Archive
ECI – Not As Benign As You Think
The Employment Cost Index just printed +0.4%, below expectations of +0.5%.
The ECI consists of two parts: wages and benefits. The benefits component is very hard to seasonally adjust – for example, while companies tend to adjust benefits on a calendar year, they don’t do it EVERY calendar year. So it is usually important to separate the two components.
And thus, we find that the rise in benefits was somewhat soft, but the increase in wages was +0.52%, the biggest rise since 2008 Q3 (see Chart, source BLS).
As I constantly remind people, wages follow inflation and do not lead inflation, so for me this uptick confirms the inflationary dynamic rather than starts me worrying. But those who worry about wages causing inflation will find reason to be concerned here, even though the overall ECI number looked benign.
(Wages do play a role in causing inflation to be more persistent, so this matters in that sense as well).
Don’t End the Fed…Just Ignore It
I’m not really sure what to make of the market action the last couple of days. I know Q1 earnings have looked good, but in a number of cases that was related to the very mild Q1 weather. Investors are being very credulous of the view that this represents real, lasting improvement and not a pull forward from Q2. (Remember, I’m not one who thinks the economy is on the verge of collapse, but I also don’t think it’s on the verge of exploding in a positive way either.)
The Fed was equally credulous yesterday. While there was no surprise in the Fed’s lack of action on Wednesday, nor any surprise that the statement was roughly unchanged, there was aggressive improvement in the Fed’s projections for 2012 since January’s estimates. In January, the central tendency of the FOMC’s individual projections for the Unemployment Rate this year was 8.2%-8.5%. In April, that became 7.8%-8.0%. That’s an aggressive improvement to a 9-month forecast in only three months. The Fed has proven repeatedly that they are no better at forecasting than Punxatawney Phil, so the forecasts don’t mean a lot – but what it should tell you is that they don’t seem to have much of a clue, if three months of data can change your 9-month forward Unemployment forecast by half a percent.
Their forecast for 2012 PCE inflation was 1.4%-1.8% in January; It’s now 1.9%-2.0%. Combining those alterations, if the Fed had any credibility, would mean sharply higher interest rates, because it shows the Fed thinks growth is faster and inflation is higher than they previously thought it was. In fact, if the Fed was perfectly credible, you’d believe them when they said that short rates will be held down until 2014, and you’d believe that the implication of their forecasts would be a rapid series of hikes thereafter. Ergo, the yield curve should be higher and more flexed: steeper from 2y-5y or 2y-7y and flatter from 5y-30y or 7y-30y. And yet, the 5y yield is down to the lowest level since February and 5y-30y is steeper than it was back then.
The market is basically ignoring the Fed, despite the fact that Bernanke said in the Q&A that it’s the Fed’s view “that it is reckless to accept higher inflation in exchange for possibly greater employment.” Of course he must say that, so it doesn’t have much content, but it’s still remarkable that the bond market is just brushing off the Fed altogether.
I hope the bond market isn’t putting too much stake in the recent worsening of Initial Claims, which surprised on the high side Thursday for the fifth consecutive week (in fact, if you consider the original survey compared to where Claims ended up after revisions, the consensus estimate has been too low in every seek since Feb 17th!). The chart below (Source: Bloomberg) certainly looks like there has been a sudden worsening in the job market.
But I think that would be a mistaken reading. In my view, the recent numbers are likely just payback from the weather-inspired strength in Q1, and my hypothesis is that the true underlying run rate has merely flattened out at 370k-380k. One reason I am not particularly worried about Claims yet is that the Consumer Confidence “Jobs Hard to Get” figure that I referred to earlier this week (and which is shown below) is ordinarily a better indication of true improvements in the employment situation.
It turns out that if you ask the average “man on the street” how the job market looks, he’s likely to have a pretty good feeling for it (in contrast to, on the other hand, asking about inflation – which no one internalizes well) because he has some idea of how many of his friends are looking for work. It’s a relatively clean number, unlike Claims.
The bond market might instead be reacting to ever-worsening news from Europe. The latest news today seemed to fly under the radar, but I think is striking. In a report in German paper Sueddeutsche Zeitung (summarized in English here), we learn that the ECB is working with Eurozone countries on a plan that would let banks access European Stability Mechanism (ESM) funds directly. Why is this a big deal?
Well, my first question is: since these banks can already access liquidity directly from their national central banks (and thus indirectly from the ECB)…why would the ECB want to have banks access the ESM directly? The obvious answer is that the ECB likely fears the impact that a default would have on its own solvency (which is to say, it would be devastating to the institution) and if banks borrow from the ESM it means the sovereigns backing the ESM…mainly Germany, France, Italy, and Spain…would be on the hook directly. Can you imagine the Fed saying that U.S. banks should borrow directly from the Treasury rather than from the Fed? What signal do you think that would send?
Yeah, that’s what I think too.
Whatever the bond market is looking at – whether it’s worsening conditions in Europe, or worsening economic conditions (which I think is a misreading) – it clearly isn’t what the stock market is looking at. If bond yields are low because of growth fears, then stocks are clearly ignoring that issue. If bond yields are low because of Europe fears, then stocks are clearly ignoring that issue. And frankly, even if bond yields are wrong because the recent worsening data is merely a give-back from a mild Q1, then stocks are still misinterpreting the recent earnings numbers.
I still own equity puts, although they are mostly worthless. I am still short bonds, long RINF and INFL (that is, long inflation expectations), long commodity indices, and long the dollar against the Yen. While I am not invested this way because I am a growth bull, all of these positions except the equity puts get penalized with a weak turn in the economy. Accordingly, I am inclined to trim the bond short and refresh the equity put position while implied volatility remains cheap. I’m still bearish bonds, but the trade hasn’t performed and the worst of the bearish seasonal pattern is past.
On Friday, the advance Q1 GDP number will be released. The consensus estimate is for a 2.5% rate, with a 2.3% rise in Personal Consumption. A stronger number probably implies a weaker Q2 as it would suggest more mild weather pull-forward, but the markets won’t see it that way!
Taking the Market’s Temperature
Forget for a moment, if you can, the European drama – the falling of the Dutch government, the possible imminent failure of the French one, and the ongoing heated argument about whether Europe can stand austerity (and whether that means austerity for all, or just for the periphery). If you want to take the temperature of the U.S. market, we have other tests worth considering.
It was revealed yesterday that Wal-Mart is the subject of a U.S. criminal corruption probe by the U.S. Justice Department, resulting from allegations of bribery in its Mexican unit Wal-Mart de Mexico. The company had already announced an internal investigation, but a criminal inquiry is another matter. This is potentially a good test for the equity market. A bull market tends to shrug these things off; a bear market tends to accentuate them. On Friday, Wal-Mart fell $2.91 (4.7%); on Monday it dropped another $1.77 (3%). The early returns are that the market isn’t taking it well.
The other proximate test is the earnings report for Apple, released today after the close. Apple reported great second-quarter numbers, handily beating estimates, but harshly revised its forward outlook lower. In bull markets, investors will focus on the current beat and speculate happily about how easy it will be to beat the lowered estimates. In a bear market, investors conclude that the beat represented sales pulled forward into the current quarter, don’t therefore give the company credit for the beat, and push the price lower since the future earnings (which after all are a more important part of the current price than the current single-quarter’s earnings) are expected to be weaker. Especially with interest rates (and therefore discount rates) low, this latter effect ought to be the dominant effect, but in my experience market reaction has had more to do with investor mood than analytics. With Apple, the shareholders form a virtual cult so expect to see many columns about how great it was that the company outperformed lofty expectations – and if Apple, already 13% off its highs over the last couple of weeks, cannot quickly stage a convincing rally (for more than one day!), it is a bad sign for the market as a whole.[1]
This is one way to take a market’s temperature. In the same way the way a boxer takes a punch can reveal whether he has a glass jaw, the way a market takes a metaphorical punch (or even perceives that a punch has been thrown!) can reveal much about the underlying strength of the bid.
Whatever investor confidence is doing, consumer confidence isn’t exactly buoyant. On the other hand, today’s 69.2 print on the Consumer Confidence index also wasn’t miserable: as recently as October, the index was at 40.9. Moreover, the critical “Jobs Hard to Get” subindex showed surprising strength, declining to 37.5 (see Chart, source Bloomberg) and giving hope that the recent Payrolls gains aren’t as ephemeral as some had thought they may be. Still, as the chart also shows – we’re a long way from a robust jobs market.
On Wednesday, the Federal Reserve will meet for the second day and release their policy decision around 12:30ET. The only additional data point they will see is a Durable Goods number (Consensus: -1.7%/+0.5% ex-transportation). If the Committee was going to do something hawkish, such as reduce the “at least” time frame for the projection of low rates, the odds are certainly better after two months of pretty good (although partially weather-induced) data and with the stock market high and having risen for months. I doubt, though, that they want to upset the gentle growth they’ve recently seen, especially with tensions rising on the Continent again.
As I’ve pointed out recently, some thinkers inside the fed have begun to question the usefulness of a permanently-low rate regime and the risk of the steady rise in money, which has pushed core inflation higher in 16 of the last 17 months. But those are still peripheral thinkers, and even the hawkish-leaning policymakers seem willing to go along to get along. At the same time, I think the odds of a QE3 announcement, or even hint, at this meeting is quite small for the same reasons cited above.
Now, the members of the FOMC mostly arrived at this week’s meeting by plane, and if any of them made their own reservations they may have noticed that domestic airfares have risen quite a lot recently. At least, I had noticed, and was not surprised to find that average domestic non-premium Y-class airfares reached a record $477 per ticket last month (see Chart, source Bloomberg, Airlines Reporting Corporation).
However, much of that record is due to jet fuel, which while near the highs of the last year is still 26% below the highs of 2008. The relationship between air fares and jet fuel is actually pretty interesting. From 1990-1998 or so, the gradual rise in air fares was decoupled from the jet fuel market, which was basically flat. After that period, but especially from 2004 onward, air fares more often moved in tandem with jet fuel prices (see Chart, jet fuel prices on right axis).
This point is actually made more powerfully by the following scatter-plot of the same data. Before 1998, air fares were essentially non-responsive to jet fuel prices. Since 1998, the variation in jet fuel prices explains 75% of the variation in the CPI-Airfares series (which is several levels down in the Transportation major group of CPI). Every penny rise in jet fuel prices causes a rise in air fares of about 0.09%.
The recent rise in airfares is somewhat beyond what would be expected from the recently-placid behavior of jet fuel, which raises the possibility that the increase represents other cost pressures, increasing profitability, or the influence of a general inflationary dynamic taking hold (also known as: our customers are expecting prices to rise, and we expect energy prices to resume rising, so let’s go ahead and increase prices). Now, air fares only represent 0.75% of the CPI, so if the year-on-year rate of increase went from essentially flat as of the March CPI to +13% where it was one year ago and where the Airline Reporting Corporation data suggest it could be heading, it would only add 0.1% to headline inflation. But the ample variability of air fares tends to increase the salience of the information in our minds – which is to say that in our personal CPI calculation, we will tend to overweight the importance of air fares, like we do gasoline, because the volatility makes it noticeable, and makes it hurt more.
I doubt that it will hurt enough to turn the FOMC into a bunch of hawks, but – these also aren’t the only prices that are rising visibly.
[1] By the way, I’m not necessarily a believer in bad karma, but if you are then you should be aware that at the end of the Apple earnings call the company played a strange saccharine song called “Happy.” Read the story, and listen to the song if you must, here.
Stalling?
Be careful here. The most dangerous market climates occur when the news and/or the economy is in transition. When things are great, everyone knows they’re great; the market may get overvalued but there’s not a catalyst for a drop. When times are awful, everyone knows they’re awful; the market may get undervalued (although this has not happened in a while) but there’s not a catalyst for a pop. It’s when the economy is in the middle of a phase change that sharp movements can occur as we shift from euphoria to lamentation, and sometimes right back, overnight.
The key test on Thursday was the auction of 10-year Spanish bonds. Spain also sold 2-year maturities, which gave it some flexibility to sell more of those and less of the 10-year and still sell “more than the €2.5bln target.” The bid:cover ratios were okay, but the 10-year got bombed after the auction, trading up 10bps in yield to 5.90%. Watch how this trades – it is very likely that some participants were arm-twisted into bidding, and those buyers will be dumping paper indiscreetly.
Meanwhile, in the background, Italian yields have been rising again as well. The 10-year bond is at 5.60% (see Chart, source Bloomberg). No one is worrying about Italy at the moment, because we’re all too busy worrying about Spain. But the positive momentum has evaporated there, as you can see from the chart. Somewhat amazingly, investors are completely ignoring the silly talk about the trillion-dollar firebreak. Today Poland announced it would contribute $8bln to the IMF effort. With Japan and Poland leading the way to saving Europe, we have officially descended into farce.
In the U.S., the economic data was weaker-than-expected. It wasn’t disastrous; the economy continues to grow, but isn’t gaining strength in any measurable way. Initial Claims were 386k (with an upward revision) compared to 370k expected. Philly Fed went from 12.5 last month to 8.5 this month (vs. 12.0 expected). Philly Fed is a good current illustration: the index measures not the level of activity, but the rate of change, by asking how conditions are compared to the prior month. So low, positive numbers means that growth is limping, but limping forward a little bit every month.
Existing Home Sales have fallen back after a couple of good-weather months. On the plus side, the inventory of existing homes remains near a seven-year low, which should help support the pricing dynamic in the housing market (as will the general buoyancy of inflation generally). More on housing, below.
Five-year TIPS were auctioned, and as is normal for the 5-year it was somewhat sloppy going in and coming out. Finding natural demand for long-dated real bonds is easy. Finding natural demand for shorter-dated real bonds is always somewhat iffy. After the auction, TIPS backed up 3-4bps across the board. Unlike with Spanish bonds, however, other investors are actually willing to buy TIPS at these levels (because, while very expensive, they’re still cheap relative to nominal bonds).
Tomorrow’s calendar is light, and trading will probably be thin. But as I say: be careful here.
.
The housing market is obviously still suffering, and one reason that the inventory of existing homes appears so manageable is that there is a considerable ‘shadow inventory’ of homes that aren’t on the market because the sellers are discouraged by market conditions. So it is even more surprising to me that we haven’t seen a development that some observers have been long waiting for in the U.S.: the home price indexed mortgage (hereafter abbreviated HPIM).
A HPIM is a loan, secured by a home, whose principal value rises or falls with the value of home prices. The index chosen for home prices can be a national index (which would enhance the securitization of the mortgage) or a more local index (which would more-closely connect the mortgage’s principal to the value of the particular home). The coupon is fixed, as with TIPS, but paid on a variable amount of principal. The principal amortizes over time as with a regular mortgage.
Various laws set up for the nominal world, and possibly taxation issues, have impaired the development of the HPIM in the U.S. But they exist in some other countries (e.g., Turkey), and theorists have spent some time examining the concept so this is not a “new” idea. But when the housing market was booming, and people saw their houses as leveraged speculative vehicles as well as places to live, borrowers also didn’t want to take a loan that they saw as likely to grow rapidly in principal value. Now, however, the value is more obvious:
If you are a homebuyer, you may be willing to take your time buying a home right now, fearful that prices could fall further. But with an indexed mortgage, if the value of the home falls then so does your loan. Therefore, there’s much less reason to defer a home purchase, which is one reason that HPIMs could help clear the housing market inventory. Also, while your total outlays will be similar if housing inflation actually turns out to be what is currently priced into the market when you take out your mortgage, the pattern of those outlays tends to help the homebuyer because the coupon payment would be lower than a nominal coupon, especially in the early years of the mortgage, as the inflation accrual adds to the principal.
At present, for example, 30-year mortgage yields are around 4%, so your interest payment on a $100,000 mortgage will be $333.33/month in the first month of the loan. However, the coupon on a HPIM would likely be around 1.5%, or $125/month, if long-term inflation is expected to be around 2.5%, and the principal would be expected to grow around 0.2% per month. And after one year (if no principal was paid, for simplicity) the coupon would be expected to rise to $128.12, which is 1.5% of the new principal ($100,000 * 1.025 = $102,500).
Again, in the boom years it would have been hard to persuade a homebuyer to give up his perceived upside, but notice that the “upside” depends on home prices rising faster than the nominal rate embedded in the loan. Still, a home financed with a fixed-rate loan does represent a serious inflation hedge in normal times. With an HPIM, however, the ability to participate in the upside doesn’t vanish – it is just limited to the amount of equity a homeowner has. So if I own a $100,000 house and I have an $80,000 mortgage and prices double, I still ‘participated’ in the home price rally: my asset is now worth $200,000, my liability is now worth $160,000, and instead of $20k equity I now have $40k equity. That’s not as good as if I had had a nominal loan, which is still worth $80,000 so that my equity is now $120k, but if I want more participation I can always buy more of my house back from the bank (that is, pay down the loan and build equity). In other words, with the HPIM structure a homebuyer cannot take a highly-levered speculative position in housing; however, you profit on the part of the house that your family, and not the bank, owns. This doesn’t sound like a bad idea, does it?
Moreover, the idea that taking out a mortgage to buy a house is a sure-fire way to build wealth was mostly a period myth anyway. Over the long haul, residential real estate grows at a real rate of only about 0.5%, which means that without a good bit of inflation, a mortgagor paying a fixed rate of 5% or 6% or 7% is actually falling behind in real value (even with the tax deductibility of interest, although that helps). It is true that in a boom, you can make lots of money borrowing 99% of a purchase that rises 15% in value every year…whether that purchase is a home or an internet stock. The problem is that you can lose it all by being levered in a bust, and you don’t do very well if prices simply stagnate.
As an investor, by the way, I’d love to be able to buy a bond backed by home-price-indexed mortgages. And the existence of such a market would allow the creation of bonds that paid inflation minus housing inflation; in other words, it would help the ‘inflation basis’ market germinate.
I don’t see much hope that this sort of mortgage is coming soon, because while there are proponents and theorists around for the concept, it is an innovation that requires some changes in legal and tax infrastructure – and there are few evangelists out there for this sort of product. But despite that, I am still a bit surprised that we don’t hear more talk about it – because it is a good idea.
Ghost Rally
Equities launched aggressively higher on Tuesday, driven essentially by pique.
The best that news hounds could do was to point to a good German confidence survey and the fact that Spain sold 12- and 18-month bills successfully. If that’s worth 1.55% on the S&P, I’m unclear on why. Selling T-Bills with gallons of LTRO money sloshing around shouldn’t be particularly challenging, especially because the bills will be rediscounted at the ECB for free carry. Give me a call when Spain sells 10-year notes to investors who actually have money at risk!
The Bank of Spain announced that banks under its supervision had made progress cleaning up their balance sheets. Last year, the government had estimated banks would need to take €52bln in charges, and banks have made a grand total of – drum roll – €9.19bln in improvements through the end of last year. They still need €29.1bln in additional provisions and will need to raise another €15.6bln as a capital buffer, so remarkably the Bank of Spain is claiming that banks’ conditions haven’t worsened since the original estimate.
Some other pundits pointed to optimistic talk out of Berlin, where a German minister said there was “no Spanish bailout talk” in Germany at the moment. That sounds more like a threat, but Schaeuble said “data don’t point to bailout.” The market was euphoric on this, and the DAX rose 2.65% on the day. Really? Ask yourself whether any finance minister or central banker would ever say “yep, we’re pretty sure those suckers are going down. I sure hope no one starts selling bonds right now before they default because that would really make things difficult!” You can listen to ministerial pronouncements with a bias: discount positive statements and take negative statements seriously (indeed, assume the negative statements are shaded to the optimistic side).
Overnight Monday night there was a headline that would have made a great April Fool’s Day joke. Japan announced that it is going to contribute $60bln to the IMF. Shouldn’t that be that the IMF is contributing $60bln to Japan? Where exactly does Japan plan to get this $60bln? Presumably they will borrow it, despite the fact that they are one of the world’s most-indebted governments with one of the worst demographic setups. Nice of them to contribute to the office gift, but for the sake of the gesture they could have just pitched in twenty bucks and signed the card.
U.S. data was modestly weak. Housing Starts printed 654k against expectations of 705k – but realistically, housing was never going to be what led us out of the housing-bubble-collapse – and Industrial Production was flat versus expectations of +0.3%. These aren’t dreadful, but not the sort of thing that +1.55% is made out of.
Now note this: total NYSE volume was only 665mm shares, fewer than traded on Monday and the lowest total in a month. This was a rally on vapor, a ghost rally. If this is supposed to produce the next leg of the rally, it is a foundation built on sand.
.
Following on my remarks yesterday about monetarist murmurs beginning to develop among some staffers at the Fed, I take notice today of two developments in other central banks.
First, after core inflation surprised the Bank of England by rising to 2.5% year/year (it was expected to decline, to 2.3% y/y), respected Bank of England policymaker Adam Posen said “If core inflation doesn’t come down on a sustained basis—then we have to rethink.” Now, core inflation in the UK had previously dropped from 3.4% in October to 2.4% in February (core inflation tends to move much more rapidly in the UK than in the US, simply because the nation is smaller and more homogeneous), so Posen has the wind at his back. In this way he is unlike, say, U.S. policymakers who are looking at 16 increases in core inflation out of the last 17 months. It is a prudent comment, even if it is easy to say in these circumstances: a surprise is a surprise, and though one surprise shouldn’t cause one to reject the null hypothesis (see yesterday’s comment for more on that), a thoughtful policymaker takes notice of the surprise. Especially if the policymaker doesn’t believe that monetary policy is magic.
Second, the Bank of Canada held rates steady but included some hawkish words in its statement:
“In light of the reduced slack in the economy and firmer underlying inflation, some modest withdrawal of the present considerable monetary policy stimulus may become appropriate, consistent with achieving the 2 percent inflation target over the medium term.”
That’s not drastically different from what some Fed officials have said unofficially, but it is far ahead of the FOMC in terms of official communication.
More thinkers are starting to question the wisdom of unlimited liquidity. I don’t think they’re about to change the majority thinking on the topic at the FOMC, but it does raise the stakes for the majority if there are some who have strayed from the reservation and might cause trouble if they turn out to be right. All else equal, the light increase in hawkish chatter globally raises the bar slightly (ever so slightly) for QE3 here or elsewhere.
Monetary Sedition
Is it really necessary to have a canary in the coal mine when the mine is belching clouds of noxious smoke? Today’s Empire Manufacturing Report surprised on the weak side by printing only 6.56 for April, the weakest number of the year so far although still well ahead of the lows from last year (see Chart, source Bloomberg).
With most recent data being acceptable, albeit not robust, this early current-month data will worry some observers. It doesn’t worry me very much, partly because the series clearly has some choppiness to it but more because I’m already fairly worried about how rapidly the European situation is unraveling again. I am generally towards the more-skeptical end of the spectrum, which tells me that it’s probably true that most observers thought that surviving the cliffhanger over the Greek funding package bought us 3-6 months, if not a year, of relative calm. That includes both the Pollyannas who really thought the worst was over, and those of us who were confident that the last chapter had not been written by a bailout that added to the debt burden of Greece.
The first hint was that the new Greek bonds immediately started trading with yields to maturity of 18-20%, but it is still striking that the dogs were only put at bay for one solitary month.
Because now that Spanish yields are officially back above 6% in the 10-year sector and Spanish economic ministers are publicly pleading with the ECB to buy bonds to support the market, the blood is back in the water. On Friday (but not getting much play until the weekend) there was also a report that net borrowings by Spanish banks from the ECB rose 49% in March, and that Spanish banks represent about 29% of the long-term borrowings from the ECB to Euro-area banks. The “net” number, which recognizes that some of the money that banks borrowed in LTRO was immediately re-deposited with the ECB, indicates that Spanish banks account for 60% of that “net” lending.
Curiously, equity markets took only executive notice of the rising temperature in Spanish debt markets, with the US bourse closing unchanged measured by the S&P. Indices with more Apple exposure closed weaker, and indices with less Apple closed stronger, as the Nifty One stock continued the now-stomach-wrenching decline started last week (see Chart, Source: Bloomberg).
It should be noted that 26% of Apple’s 2011 revenues, and about 21% of its growth in revenues from 2010 to 2011, came from Europe. I make no predictions about Apple’s future trajectory, but I will note that I was stunned to find that revenue for Apple’s hugely popular iPod line actually declined last year to a level last seen in 2005, when it was 40% of the company’s revenues as opposed to 7% now (as the iPhone is 44% of revenues in 2011). I wonder aloud (without stating a conclusion) whether a high-teens multiple ought to be attributed to a company that needs to reinvent whole product lines every six years. I guess the market is asking the same question, as the P/E is now down to 16.5. (By contrast, Microsoft has an 11.5 multiple, and its revenues have been roughly 30% “Business Division,” 30% “Windows Division,” and 20-25% “Server and Tools” for quite a long time. And MSFT pays a higher dividend. Disclosure: I have no position in either stock).
The other topic that was distracting from Spain discussions was the sharp decline in gasoline futures. Front gasoline futures fell to $3.267/gallon. Retail gas is up around $3.91, but this is almost the lowest that gasoline futures have been since early April. Brent Crude dropped to the lowest level since February, although NYMEX Crude didn’t decline very much. Some observers attributed these declines to agreement among the UN Security Council members (plus Germany) to go meet Iranian delegates in late May to talk about Iran’s nuclear program, but the fact that Brent and Gasoline fell further than NYMEX Crude suggests the real reason is more likely the growth fears emanating from Europe.
Interestingly, inflation markets mostly ignored the decline in energy markets. I wonder if the relative buoyancy of TIPS lately has anything to do with the persistent elevation of money supply growth. I have been harping on the steady rise in the broad transactional aggregate for a while – for at least 36 weeks, in fact. That’s how long that year-on-year M2 has been above 9.2%. To find a longer streak of such rapid money growth, you have to look back to 1983-84, when M2 rose at a 9.2%-or-faster pace for 56 consecutive weeks (see Chart, Source Federal Reserve).
There is some sign, at least, that there is starting to be some introspection around the Federal Reserve system about this money growth; perhaps rebellion is more like it. I pointed out on February 29th the article by St. Louis Fed economist Daniel L Thornton in which he said “While discussions of the money supply are nearly nonexistent in modern monetary theory and policy, both economic theory and historical experience suggest that a significant and persistent expansion in the money supply will be associated with a significant increase in the longer-run inflation rate.” Today, on the Federal Reserve Bank of Atlanta’s “macroblog,” senior economist Mike Bryan introduced a new animated video the Fed has created (the ostensible reason for the blog entry) by citing Fisher’s explanation of the difference between two types of inflation – one of which is purely monetary:
“If it can be shown, for instance, that today the good things of this world are becoming scarce on the one hand while money and its substitutes are not becoming plentiful it would be reasonable to conclude that the fault lies with goods and not with money. If, on the contrary, it can be shown that money and its substitutes are becoming plentiful and that goods are not becoming scarce, it is reasonable to conclude that the fault lies chiefly on the monetary side.”
Clearly, in the current instance the latter definition is the dominant force. It is interesting, isn’t it, that as far back as 1913 economists recognized that money could cause inflation even without growth-driven demand pushing on prices? And yet, today, this point is difficult for some economists to accept.
By the way, the video explaining the difference between increases in the cost of living (real prices) and inflation is very good (except that it makes you wonder why the Fed is letting the money supply grow so rapidly), and worth the four-minute investment.
I don’t necessarily think that the cheeky blog entries by the Atlanta Fed and the “Economic Synopsis” articles by St. Louis Fed economists indicate that the Board is about to rein in money growth, but it is heartening that the “nearly non-existent” minority opinion that money matters is starting to become at least a little more vocal. There is no rebellion, but there is sedition in the ranks.
The Problem With Small Surprises
The phrase “paradigm shift” is meant to sound dramatic. Like the sudden slipping of tectonic plates, a paradigm shift moves mountains (metaphorically). Deregulation of airlines caused a paradigm shift, transforming airplanes from airborne luxury cruises to cattle cars. Decimalization of equity bid/offers caused a paradigm shift, dropping bid/offer spreads about 90%.
Economic paradigm shifts can also be dramatic, as when the credit crisis of 2008 caused lending to contract almost overnight. But not all shifts are dramatic. The paradigm shift from horse-drawn carriages to ‘a car in every garage’ brought the world dramatically closer together. But it took a long time before it happened…before, anyway, it was obvious that it had happened. The paradigm shift was clear in retrospect, but not in prospect. It wasn’t as if people were waiting for the world to change: Henry Ford famously said that if he’d asked his customers what they wanted, they’d have said “faster horses.”
Core inflation, by its nature, rarely produces good surprises. Friday’s release was a case-in-point. Forecasters were looking for a +0.2%, and got a +0.2%, but they were actually looking for about +0.17% and got +0.23% instead. It doesn’t even look like a surprise, when the rounded data is announced, but it assuredly was one. The y/y core CPI, which decelerated last month for the first time in 16 months, rose back to 2.3% (although just barely, and shy of the high from January), after last month’s decline had produced a chorus of predictions that core CPI for the year would end up being in the low-to-mid 1% range.
It is hard to imagine that, following the 2008 collapse of Lehman Brothers, there were very many who didn’t see the paradigm shift. On the other hand, Henry Ford churned out millions of Model Ts before the wagon-wheel manufacturers went bust. Could we be in the midst of an inflationary paradigm shift without knowing it? Put another way, does the fact that many economists deny such a shift imply that there isn’t such a shift? Well, would the fact that many analysts still projected record profits for buggy-whip producers, which could plausibly have happened if our current research structures existed back then, have implied that there was no revolution happening in locomotion? I personally think it would have been very remarkable if an analyst covering such companies had deduced that the Ford development would change the demand/supply balance for automobiles in such a dramatic way.
This is not just abstract musing. In 2008, although the Fed was audibly speculating in May about how quickly the exceptional easing in the spring of that year (and late 2007) would need to be reversed, by October there was no mistake (although it took until December to lower the Fed Funds rate all the way to 0.25%). Missing the paradigm shift has implications, and thankfully the central bank didn’t miss this one although I would argue with what they did – I would not argue that central bank response of some kind was required. The accumulation of small misses, though, is more insidious. Traders know the phenomenon of getting nicked to death with small losses and only later realizing that these were signs that the game had changed. Economists are not good at this. Rejecting the null hypothesis requires a movement sufficient to refute the presumption that the result was merely noise. How do forecasters do that when the misses, as with core CPI, are small (but persistent)?
Part of the answer depends on your hypothesis. A truly ridiculous hypothesis – say, that the output gap drives inflation, so that we should have experienced a savage deflation in 2009-10-11 – should be simple to refute; however, we’ve seen even in this case that when the hypothesis is rejected, economists sometimes try to “fix the model” enough so that the hypothesis will not be rejected this time. This is bad economics, and it often comes even from otherwise good economists. It is hard to let go of a cherished old paradigm.
Better hypotheses, but still incorrect ones, create smaller misses, so that one point is almost never sufficient to reject the null. There are methods which can help identify when a series of misses is sufficient to (jointly) reject the null, although these have their own issues. More important, though, is the problem that economists are human and hate to be wrong, so they tend to try and reinterpret hypothesis rejections (I also hate to be wrong, but it happens so much that I am used to it; and, as a trader, I am at peace with fallibility because I must be).
Returning from the philosophical from the practical: at what point does the Federal Reserve admit at least internally that inflation is not going to self-regulate just because they say so? Already, we’ve seen the Fed move the goalposts from the presumptive 1.75%-2.00% target on CPI to an official 2.00% target on PCE, which is a 25-50bp nudge, and have heard many expressions from officials of the sentiment that “in the short run, inflation might exceed the target somewhat if we feel it is going to return to target.” That seems to me to be an approach designed to miss a paradigm shift as long as possible.
Year-on-year core PCE this month will likely reach the 2% target. Now what? I believe we may be in the middle of a paradigm shift from the 1%-2% low-and-stable inflation we have experienced in recent years to higher and less-stable inflation. The startling buoyancy of housing inflation, the possible shift in apparel inflation dynamics back to the 1970s-1980s paradigm, and the policy straitjacket all suggest that something very different is happening, or could be happening, at the moment. By the straitjacket, I mean that draining reserves, as necessary as it may become, will probably be more difficult to do technically than the Fed lets on, and would almost surely cause a large spike in interest rates while the Treasury continues to come to market with trillions more in new debt every year. Draining reserves while the Unemployment Rate is above 7%, especially during an election year, is almost out of the question. Trying to talk inflation down, while the only option at the moment, burns the credibility log (and like all logs, it can only be burned once).
I continue to believe the Fed is in a pickle, and the pickle will be worse the more time passes before the Committee recognizes that the inflation paradigm may have shifted. As I said, that will probably take some time.
The fact that Europe seems to be sliding back down from the comfortable but unstable equilibrium it had reached in March does not change my view. If anything, the probability that global central banks will continue to pour fuel on the fire in the form of banknotes increases, rather than decreases, the inflation risk. The news over the coming weeks and months will focus on the dramatic, while the important inflation paradigm shift takes place quietly, with small surprises, in the back pages of the financial papers.
The Prius Economy
A bona fide growth scare is upon us.
The first inklings of the scare may have come from China, a week or two ago, or perhaps from Spain as the 10-year Spanish yield rose through 5.5% and today ended conveniently at 5.99%.
Friday’s U.S. Employment report didn’t help. In recent months, employment had been rising a lot while the Unemployment Rate fell; but on Friday’s number, Unemployment fell due to shrinkage of the Civilian Labor Force despite weak job growth. That is clearly weaker-than-expected, and disappointing to some who thought the economy was surging. To my mind, it merely continues a recent theme of slow, weak, but positive growth. Hardly a growth scare, unless you were suckered in by the equity market to think there was robust growth.
That happens a lot, especially coming out of recessions. The naturally optimistic U.S. investor, prodded by the professionally-optimistic Wall Street broker, sees rising equity prices and assumes that stocks are starting to price good times ahead. That they are, and the goal of said brokers (and Washington brokers of the power variety) is to make the perception of good times trigger the reality of good times as higher prices beget a wealth effect. If it doesn’t happen, you get a scare.
But you can’t slap a number on the side of a Prius and call it an IndyCar. We have a distinctly Prius economy at the moment (actually, it may be more of a Pinto economy in that it could burst into flames if tapped lightly).
Perhaps that’s the fundamental question at the moment: is this a Prius economy – not pretty, but it’ll get us there – or a Pinto economy – potentially disastrous, given any provocation.
TIPS voted strongly for the Pinto version, as the yield on the 10-year TIPS bond fell 7.5bps to -0.26%. That was further than the nominal yield fell: 10-year nominal Treasuries rallied only 6.5bps to 1.98% (and the reversal of the breakout to higher yields is complete). The decline in TIPS yields implies that today’s leg of the rally, anyway, was led by declining growth expectations rather than declining inflation expectations. Indeed, 10-year inflation expectations actually rose 1bp, while 1-year inflation expectations declined sharply due to a sharp fall in gasoline prices (also growth-related).
Lower long-term growth expectations and a decline in near-term inflation expectations? That sounds like the sort of cocktail that would have produced a QE3 rumor just a week ago! But equities have dropped 4.3% over the last 5 trading days, with today’s 1.7% decline the heaviest-volume day of the five. The 916mm shares traded would be feeble by any standard except that of 2012, but would you believe today was the busiest day in the stock market of the year, with the exception of the March triple-witching and the three month-ends?
Oddly, the dollar was roughly unchanged. If the growth scare is sourced from Europe but the cold is caught by the U.S., where is the safe haven? Weirdly, the answer seems to be the Yen, which represents the most over-indebted developed economy with the worst demographic issues. Go figure, but the buck has fallen from 84 Yen to 80.7 Yen over the last couple of weeks.
Personally, I think our economy is more of the Prius variety, which has been my opinion for a while. Europe continues to be a basket case, and I keep repeating my conviction that it won’t be over until it’s over over there (and, unfortunately, before it’s over the Yanks may be coming)! But the U.S. will do fine, as long as you’re not looking for a big expansion. Low growth, and possibly a mild recession, are in our future…and that’s not the worst thing that has ever happened, it just feels like it since we’ve been told to expect the equity rally to be validated by subsequent growth.
Equities remain expensive even with the mild selloff. Until a week ago, the operative analogy for me was the rally in 2010 Q3 following the Bernanke quasi-announcement of QE2 at Jackson Hole in late August. There was a pullback in that rally as well – actually a deeper one – after QE2 actually showed up, until the liquidity gusher pushed stocks higher. The problem is that although we got the anticipation of the gusher, we didn’t get the gusher. And, unless we do, I think stocks will have difficulty rallying. And if the equity market won’t rally, it very likely will decline.
If (probably when) we actually get QE, then the equity rally will resume getting over-extended and ahead of itself, thanks again to the naturally optimistic investor and the professionally-optimistic stock jockey. When that happens, it will be time to look for the Pinto moment.
Keynes, Marx, and Bernanke
These days, the glimmerings of crisis are never far away, are they? Today, the sign was a very weak government bond auction in Spain, which caused 10-year Spanish yields (Portuguese and Italian as well) to rise about 25bps. Ten-year Spanish bonds now yield 5.69%, near the calendar year’s highs although still considerably lower than the spike highs of last July and last November (see Chart).
However, during those prior episodes Spain was not merely reflecting its own fundamentals but those of its sick brethren. Compared to the German 10-year, the current spread around 400bps is just as high as it was in July of last year and only about 65-70s shy of the peak in November.
Meanwhile, in the last few days the German central bank and now the Austrian central bank have each declared that they will not accept Greek, Portuguese, or Irish bonds as collateral. Greece, remember, has been “saved” and the new bonds are supposed to be money-good; however, the yields on those bonds has risen since the exchange was made. The Feb-2023 maturity initially traded around 19% but has risen to 21.5%. If this is what healing feels like I’m sure glad we’re no longer hurting!
In the U.S., General Electric was downgraded by Moody’s to Aa3 from Aa2, and GE Capital downgraded to A1. Investors shrugged off this news, which GE claimed was due to a change in Moody’s methodology rather than a change in GE’s credit rating. That seems a risky claim, because the counterargument would be (assuming that Moody’s isn’t making their methodology worse) that GE (and more especially GECC) has been rated too highly in the past. GE stock declined in line with the broader market, although credit default swaps moved wider.
Equities dropped around 1%, largely from the news delineated above but also partially in follow-through to the “disappointment” that the Fed said exactly what they had been saying previously. However, bonds also rallied, and this wouldn’t make much sense if the main impetus for today’s movements was disappointment over the Fed’s failure to provide support for the bond market. This is why I attribute most of today’s movement to a renewed rise in the temperature of the European crisis.
Precious metals were killed, losing 4.2%, and commodities in general declined. For a change the move in commodities makes some sense, if you believe the tiny alteration of the Fed’s direction in the minutes was significant, if you think the Fed is serious, and will pull back on liquidity rather than just fail to add more, if commodities weren’t already very cheap, and if the easing of other global central banks was irrelevant. But if the decline was related to the Fed’s tilt, then at least the commodity decline is the right direction, because the adjustment in the Fed-speak (if there was an adjustment) concerned cooling the degree of monetary support; prior recent declines in commodities have come due to growth fears that I don’t think are particularly relevant right now to the outlook for commodities in the medium term.
.
I routinely deride economists who rely on the discredited notion that growth in excess of a nation’s productive capacity is what causes inflation – and, conversely, a surplus of productive capacity is what causes deflation. See, for example, here, here, and here. And that is just in the last month!
I want to point out that it isn’t that I don’t believe in microeconomics (where an increase in supply causes prices to fall and a decrease in supply causes prices to rise). I believe deeply in the supply-demand construct.
But the problem with applying these ideas to the macroeconomy is that people get confused with real and nominal quantities, and they think of the “productive frontier” of an economy as being one thing rather than a multi-dimensional construct.
When an economy reaches “productive capacity,” it isn’t because it has used up all of its resources. It is because it has used up the scarcest resource. Theory says that what should happen isn’t that all prices should rise, but that the price of the scarce resource should rise relative to the prices of other resources. For example, when labor is plentiful relative to capital, then what should happen is that real wages should stagnate while real margins increase – that is, because productivity is constrained by the scarce resource of capital, more of the economy’s gains should accrue to capital. And so Marx was right, in this sort of circumstance: the “industrial reserve army of the unemployed” should indeed increase the share of the economic spoils that go to the kapitalists.
And that is exactly what is happening now. In the banking crisis, the nation’s productive capacity declined because of a paucity of available capital, in particular because banks were forced to de-lever. Output declined, and after the shock adjustments the margins of corporate America rose sharply (which I recently illustrated here), near record levels from earlier in the decade of the 00s. And real wages stagnated. Be very clear on this point: it is real wages which are supposed to stagnate when labor is plentiful, not nominal wages.
Now, what should happen next in a free market system is that the real cost of capital should decline, or real wages should increase, or both, as labor is substituted for capital because of the shortage of capital. We indeed see that the real cost of capital is declining, because real rates are sharply negative out to 10 years and equities are trading at lusty multiples. But real wages are stagnating, going exactly nowhere over the last 36 months. Why is the adjustment only occurring on the capital side, with bull markets in bonds and stocks?
We can thank central bankers, and especially Dr. Bernanke and the Federal Reserve, for working assiduously to lower the cost of capital – also known as supporting the markets for capital. This has the effect, hopefully unintended, of lowering the level at which the convergence between real wages and the real cost of capital happens; and of course, it obviously also favors the existing owners of capital. By defending the owners of capital (and, among other things, refusing to let any of them go out of business), the Fed is actually helping to hold down real wages since there is no reason to substitute away from capital to labor!
But all of this happens in real space. One way that the real cost of capital and the real wage can stay low is to increase the price level, which is exactly what is happening. We call this inflation.
.
On the last full trading day of the week, Initial Claims (Consensus: 355k versus 359k last) represents our final chance to try and trade the Employment number before the actual number is released. ADP was right on target today, giving no clues about which way traders should lean going into Friday. I expect this means that traders will spend the afternoon trimming positions that they would be ill able to cover on Friday if there was a surprise on the Employment number. That probably means more weakness on stocks and possibly some further strength in bonds.
This Is Your Brain On Leverage
The event du jour on Tuesday was the release of the FOMC minutes from the March 13th meeting. There was almost nothing surprising in the minutes, although the market’s reaction suggested otherwise.
Prior to the release, there had been some very odd reports from respected sell-side shops (such as Goldman) that predicted the Fed was about to announce an extension of Operation Twist or some other policy initiative. Those reports were nonsensical. This was not an FOMC meeting; it was the release of minutes from a meeting several weeks ago. The Fed has never use the minutes as a way to announce new policy measures; not surprisingly, new policy measures that need to be announced are announced, either in the statement following the meeting or on rare occasions in a separate news release. It is a real head-scratcher to me why these economists in the last few days suddenly decided that the FOMC minutes might be the place we find out about an official new policy.
At best, the minutes occasionally reveal more concern, or less concern, about a particular economic variable than the market expected, or more interest or less interest about a particular policy tilt. The one quasi-surprise in these minutes was that the Fed explicitly stated that their description of the period of extremely low rates “at least” until mid-2014 was conditional:
“It was noted that the Committee’s forward guidance is conditional on economic developments, and members concurred that the date given in the statement would be subject to revision in response to significant changes in the economic outlook. “
In other words, it isn’t “at least” at all. Rates will be low until they need to be increased, which means it was complete idiocy to ever put a date in the statement to begin with. If it is a promise, it bound their hands unnecessarily; if it was not a promise, then (a) why say it at all, since the operating understanding is that the Fed will change rates when it feels conditions require, and (b) learn some English, and don’t put absolute phrases like “at least” in statements meant to be squishy on timeframe. I draw the almost inevitable conclusion that the Fed believed we cared about their forecast of economic conditions two years forward, as if they not only are not the worst economic forecasters out there, but actually are dramatically better than most other economists who feel that a 6-month forecast has pretty big error bars.
Either that, or the statement was never meant to do anything other than jack around with interest rates. Perhaps it shouldn’t be surprising that the Fed, and even the Chairman himself, are alternating between saying dovish things and saying hawkish things (or re-interpreting prior dovish statements to appear more hawkish). The Fed’s main tool right now is its “communications strategy,” in which it wants to talk down inflation expectations while also talking down interest rates. The former requires hawkish talk, while the latter requires dovish hints. While QE3 is probably still coming (although I don’t see a “sterilized Operation Twist,” which doesn’t really accomplish anything I can think of), it’s a decidedly more-difficult operation now when core inflation is at 2.2% and global inflation is rising than when it was at 0.6% and bottoming. Before, they didn’t mind if inflation expectations rose; that also suited their purpose. Now, though, it would damage the same purpose.
The reaction in the bond market was swift and violent although the ‘disappointment’ was small and insignificant. The severity of the move – 10-year rates rose 14bps in minutes – is a direct result of the Fed’s policy of pegging interest rates and trying to be very transparent. In short, rates are so stable that “2 basis points is the new 5 basis points.” With no market movement, traders and investors put on larger positions because they are confident that there won’t be violent moves with Sheriff Bernanke on the watch, and because to make any money at all from a trading position, trading size needs to be larger. When there actually is a market move, the move will tend to be more violent because positions are larger (and, because of the Volcker Rule, liquidity once the market leaves its safety zone grows thin quickly).
You can see this in the curve’s movements today. While the main change was that the FOMC made the unconditional rate pledge entirely conditional, 2-year rates moved only 4bps. But 5-year and longer rates rose 12-15bps on the announcement (the 10-year note is now at 2.30% again). Honestly, 2-year notes at 0.37% if the Fed isn’t promising to keep rates low seems a little rich to me (meaning that the yields are too low), if only because of the relative lengths of the up and downward tails (since the bearish tail is not truncated by the Fed promise!), although I happen to believe the economic situation is such that the Fed will end up honoring its pact despite inflation that will continue to accelerate.
Nonsensical was the trashing of TIPS today. Inflation-linked bonds fell just as far as nominal bonds, so that inflation breakevens were approximately flat on the day. That’s wild. It isn’t as if the inflation outlook depends on the next trillion in Fed-sponsored liquidity! The global spigots remain on, and the Fed has already done far more than enough to ensure inflation will keep rising unless money velocity rolls over again. 10-year breakevens have risen this year from 2.00% to a recent high of 2.45%; at the current level of 2.35% they remain an easy buy. 5-year breakevens at 2.06% are an even better deal, since headline inflation over the next year will be well above that level thanks to gasoline. You’re buying forward inflation there at a very cheap level, in my opinion. (Retail investors can’t directly access the short inflation part of the curve, although they can participate in a general rise in inflation expectations through the INFL ETN and the RINF ETF. I own small positions in both of those securities and have no plans to change that position in the near-term).
To be sure, negative real rates are not sustainable in the long run, and while the 10-year TIPS real rate of -0.07% is starting to look almost cheap compared to where it has traded in the last six months – and indeed, I think investors will scoop them up at 0%, and 30-year TIPS if they get to 1.0% – they probably won’t be there a year from now. But TIPS are still a better deal relative to nominals, so if you must own some fixed-income, I prefer to position in real rates.
Wednesday’s main release is ADP (Consensus: 206k from 216k). Although this report is losing its punch as it fails to track the Payrolls number well, in this case there may well be more attention paid to it than usual because the Employment Report will be released in thin market conditions this Friday during a half-session recognizing the Good Friday holiday. Accordingly, if ADP contains much of a surprise, you may well see an outsized-reaction.
