two reasons to announce a release of reserves now. The first possibility is that it is a political gambit by the Obama Administration to take away a talking point from the Republicans, pushing gasoline prices (ironically, only a week or so after the President said that a plan to lower gasoline prices to $2.50 – proposed by candidate Gingrich – was a ‘phony, election year promise.’) But if the main point was political, then why involve the UK when any important domestic effect would be driven by a release of US stockpiles?
Possibility two is that a behind-the-scenes discussion on releasing stockpiles in the event of hostilities in the Middle East was taking place. This isn’t as much of a stretch to consider as you might think; the current naval deployment map shows that in addition to two aircraft carriers already present in the Gulf region, the U.S. has newly moved a big-deck amphibious warfare ship into the region; also, two other carriers recently put to sea, with one halfway to the Mediterranean already. The Administration’s denial of the Reuters story, which caused prices to rebound warily, was also phrased curiously, with White House press secretary Carney saying that “It is inaccurate…that any kind of agreement was reached.” “Inaccurate” seems a bit wishy-washy if what he meant was that there were no discussions being had, or that the report was outright false.
If there is any chance of hostilities near-term, of course, it would be stupid to release reserves before shots were fired, because then prices would still spike on news of combat. Any agreement would presumably concern a co-ordinated stockpile release to be announced after fighting commenced. This is not a prediction of war – I am even less qualified to comment on that than on many other things people bash me about. I am simply saying that I am raising my antennae as a result of this curious combination of events.
Any prospective rise in oil prices, as well as the lagged effect of energy price increases which have already happened, is additive to whatever numbers are reported tomorrow in the BLS’s CPI report. The consensus estimate is for a rise in headline inflation of 0.4% and 0.2% on core inflation, keeping the year-on-year measure of headline at 2.9% but allowing the year-on-year core reading to slip to 2.2% from 2.3%.
I don’t think we will actually get a downtick in core inflation. If core is only 0.17% month/month, then it will be sufficient to sustain the 2.3% year/year print (which was really 2.27%), so to get a downtick to 2.2% you either need 0.15% or 0.16%, or month/month needs to surprise by coming in at only 0.1%. In fact, last February core CPI rose 0.20%, so in order to get an uptick only a +0.27% monthly print is necessary.
It has been 15 consecutive months that we have watched year-on-year core inflation rise, the longest such streak since the mid-1970s. If we get a clean, unrounded 0.2% rise in Core CPI, it should be enough to set a record by edging year-on-year core inflation higher for a sixteenth consecutive month. A downtick is possible tomorrow, but I believe we will set a record.
Record or not, the underlying reasons for being concerned about inflation are just not going away. The latest data on Commercial Bank Credit show that the “wall of money” that was safely in sterile reserves a few months ago continues to leak out. The year-on-year rise in commercial bank credit has finally surpassed 5%, the first time it has returned to the “normal” 5-10% range since the crisis began (See Chart below, source St. Louis Fed).
So if 9%-10% M2 growth, where year-on-year growth in that metric has been for the last 32 weeks, doesn’t bother you because of the decline in M2 velocity, the acceleration in commercial credit growth should cause at least a mild discomfort. Yes, banks are healing – and while that is mostly good news, the flip side of healthy banks is recovering money velocity.
The Cool Kids Don’t Like Bonds Any More
Global stock markets were the boring markets for a change, as today global bond markets took a potentially meaningful step back. In the U.S., 10-year yields rose 15bps (with no economic data to point to), reaching 2.28%. Yesterday I noted that most of the last week’s rise in yields had come from an increase in inflation expectations; that trend corrected today, as TIPS were also hammered. Ten-year TIPS yields rose 12bps, to -0.10%, implying that the 10-year breakeven rose a mere 3bps.
This was not just a U.S. story. The 10-year UK Gilt rose to the highest yield since December, +17bps today. Germany was +13bps today although still in the range; JGBs up to the highest level since December although that’s also only 9bps above the low yield from the last quarter since JGB yields have been effectively ‘pinned’ for a long time.
Although in the U.S. our selloff was largely in real yields today, the underlying pressure here is from prices. I have previously illustrated the fact that core inflation globally has been rising for two years; this is starting slowly to be reflected in yields. The chart below is an eye-opening one of Japanese 5-year breakevens (there is no 10-year breakeven because Japan stopped issuing inflation-linked bonds a few years ago although they may soon resume). It has been rising almost non-stop since mid-2010, from -1.5% in five-year inflation expectations to…a positive number. That’s right, the poster child for deflation now has investors expecting prices to rise (albeit a small amount) over the next five years.
And with that small change, the yen has fallen 8 big figures against the dollar in about a month (see Chart, shown in terms of the number of yen per dollar). Higher inflation in Japan means the Yen is finally losing real purchasing power too, and is no longer essentially a one-way bet versus the dollar.
Here is another chart you don’t see much. This is 10-year Australian breakevens:
Euro 10-year inflation swap rates, despite the tremendous recent troubles, are closer to the highs than the lows of inflation expectations over the last several years:
Twenty basis points, or forty basis points, is nothing to get all in a lather about, yet. But I believe it is significant that global bond markets are all pricing in more inflation over the last few months, and nominal yields today all rose. This is not a global growth story – it’s mostly a global inflation story.
In that context, it was especially odd to see precious metals get battered again today (-3.3%), although the reasoning is easy enough to understand. Precious metals may hedge against a growth Armageddon, or they may hedge against inflation – but it is hard for them to hedge both outcomes at the same time. Betting on Armageddon has never been a good bet, so far (since we’ve had zero Armageddons as of this writing), and being long precious metals in anticipation of that event is never a good idea. That said, there are other reasons to be long precious metals as part of a diversified commodity index, and I continue to be amused and confused by the fact that inflation indications are sprouting up all over, in many markets…but not yet in commodities, which historically produces the highest inflation “beta” in the early stages of an inflation episode. I think the adjustment will eventually come, and it may be swift when it does.
To repeat, a one-day or one-week selloff in bonds, even global in nature, is nothing to get panicky about. But higher inflation, higher interest rates, and higher gasoline prices each singly poses a challenge for increasingly-lofty equity valuations. Collectively, they pose a dangerous threat. Right now, the stock market doesn’t seem to know what is good for it. It reminds me a bit of a rebellious teenager, like James Dean in “Rebel Without A Cause.” No good can come of the drag racing being done in equities right now. That being said, I covered some of my short (through equity options) on Tuesday before the Fed, because this feels like a pom-pom rally and everything is going to feel great until the morning.
So far, I can’t figure out how far away dawn is. The rapid movements in the dollar/yen, the abrupt drop in bonds, the rise in energy prices – these are all bad, but they’re still fairly insignificant moves. It will take more to derail stocks.
It won’t likely come tomorrow from the surveys (Empire Manufacturing, Consensus: 17.5 vs 19.53 last, and the Philly Fed Survey, Consensus: 12.0 vs 10.2 last) or Initial Claims (Consensus: 357k from 362k). But those are also not likely to be very bullish figures for bonds, either. I suspect the crack in stocks will come if investors notice that conditions in rates markets are getting less accommodative (or more attractive as a competing investment!). At 15bps per day, that may not take long but it’s probably not going to be on Thursday!
My Two Cents On Nonsense
I had not planned to write tonight, but there was too much that happened today, and too much that is likely to be misunderstood and misinterpreted. Not, necessarily, that what follows will help that situation, but I felt a need to add my two cents (which, don’t forget, is two cents more than you paid for it, so you’re two cents ahead no matter what).
Let us start with the good news, however. Retail Sales exceeded expectations, with +0.9% ex-autos and even +0.6% ex-autos and gasoline (yes, higher gasoline prices show up as higher retail sales), with upward revisions to both series last month. Clearly, retail sales are doing better than expected and are a bright spot; as I’ve said for a while, the trick here isn’t figuring out that the economy is improving, but figuring out whether that improvement will be consistent and can be built on. The jury is out on that one, and I will say that I am not exceedingly optimistic. But that is not today’s trade!
The Fed met today, and the market actually took a statement that was nearly empty of significance and wrung drama out of it. Stocks leapt, because while the Federal Reserve acknowledged that the economy was improving there was no sign of any wavering in the resolve to provide easy money for the next couple of years. They were correct to do so (based on that interpretation), although the curious thing was that commodities rose only sluggishly, and precious metals actually dropped 1% or so. That’s confusing because easy money for a couple of years ought to have the most direct effect on the prices of commodities. The dollar strengthened, though, partly because of the strong economic data, and this blunted some of the natural upward pressure in this circumstance.
Bonds sold off, also correctly, on the lack of any sign from the Fed that QE3 is being considered in any form. The question is, when the Fed is done with Operation Twist II, who will be buying the 10y note at 2%? China recently announced a large trade deficit on the basis of declining exports; this is probably a one-off but it raises the question of whose surplus will be dedicated to buying Treasuries (obviously, there is a net surplus somewhere; every country can’t run a deficit! We just don’t know whether the other surplus countries will prefer to buy Treasuries). Accordingly, the 10y note yield rose to 2.125%, up 9bps to the highest yield since the false breakout in late October last year (see Chart). While it is probably early to say that this will lead to a big rise in rates, every trader knows the old saw that the market will find the greatest pain, and right now there is a holder of trillions of dollars of long Treasury securities who has no way to sell them and is growing tired of supporting the market at these yields.
The rise in yields was predominantly due to a rise in inflation expectations; indeed, over the last week 10-year yields have risen 18bps; 16 of them have come from an increase in 10-year inflation expectations and only 2 of them from a rise in 10-year real yields. See the chart below of 10-year inflation breakevens, which are back at the highest levels since August.
This is significant, especially as it extends, because the Fed continues to profess that one reason they are not concerned about the rise in core inflation is because “inflation expectations are contained” and this is less and less true, whether you’re looking at market indications or listening to retail customers (whose perceptions of inflation turn out to be driven quite significantly by fluctuations in gasoline prices). Today retail gasoline prices reached $3.80 nationally, and given the usual lags in wholesale-to-retail transmission, it appears that record prices above $4/gallon are likely in the next month or so. Whatever the implication for economic growth (negative, but probably not as bad as the first time we saw those prices) and core inflation (no real effect), the effect on inflation expectations will be large and not helpful for either the Fed or a Treasury which still has a few trillions in securities to unload this year.
And this takes us to the final, and most interesting, event of the day. It began when JP Morgan trumpeted a nickel increase in its dividend and a $15bln stock buyback. My first reaction was that this is not a phenomenon you tend to see in bear markets or early in bull markets, but rather in mature bull markets. Firms have a marked tendency to buy stock back when it’s expensive, not when it’s cheap, and an even more marked tendency to announce a buyback when they want a stock price supported. An announcement of a buyback program is not a promise to buy, and often no stock is actually bought. It is only an announcement of an intention to buy, which the firm need not honor. And this is a bank. Anyone with even a passing knowledge of Basel III knows that banks are going to be raising Tier 1 capital – especially in Europe, but in the U.S. as well – for a while. There is no way that banks, whether or not they feel overcapitalized by 2000s standards or not, are actually going to be buying back large chunks of stock. So my second thought was “wow, are they actually going to scare up the stock so that they can sell more? That can’t be legal.”
Moments later, we found out what the real point was. It seems the Fed had completed the stress tests and informed all of the banks a couple of days ago (it’s unclear when), and were going to make a public announcement on Thursday.
Sidebar: This is why people think that Wall Street is run by a bunch of crooks. The moment that banks had this information, they were in possession of material nonpublic information that should have been immediately released if the banks were going to prepare any offering in their own securities. Whether the Fed says they can or can’t, the information must be released. And here is one positive checkmark for JPM: they announced that the Fed had approved their buyback and dividend plans in the context of passing the stress test. But thanks a lot, Fed, for putting banks in the awkward position of having to choose between ticking off the Fed, or ticking off the SEC. And great job, bank managements, for mostly choosing to keep a secret that makes you look like a member of an elite club/secret cabal, rather than choosing to release the information. Good job, JPM. (But I’m not done with you yet).
So, the Fed decided that they needed to immediately release the stress tests results, early. Well, not immediately; they decided to wait until 4:30ET, after the markets closed to retail investors, because golly it would be too much to ask to let people get the information when the markets were open. Sidebar: this is why people think the Fed is run by a bunch of crooks who are in bed with the Wall Street crooks. Who is running the PR at the Fed?
Bank of America bravely followed JP Morgan through the breach to announce that they, too, had passed the stress tests. US Bank announced a share buyback, dividend hike, and a passing stress test grade. (Quick quiz, with the answer to be given later: are the banks announcing share buybacks likely to be the strong banks or the weak banks with respect to the stress test? Write down your answer and we’ll come back to it.) Volume on the exchange spiked, with better than 50% of the day’s volume coming in the last hour of trading, and almost 30% in the last 7 minutes before the bell.
The stress test results were released, and four financials failed: Ally Financial, SunTrust, MetLife, and Citigroup. Well, good luck raising capital now, Citi. (Important Disclosure: I am expressing no opinion on any of these individual equities or any of the other securities of these companies. I neither own, nor intend to buy, nor sell, any of their securities in the near future. My negative opinion on banks generally is well-known, but I do not have any position, positive or negative, on the banking sector, nor do I plan to make such a sector bet in the near future).
Now, initially the press coverage listed three of the four firms that failed, but not MetLife, so I was forced to go skimming through the “CCAR” report to find the fourth one. If I hadn’t done that, I almost certainly would not have noticed Figure 7, which is reproduced below for your easy reference.
You can see the four banks which failed are the shortest bars on this chart, so you can easily pick out Ally, Sun Trust, Citi, and with a straightedge you can conclude that MetLife is the fourth. But then it’s a really close race for fifth-worst with KeyCorp, US Bank, Morgan Stanley, and… JP Morgan. It must be great to be JP Morgan. When you wonder why they drew the line where they did, you might imagine the counterfactual situation where JP Morgan came out on the other side of the line. JP Morgan, which was the Fed before there was a Fed, and will probably be the Fed after the Fed is gone. JP Morgan, which the Fed called on multiple times during the crisis to save the world (for example, by serving as a lending conduit to entities which the Fed could not directly lend to). I wonder what the odds are that JP Morgan would be allowed to fail? I’m going to speculate: zero. And that’s why the line is where it is.
Now, it is interesting to see which banks scored very highly. They’re banks that don’t have exposure to as many of the blow-up areas that were tested by the Fed (which is not to say they aren’t exposed to blow-ups: just that they’re not the ones that the Fed tested).
By the way, don’t let anyone tell you “well, this was a really severe test, and so these banks are actually in really good shape.” Yes, this test is much more stringent than the cotton-candy version the European regulators put their banks through last year, but it only measures expected reactions to broad macroeconomic events, and not the interaction of the entire system under such a stressful scenario. That reaction is non-linear, and it is very difficult to model. Moreover, we can’t model the unknown: a rogue trader, a $65billion Ponzi scheme, a tsunami and nuclear meltdown in Japan, a terrorist attack in New York. As Roseanne Roseannadanna used to say, “It’s always something.”
When all is said and done, are we better off that the Fed did these stress tests? I suppose the answer is yes, if only because it means the regulators actually took some interest in looking at these businesses and their risks. But if it creates a false sense of comfort, or reverses the trend towards greater capital cushions, then probably not. Time will tell.
I am about ranted out for today, and there are no important economic releases tomorrow. It will be interesting to see how the spin machines work on Citigroup and JP Morgan, which are after all separated by only a thin line on Figure 7, but by a huge gulf in reputation.
From Sizzle to Simmer, Overnight
Have we forgotten how to trade anything except Europe?
Bonds today were unchanged. The S&P ended with a gain of 0.02% after trading in a 6-point range all session. Volume barely cracked 600mm shares, easily the quietest Monday of the year and barely exceeding the 599mm shares printed on the slowest day of the year so far, February 24th. It bears reminding that, with the exception of the day after Thanksgiving and the week between Christmas and New Year’s Day, the equity market hadn’t seen a day with only 600mm shares traded since at least 2004 (the data provided by Bloomberg only go back to 2005). And now we have two of them in the span of slightly more than two weeks.
We are only days removed from the most-threatening period of financial disruption since at least 2008, and that assumes that we are removed from that period. It is not clear yet when the next shoe will drop, but one seems likely. Will it be Portugal, with 13.3% ten-year-notes? Spain, which just unilaterally announced that it will not deliver a deficit/GDP ratio this year that it had previously agreed to? (They said they preferred 5.8% to the 4.4% they’d told the EU). Or Greece again, for any of ten different reasons?
Let’s revel in the calm, I suppose. If Europe can go from sizzle to simmer for a few weeks, attention will turn soon enough to the Middle East where Syria, Iran, and Israel/Gaza all offer compelling story lines. Any one of these stories is probably not enough to move markets, but any overlap in the stories (Iran expresses overt support for Hamas in Gaza, for example) could have non-linear effects in the market – that is, energy markets may suddenly care.
On Tuesday, the FOMC is meeting, but there are no expectations for anything more than token tweaks to the official statement and certainly no hint of any change in policy on the horizon. The market will be quiet and thin, less because the FOMC is meeting than because hey, the NCAA bracket won’t fill itself out! (Plus, the NFL free agency period begins…with the NFL today taking a page from the Troika and instituting an NFCAC, changing rules retroactively to seize $46mm in salary cap space from Washington and Dallas and distributing it to other teams. But I’m not bitter.)
In principle, the 8:30ET release of Retail Sales (Consensus: +1.1%/+0.7% ex-autos) could trigger some volatility, but I honestly don’t expect it.
It isn’t just that the market is thin. Thin markets can be volatile and whippy as moderate-sized flows push prices around. It’s that the market is thin and investors and traders are remarkably noncommittal, so it is thin and lethargic. I don’t know what that indicates, exactly. It could indicate that investors are very conservatively positioned, so that there is a lot of “potential energy” when they come off the sidelines. But it could just as easily mean that investors are fully committed to their favorite strategy, and will run for the hills if it stops working. I’ve seen both kinds of markets, and they are not easy to distinguish a priori.
I am not one who changes positions just because nothing is happening, however. I remain bearish on fixed-income, bearish on equities (although with the success of the Greek tender I am not adding any more to put positions), and bullish on commodities. I don’t expect to win all three of those bets.
The Second-Slowest Prey
Finally, we can perhaps put Greece in the rear-view mirror. The result of the exchange “offer” produced around 83-85% commitment (there are several conflicting calculations out there), although much less on the foreign-law bonds which subsequently saw the exchange deadline extended as a result. Some reports say that 85% is a “very high” participation, with at least one report I read saying that it was “higher than even the most-optimistic estimates beforehand.”
That’s certainly false. Greece was publicly aiming for 95% and threatened the holdouts with every plague conceivable. Ultimately, they had to exercise the retroactively-added Collective Action Clauses, and triggered a Credit Event (therefore bringing to nothing the billions of dollars wasted trying to avoid just such an event), and will still fall a bit short. Troika representatives said a tranche of the second bailout will be released while further discussion continues on the next tranche.
It is important, and sad, to note that when-issued trading of the substitute securities being issued in exchange indicate yields of over 20%. Remember that one of the points here was to restore Greek access to markets – but, despite the fact that they continue to run large deficits (something about the economy contracting at a 7% annual rate will do that), there is no chance that they can raise more money on their own at anything like a sustainable rate. It doesn’t help that all future Greek govvies, and the existing exchange debt, are now subordinated debt.
Greece, in short, is “saved” only in this sense: they were being chased by a lion, and they managed to become the second-slowest prey for a little while. The lion is now zeroing in on Portugal, with everyone cheering for Portugal…except for Greece.
It will slowly dawn on investors that this solution, as painful and costly and dramatic as it was, buys only a short period of time for Greece. And there’s no way to ‘get its house in order.’ The right thing to do at this point would be to use the period of relative calm to gracefully leave the Eurozone and devalue. But being the second-slowest prey might provoke undeserved optimism, a vain hope that the lion will be sated soon (or tire of the chase). It would be a terrible mistake to take this as a signal that the worst is over, at least in Greece.
Hopefully, though, Greece will at least move lower in importance for a little while, so we can concentrate on other developments that in the absence of crisis are more-relevant to the dollar-based investor. Developments such as another decent month of Employment growth: in February, the economy generated 227,000 new jobs, a bit better-than-expected with the upward revisions to the prior month. The Unemployment Rate stalled at 8.3% as the number of unemployed actually rose as well (the Civilian Labor Force swelled 476k this month, and this time we can’t say it had anything to do with benchmark revisions – the labor force participation rate ticked up to a still-anemic 63.9%). Most of the internals were pretty good, although one indicator I follow is curiously flaccid. The chart below shows the number of respondents to the household survey that are “Not in the labor force but want a job now.” That is, they responded that they are not looking for work (ergo, they are not in the labor force, since you need to be employed or looking for work to be considered in the labor force), but would take a job if they thought there was one on offer.
This is an interesting series because it’s a weird category – if you want a job now, why aren’t you looking? These people are not officially “discouraged” workers; that’s another series. These are folks who just don’t think it’s worth the time to look. As you can see, from 2001 through the crisis, there were generally about 4.5mm-5.0mm people in this category, and so there is something like 1.5mm people who conceivably could enter the labor force to soak up jobs. That’s roughly 1% on the Unemployment Rate.
The number has been this high before: back in 1994 (as far back as BLS data goes for this series), there were also about 6.5mm in this category, and between 1994 and 2000 the number slowly dwindled. Now look at the chart below (Source: Bloomberg), and you will see that between late 1994 and 2000, the Unemployment Rate’s rate of improvement slowed. Had the 1% drag from this category not happened, the slope of the improvement would have been nearly constant.
Now, I’m actually not claiming that the rate of improvement slowed because of this factor; in 2003-2007 the slope of improvement in the Unemployment Rate was about the same as it was in 1995-2000 so it’s more likely that the slope is related to the level – once you get below 6%, you can’t expect more than about 0.3%-0.5% per year. And, now that the Boomers are retiring, the employment dynamic is clearly different anyway. But the persistence of a large group of people who “want a job now” but aren’t working should dampen out enthusiasm a little bit about the improvement from 10% to 8.3% Unemployment over the last two years. That was the easy 2%. The next 2% is likely to take longer. To get down to the highs of the last recession will probably take three years at least, even though the exit of Boomers from the workforce will help.
Steady improvement in the Unemployment Rate would be a good thing. But what is the implication for Federal Reserve policy of an Unemployment Rate which – even in the absence of another recession, which is certainly not exactly assured – will be over 7% well into 2013? With a bloated balance sheet and core inflation above their target (core PCE right about at the target), if the Fed wants to forestall a bad inflationary outcome it needs to consider unwinding monetary stimulus while conditions are sunny. And yet, we’re hearing trial balloons about “sterilized QE3,” because the Unemployment Rate remains above 8% and will be above 7% for quite a while.
As I first pointed out in 2010, monetary policy is simple if both the growth and inflation mandates argue for the same policy (in that case, strong provision of liquidity to push inflation higher and, some believe, to improve growth). It gets much harder now. So which is the slowest prey, that tightening policy would bring down first? Growth, financial institution liquidity, or inflation? Unless the answer is “inflation,” there are no easy choices from here.
