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From May Day to Mayday
By the time the calendar turned to May, one month ago, we already knew that the economy was weakening. The jury is still out on whether the weakening in the U.S. economy is due entirely to payback from the unseasonally good winter weather, but over the course of the month it became clear to most observers that the data were coming in soft. The exception to that rule was the inflation data, but we have been assured that worry is needless.
But back in the halcyon days of April we were just beginning to realize that the Greek “bailout” had not kicked the can down the road sufficiently far. Bankia had not failed, and Spain was not yet so threatening as it is today. And certainly, the head of the ECB had not yet taken to calling the Euro framework “unsustainable,” as he did today:
“That configuration that we had with us by and large for ten years which was considered sustainable, I should add, in a perhaps myopic way, has been shown to be unsustainable unless further steps are taken,”
Lest we forget how far we traveled in May, here is a quick summary of the way we were: (Source: Bloomberg)
|
4/30/2012 |
5/31/2012 |
Change | |
| Crude |
104.87 |
86.54 |
-17.5% |
| Gasoline |
318.44 |
282.5 |
-$0.36 |
| DJUBS Ag |
160.8088 |
144.8983 |
-9.9% |
| DJUBS Softs |
153.9553 |
135.8419 |
-11.8% |
| DJUBS Prec Metals |
514.6371 |
477.9181 |
-7.1% |
| DJUBS Ind Metals |
326.637 |
295.1249 |
-9.6% |
| Dollar Index |
78.776 |
83.066 |
5.4% |
| S&P 500 |
1397.91 |
1310.33 |
-6.3% |
| Spanish 10y yields |
5.77% |
6.56% |
+79bps |
| US 10y yields |
1.92% |
1.56% |
-36bps |
| US 10y real yields |
-0.35% |
-0.56% |
-21bps |
| US 10y breakevens |
2.24% |
2.09% |
-15bps |
Those are the financial market indicators, but we could go further. Initial Unemployment Claims for the last week of April were 368k; for the last week of May, the figure was 383k. That would seem to be the wrong direction. ADP was also weaker-than-expected at 133k. More concerning perhaps was the Chicago Purchasing Managers’ Report for May, which fell to 52.7 (the lowest figure since 2009) instead of rising to 56.8 as expected. The chart below suggests that the recent numbers have been weaker than the prior numbers were strong.
Stocks sank, although slowly, until the S&P reached and briefly sank below the 1300 level again. Then, for the second time this week, the market rallied on a poll showing the largest pro-austerity party in Greece leading the largest cancel-bailout party by 26% to 24.3%. Yes, that’s right: a 1% increase in the aggregate value of the equity market in the U.S. in response to a polling that was within the margin of error!
If you sold in May, I hope you went away because there weren’t many places to hide. Bonds were the clear winners, but with core inflation rising in virtually every country that is obviously a limited-time offer. Today, year-on-year core inflation in Europe exceeded expectations for the second month in a row. European HICP ex-tobacco, food, and energy rose 1.6%, matching last month’s figure and the high since 2009. (You wouldn’t know this from the widespread headlines of “Euro Zone Inflation Drops to 15-Month Low,” focusing on a headline figure that pundits hope can be interpreted as giving the ECB more room to ease. I fully expect that to happen, and for the Fed to also ease as the European disaster grows more frightening. It isn’t necessary for inflation to be falling, and it won’t matter that core inflation continues to rise. Central bankers simply won’t consider inflation to be a matter of signal importance compared to recession/depression fears.
What a month it has been. And as May draws to a close, we are plainly getting close to a mayday cry.
The Not-Laid Plans Of Mice And Men
The nice aspect about Europe being the only thing that matters these days is that I don’t have to wait until the end of the U.S. trading day to begin writing an article. All of the damage is done early in the day, and then we watch the markets trade more or less sideways or sometimes even correct a bit once the sun sets on the Continent.
Wednesday was no different. Earlier in the week, there had been some optimism that Greek voters on June 16th might vote into power a bailout (and austerity)-friendly coalition. With weeks to go before the election, this seems a thin reed on which to base a strong rally, especially since the polls in question are both highly variable and highly suspect, given the perceived extreme importance of the election. Personally, I don’t see the election being extremely important – mathematics trumps politics, so no matter who wins the election the outcome won’t change. Greece will almost certainly leave the Eurozone, and the only questions are how soon it will happen, and how prepared Euro institutions will be. The answer to that latter question is somewhat frightening, since the headlines last week focused on how this country or that agency or that supranational organization was “discussing contingency plans” in case Greece exits the Euro. It is incredible to me that such a contingency hasn’t already been discussed in each of these institutions sometime over the last year, even if a Greek exit was seen as very unlikely. It’s prudent to plan! (Then again, I spent hours last night getting home because New Jersey Transit had no plan in place describing what to do if a tree fell on the tracks).
The optimism early in the week faded quickly and markets were more or less in rout mode today. Spanish 10-year yields rose to 6.65% (see Chart, source Bloomberg), near a new crisis high, so we are only days or at most weeks away from that situation coming to a head.
In Spain, the bailout of Bankia has taken on a drama all of its own. The original estimate of the size of bailout required was, of course, too low. Spain cleverly proposed to inject €19bn of its own government bonds to Bankia, that is would then use as collateral to borrow actual money from the ECB. Spain would count this as an investment, rather than as a debt, so that it would improve the country’s balance sheet rather than worsening it. The ECB thought this too clever by half, and by the way far too transparent a violation of the ECB’s stricture against “monetary financing of governments,” and rejected the plan out of hand.
But that’s okay, because this morning some EC functionaries passed around the notion that they were “open” to using the ESM to lend directly to banks. Markets rallied euphorically but briefly on this news, but the rally quickly failed on some little details…such as the fact that the ESM isn’t set up yet. Actually, the best discussion of the merits and demerits of this idea was Peter Tchir’s article “National Acronym Day in Europe. Don’t Underestimate the ECB.” Pete explains why there’s some desire to use the ESM rather than the EFSF:
“If ESM can be launched, and it can get a banking license, then the EU has a powerful tool. The ESM is allowed to do all the things the EFSF can do – participate in new issues and the secondary market and lend to countries for them to support their banks. Without a banking license its firepower is limited. With a banking license it can leverage itself to a very high degree and can tap all the cheap funding already in place and whatever new programs the ECB decides to launch.”
As Pete and others noted, the fact that the ESM isn’t set up yet is an important qualification of this idea. The other qualification is the fact that Germany and Finland, whose backing is absolutely required if the ESM is to have any value at all, flatly rejected the idea.
Markets erased all of Tuesday’s gains and then some, with the S&P dropping 1.4% on the day. Commodities, which increasingly seem to be suffering from divestment flows (and possibly momentum players on the downside), fell also with the DJ-UBS down 1.3%. That index is -8.4% on the month, even worse than the -6.1% of the S&P. NYMEX Crude was -3.7%, Gasoline -2.2%. In fact the commodities for the most part were down in direct proportion to their liquidity, with the main exceptions being gold and silver. Yes, the dollar is strong versus the Euro, but it is weak versus the yen! The buck is nearly 6% weaker versus the Yen since its highs in March, and 7% stronger against the Euro. Fortunately for commodities bears, Asians don’t use commodities…right?
Confounding expectations, including mine (although thank heavens I covered that short-bond trade), nominal and real rates continue to decline. The 10y Treasury yield hit 1.62%, 13bps lower on the day, while the 10y TIPS rate fell to -0.48%. The 30-year real rate is now only 0.55%. While real rates and nominal rates continue to hit record lows, inflation expectations do not. 10-year inflation swaps ended the day around 2.41%, well below the 2.75% of March but still well above the 2.20% of last autumn, the 2% of autumn 2010, and the 1.25% of late 2008 (see Chart, source Bloomberg).
As silly as it was for the EC to propose using an ESM that isn’t even set up yet, I actually think that the idea is targeting the right response in a way. The best (remaining) solution, in my view, involves kicking out the weaker members of the Euro and then bailing out the banking system with the huge amounts of money that will be required. Yes, it will have to be printed because there’s just not enough real capital available. But the Euro is untenable in its form, at least now. And any disaster that supposedly follows the exit of one or more members will primarily stem from the carnage it would inflict on a financial system that is loaded to the gills with sovereign debt.[1] Bailing out the financial system – not indiscriminately, mind you, but favoring the stronger albeit not necessarily the larger institutions – won’t be popular but is not entirely unfair in this case since the banking problem in Europe was partly caused by dumb regulatory risk weightings that encouraged banks to hold more sovereign debt, partly by ill-considered moral suasion used to persuade banks to hold more sovereign debt, and only partly by poor risk management.
That solution will never happen, because it would require a whole lot of legislatures to authorize some extreme solutions, and such an approach is not politically palatable. What is more likely to happen, because it is constituted of bite-sized political pieces, is closer to the worst case: don’t kick out the weaker Euro members, so that the imbalances remain, and bail out banks in serial fashion rather than all at once.
Not that there weren’t better solutions, mind you, in the past – but the time for them is gone. We’re down to just hard solutions. In this case, the cheapest fix remaining will be liberally applied: cheap money. Yes, I know that the Fed is insisting (as Fisher did today) that more stimulus isn’t needed. And they’re right, because stimulus doesn’t work. But it’s still perceived as a cheap lunch, and as the situation in Europe worsens and the bank runs accelerate, central bankers will fire up the technology that fired up Bernanke’s imagination back in 2002: the printing press.
Back on the boring side of the Atlantic, tomorrow ADP (Consensus: 150k) and Initial Claims (Consensus: 370k) will be released. There is reason to be wary of these numbers. Last month ADP came in at 119k, which was well less than expectations. History shows that with ADP economists tend to miss in the same direction at least a few times in a row, so another soft print is likely. It’s unlikely to show the economy is collapsing, but it will reinforce the sense that the U.S. economy is slowing, and unlikely to be robust enough to pull Europe (and perhaps China) out of the tailspin. This will not hurt the bond market, but if the data is weak…yet not dramatically weak…then equities may get a bounce from the idea that QE3 just got closer.
[1] Of course many other businesses will suffer losses on cross-border contracts that were poorly constructed, not providing a fallback currency arrangement to the Euro. This violates the girlfriend rule of thumb: Don’t make plans that are further in the future than you have been together so far. Greece joined in 2001, so if you wrote a contract in 2007 that went further out than 2013 without a fallback mechanism, shame on you!
Ripping The Bandage
As a follow-up to yesterday’s article, we take note of the home price data in today’s reports. New Home Sales median prices didn’t echo the spike in existing home sales, but as I said yesterday it is hard to draw much conclusion from this series, when there is so little volume that prices jump around significantly (see Chart, source Bloomberg).
However, on the other side the FHFA Home Price Index showed its biggest leap in at least a couple of decades. Again, one point does not a trend make, but the odds that existing home prices are actually rising – at least for the homes that are changing hands – just went up again.
But not all observers agree, to be sure. Readers of yesterday’s comment fell into several natural categories. One large such category was the group that feels the large amount of shadow inventory that is held by banks in their REO books, as well as homeowners who are holding their homes off the market in hopes of higher prices, virtually guarantees lower prices.
I don’t disagree with the general notion. The housing overhang is certainly not cleared, and it will take a while for it to do so. But the expectation that this inventory will depress prices further is based on a misunderstanding of the supply and demand relationship. It’s really the fault of sloppy microeconomics texts, that tended to draw “supply and demand” charts with “Price” on the vertical axis and “Quantity” on the horizontal axis. This is accurate in the static equilibrium sense, when we are just taking a snapshot of the demand and supply curves to figure out the clearing price and quantity right now. But it glosses over an important detail and so misses conveying the richness of the relationship.
The “Price” axis need not be in dollars. There’s no reason that it must be so – any exchangeable good will do. If I have a supply and demand curve for Yankees tickets,[1] there is no reason that I can’t have the ‘price’ axis in units of cups of beer. (In actual fact, that exchange regularly happens, as when one person says “come on buddy, I’ll take you to the game and you buy the beer.”) The curves will look similar, and there will be an intersection quantity and the clearing price will be in units of beer cups. Or ounces of gold. Or acres of farmland.
By putting the units in terms of dollars, we have to be very careful about interpreting shifts of the supply curve or the demand curve. Importantly, we must remember that when we shift those curves the assumption is that the shift happens instantly. When we use units of price that change in value constantly – as does the dollar – the intersection of quantity and price can move just because time passes. It is perhaps more useful to think of the “Price” axis as being in terms of “consumption baskets.” How many consumption baskets will I exchange for that new car? Let’s say the answer is ten. Next year, the answer will still be ten (assuming no change in my preferences). But if I answered in dollars, then the answer is different, and will tend to rise over time as the value of that dollar diminishes.
So yes, to clear excess housing inventory it’s essential that home prices fall. But it isn’t essential that they fall in nominal terms. If home prices rose 5% next year, but the price of everything else went up 25%, homes would be cheaper. This is actually better than seeing nominal prices fall by 20%, because it removes any incentive to default on a mortgage that is fixed in nominal terms.
Remember: supply and demand cross at the clearing real price and quantity, not the clearing nominal price and quantity, unless we are explicitly speaking only about an instantaneous equilibrium.
This misunderstanding is the same one that is at the heart of the commodities slide, which is beginning to feel to me more like momentum trading than investment flows. I keep hearing that commodities are declining on growth fears, but if that is so then why are coffee, hogs, and cotton leading the way down and not gasoline and copper? (And, by the way, how come when stocks decline it’s a “buying opportunity” but when commodities go down, everybody thinks the world is coming to an end?) Commodities got pummeled again today, with the DJ-UBS down by -1.6%. Stocks got smacked early on and played with the 1300 level again, but managed a rally in the afternoon and actually ended with a gain of +0.2%. Bonds rallied again, and inflation swaps fell.
The near-term concern of course is Greece, with more and more stories coming out confirming that various European institutions have been developing “contingency plans” in the event that Greece leaves the Euro. Some observers think that Greece might even do it this weekend.
Once you’ve decided that the bandage needs to come off, the best way to take it off is to just rip it off in one motion. So, if Europe has finally come to that view, then the right thing to do is to just go ahead and do it at a time of your own choosing rather than letting events take the timing out of your hands. I seriously doubt that Greece will leave the EZ this weekend, with an election just a few weeks away, but it wouldn’t completely shock me. I’m more shocked by the idea that all of these institutions are just now developing their contingency plans, when it has been clear for months, years even, that Greece had to leave the Euro. And I am a little shocked that markets apparently had completely discounted this possibility until recently, and are surprised.
Thursday’s economic data consists of Durable Goods (Consensus: +0.2%/+0.8% ex-Transportation), which ought to show a partial rebound after an awful -4.2%/-1.1% showing last month. Initial Claims are expected to be unchanged at 370k. And liquidity will begin to suffer in the afternoon before a thin session on Friday.
[1] We assume here that they intersect above a zero price.
Real Estate – A Good Investment Again?
After the comparatively high-volume selloff on Friday, the stock market responded with a low-volume rebound on Monday (except for new IPO FacePlant, which is now 18.4% below the IPO price) and a low-volume, water-treading session today. Monday’s rebound was punctuated by chirps of “oversold!” from certain financial news networks, but unfortunately nothing fundamental has changed other than the price.
Existing Home Sales were reported today as-expected. Inventories of existing homes rose, but this was strictly in line with the normal seasonal pattern (see Chart, which I mainly show to illustrate a neat new Bloomberg function I discovered).
Using the same style chart, though, consider what happened to the median sales price of Existing Homes. Ordinarily, the non-seasonally-adjusted price in April is down 0-5% from year-end prices. This year, though, NSA prices are up about 10%.
To the man who has a hammer, everything looks like a nail, it’s true. But to me, this is a remarkable chart that smacks of asset price inflation in housing. Consider that Existing Home Sales, at a 4.62mm seasonally-adjusted pace, are running at about 65% of 2005’s pace, and only 88% of 2000’s pace. The pace of sales is still quite a bit depressed, in other words, yet the year-on-year rise in prices is about 10.4% (see the chart below, which is a more-normal time series). Prices in other words rose much more-rapidly in April than they typically do at this time of year, despite the level of unemployment and other, various measures of economic softening.
Don’t read too much into one month’s data, even if it is entirely consistent with what should be happening given the accelerating rise in bank lending and the persistent rise in money supply. But be wary.
Housing is, as I’ve been writing for a while, near fair-value or even slightly cheap after a long period where it was overvalued compared to traditional relationships to income and rents. (The same people who today tell me I am too bearish on stocks are the ones who told me I was too bearish on housing back in the mid-2000s. But I’m not even that bearish on stocks – I’m just not bullish enough for some people!) It is, as commodities are, a classic “real asset” that doesn’t return very much, but tends to keep up with inflation over long periods of time. It ought to respond to money growth, now that the bubble seems to have run its course. However, I’m as surprised as you are that it seems to be happening – I thought, as did many of you, that housing prices would fall straight through fair value and become cheap. And they probably would have, had central banks not printed so much money.
Ironically, the other classic “real assets” are commodities, and they continue to get pummeled. The DJ-UBS index lost another 1% today, with grains and softs losing 3.4% and 2.4% respectively. I think that what is happening is that since commodities are traded and consumed internationally, it is easier to get confused about the role that the global growth dynamic should play. Case in point is cotton, which was -3.9% today and now sits 68% off the highs from March 2011. Someone in China mentioned that yarn production may drop below 20 million metric tons this year, from 20.5 million last year, due to weak global growth. -0.5 million tons translates into -68% on the price? That’s one inelastic supply curve! But weak global growth clearly shouldn’t really affect the price of a house in Idaho, so this error doesn’t translate as easily to housing as a real asset. Therefore, housing prices are now rising (maybe) while commodity prices trade incredibly cheap (although gasoline futures prices rose 5 cents on Monday).
It has been a long time since it was worthwhile to watch the housing numbers, but today’s pricing data raises my interest in the New Home Sales figures tomorrow (Consensus: 335k vs 328k). It isn’t the number of new sales that interests me; that number is low and even with a high-side surprise will continue to be low compared to old standards for a long time. But since the inventory of new homes is at a life-of-series low (see Chart) I will be looking for signs that the bids are starting to reach up for the offers.[1]
The median price series for New Home Sales isn’t as smooth as the one for Existing Home Sales, simply because the absolute number of sales is much smaller. But if there really is something going on in home prices, I’ll expect to see it in New Home Sales in the next month or two as well.
In any event, with 1-year CPI swaps ending today at 1.44% and 2-year swaps at 1.69% – let’s just say I wouldn’t want to be caught shorting that market at these levels! Core inflation is at 2.3%, so you’d better be expecting either a sharp fall in core or a huge drop in gasoline prices. Neither appears to me to be in the cards – there’s a better chance of gasoline prices falling in the near-term if there’s an economic train wreck in Europe, but in that case go out another year: the 2-year at 1.69% implies 1y, 1y forward inflation of only 1.94%.
[1] As an aside, a reader in Phoenix told me recently that bids there and in Vegas have been getting jumpy recently, all of a sudden starting a few months ago. “Pull up Redfin and try to call an agent about a property in Mesa, Tempe or Scottsdale. If a house is out on MLS more than a day they likely have 10 bids stacked with an agreement above the ask. This just started ~60-90 days ago and has accelerated. Crazy, like no one remembers 2008-2010.” It was an interesting anecdote – but now the data are reinforcing that observation.
Cooler Than The Sun
In the long run, the market is a weighing machine.
It is imperative to keep that bit of Ben Graham advice always in mind whenever you invest. Day traders can ignore whether the market is a weighing machine in the long run, since they just look at the “voting” patterns and go along with price action. But those of us investors who make moves more deliberately can best add to our performance by simply avoiding assets that are expensive, even if they may become more so, and overweighting assets that are cheap, even if they may become more so.
If you’re a good market timer, then bless you – keep at it. But you have to be a pretty decent market timer to outperform a simple value investor in the long run. I do believe these market timers exist. I just don’t believe as many of them exist as think they exist.
This preface is of course a lead-in to the observation that the decline in equities recently, including today’s -1.5% slide, is anything but shocking. The dividend yield and price multiples, the Q ratio, the high margins that necessarily must be sustained to justify these levels – I’ve written about these. Stocks aren’t as overvalued as they have been at times in the past, but they aren’t a cheap asset. About the best thing you can say about them is that they’re cheap to Treasuries, but that’s like saying Venus must be a nice place to live because it’s cooler than the Sun.
While the proximate trigger for today’s whipping may have been the weak Philly Fed index, which fell (see Chart) to the lowest level since the odd spike last year versus expectations for an increase, the market has obviously been in retreat for a while. Moreover, the idea that there was a “payback” due after strong weather-related growth in the spring isn’t exactly an epiphany.
And, though it’s probably fair to say that almost everyone was surprised with how quickly the European situation unraveled again, the notion that the crisis was probably not over was a reasonably widely-held belief. Interest rates are low, which means you don’t gain much value to an investment by pushing the date of a negative cashflow further out…which is to say, whether Europe was going to implode in 2012 or 2013 or 2014 shouldn’t have colored your view of fundamental equity value very much. Only if you thought it was not going to implode should the value have changed significantly…but many of us essentially decided to be market-timers anyway, figuring we could always exit stocks before the mess started up again.
This sounds like ‘tough love,’ and maybe it is. I should be more sensitive to those of us – and of course it’s most of us – who are nursing our losses right now. I am long some equities, and though my market exposure is pretty flat because of put options I own, it isn’t fun to watch your stocks decline.
But if you’re a long-term investor, 8% from the highs shouldn’t bother you anyway. If you’re young, and have a lifetime of net investing into the market, you should be cheering for a 50% decline so you can invest in cheap companies! So buck up, it’s not so bad, yet. And stocks might turn around and rally tomorrow and set new highs in a week. All I am saying is that the likelihood of those highs being sustained for a year are pretty small.
The same value observation applies to other assets. In general, when something has gone up for a long time, you want to own less of it, not more – so 10-year Treasuries at 1.70% should not have you rushing to buy more (and if you own long-dated Treasuries, you shouldn’t own as many now as you did a week ago)!
The Treasury auctioned $13bln in 10-year TIPS today, though, at a record yield of -0.39%. What is more, the bidding was very strong, with a 3:1 bid-to-cover ratio and the awarded price was well through the market. Market participants were amazed at the strong bid for a harshly negative real yield, but why? The 10-year nominal Treasury has an implied real yield, based on 10-year inflation expectations extracted from inflation swaps, of -0.77%. Inflation ‘breakevens,’ which approximate the amount of inflation required to break even owning TIPS rather than nominal Treasuries, are around 2.1% and core inflation is at 2.3%. Historically, that doesn’t happen very much (see Chart).
It is unusual to compare current core inflation to 10-year inflation breakevens, but the rationale for doing so is this: if current inflation is at the same level, or higher, than the ‘breakeven’ number, then you are essentially “carrying” the inflation option for free. When you own TIPS rather than Treasuries (at least, at low levels of inflation like we have now), you want to consider both the expected level of inflation over the holding period as well as the range of possible outcomes for inflation. When inflation is low so that most of those “tail events” are higher inflation, then you should be willing to pay a bit more than your true expectation, because all of the crazy things that can happen are good for you. That’s essentially an “option value” to owning TIPS over Treasuries.
When the breakeven you are buying is far above current levels of inflation, then you’re losing a little bit on that bet every day – like time decay on an option. But when the breakeven you are buying is below the current level of inflation, you are getting the inflation option with free carry.
So I am not at all surprised that buyers lined up to buy $13bln of TIPS. After all, many accounts must own fixed income (I am not one of them, which is why I own neither TIPS nor Treasuries at the moment). What I am surprised about is that buyers keep lining up to buy nominal Treasuries at this level. Those buyers are lining up to book a vacation to the Sun. H
I hope they bring enough sunblock. Because I think they might get burned.
More on CPI (Not To Be Confused With Moron CPI)
I posted earlier today some thoughts that I tweeted right after the CPI figures were released this morning, and added a few ancillary thoughts as well. I figured that may be all that I would write today, since CPI is clearly the most important release of the day and because I am hard at work on our Quarterly Inflation Outlook piece.
But then I saw a number of headlines such as this:
- “Retail Sales Edge Up, Inflation Flat as Energy Prices Fall”
- “Tame Inflation, Strong Factory Data Lift Futures”
…and I realized I had to write today.
It isn’t true that core CPI was “as-expected” or that inflation was “flat.” Of the 78 economists polled by Bloomberg about the monthly change in core CPI, one called for 0.0%, eight expected +0.1%, and the balance expected +0.2%. The average works out to be 0.184%. This is consistent with poll results on the question of the year-on-year core CPI rate, which saw one economist at +2.1%, nine at +2.2%, and the rest at +2.3%. So economists generally were looking for a “soft” +0.2% print.
What we actually got was +0.242%, the third-highest print since 2008; this caused the year-on-year core rate to be 2.314%, compared to 2.255% last month. That is, last month we barely rounded up to 2.3% and this month we had to round down. This is about as big a miss as you can have, without actually printing a +0.3% and causing everyone to wig out.
(Incidentally, while it’s relevant for short-term trading of TIPS and inflation swaps, headline inflation is not a policy target. We focus on core inflation, for policy purposes, when headline is higher than core, and we focus on core inflation when headline is lower than core. Policymaker pronouncements that discuss headline inflation are potential hints that a central banker is looking for an excuse one way or the other. Today’s headline inflation is not a good predictor of next year’s headline inflation, but today’s core inflation is likely to be reasonably close to next year’s core inflation.)
Also rising on a year-on-year basis: Rent of Shelter (2.216% vs 2.104%). The bubble is now unwound, rents are rising at near the pace of other prices, and we can no longer look to housing as being a restraining force on core inflation going forward.
Services less energy services rose to 2.449% versus 2.325% (see Chart below, source Bloomberg). This is 57% of the CPI basket. Again, there is nothing to suggest “tame” inflation here. As I wrote back in February, inflation is as “contained” as an arrow from a bow.
The implication of the chart above is interesting. The only reason that core inflation was as low as it was in the years leading up to 2008 was that commodities ex food-and-energy commodities (which category adds up to 19.4% of the CPI) were basically not inflating (see Chart below, source Bloomberg). This is where the “globalization” effect happens, since it’s much easier to import goods than services, but some evidence suggests that this effect has largely run its course.
So “Commodities ex-food-and-energy commodities” is rising at 2%. What if “Services less energy services” returns to, say, 3.5%, where it happily existed in the ‘Naughts, while commodities inflation stays steady? Core inflation in that case would rise to 3.1%. Moreover, with every central bank in the world printing money (by the way, M2 growth is back to 9.2% year/year) there is no reason to think that the standard of the mid-2000s is where inflation should stop.
In this context, it would be stupid for the Fed to consider further quantitative easing at its next meeting in June. Therefore, I fully expect it!
One-year inflation swaps are around 1.50%. Two-year inflation swaps are at 1.75%. Five-year inflation swaps are at 2.2%. I think these are all very low.
So why are people suddenly so calm about inflation, whereas a couple of months ago everyone was all lathered up?
Partly, it’s because people tend to remember the stuff they buy more than they remember the services they buy. Partly, it’s because gasoline prices have receded about 20 cents in the last few weeks, so there’s a near-term reinforcement of the idea that inflation isn’t so bad. Partly, it’s because almost every economist and the Fed itself is saying that inflation isn’t a threat while global growth is in trouble. And partly, it’s because price changes over the last few months have been very regular and much less scattered. Consumers tend to encode volatile prices as rising prices; also, they tend to remember the price changes of the stuff that’s gone up better than they remember the price changes of the stuff that’s gone down. Over the last few months, both the volatility of monthly inflation rates among the many subindices the BLS calculates, and the dispersion of those rates, have been unusually low. So much so, in fact, that my measure of “inflation angst” is at an all-time low for the period over which I have calculated it (see Chart, source Enduring Investments). The chart shows the amount by which inflation feels higher than it actually is, due to these cognitive effects.
Meanwhile, Europe is getting worse again. Greece decided to pay off a bond that was covered under UK law and which hadn’t been subject to PSI – which, as you all remember, was something they swore wouldn’t happen. But the country had to scrape together lots of green stamps and supermarket coupons to make the payment, and with the country’s politics in disarray it seems the can wasn’t kicked as far down the road as everyone thought. Greece has gone from “of course they won’t leave the euro,” to “it’s impossible anyway” to “they’re not allowed to” to “see, that was no problem,” to “I wonder when they will.” And, as expected, the effect is spreading to other periphery countries. Spanish 10-year yields rose to 6.35% today, the highest level since November (see Chart, source Bloomberg).
Stock prices fell today, extending the recent mini-slump. The only reason to own stocks here, and I think the only reason prices are as high as they are, is that you want to own anything but fixed-rate bonds with the 10-year rate at 1.74%! Inflation-indexed bonds (TIPS) are better, but still are more risk than return at this point (10-year TIPS yield is -0.41%). So the argument for stocks as “anything but bonds” is a reasonable one. But it’s an even more powerful argument in favor of owning stuff that people actually consume, and yet commodities have been dripping steadily all month. The combination of low recent returns to commodity indices and continued robust money growth has our expected return models projecting 10-year real returns of 5.4% for commodity indices, compared to 2.3% for the S&P, with similar risk.
We are confident in our valuation models. But no, that doesn’t stop it from hurting right now!
CPI: Summary Of My Tweets
- Core CPI was +0.24%, barely missing an +0.3% print (interestingly, Bloomberg no longer calculates beyond the 1st decimal).
- Y/Y core 2.31%, which is “as expected”…except that economists were looking for a round UP to 2.3%.
- Core ex-housing is no longer as important as it was…since housing is close to fair now…but it’s 2.36% y/y.
- …that’s actually the highest Core CPI y/y print yet. We’ve had 2.3%, 2.2%, 2.3% and 2.3%, but the first two 2.3% were up-rounders.
- …and means 17 of last 18 months we’ve seen y/y core CPI increase.
- Accelerating groups: Apparel, Educ/Comm, Other (15.4%). Decelerating: Food/Bev, Transport, Recreation (37.4%). Unch: Med Care, Housing
The hurdle next month to push year-on-year core CPI higher for the 18th of the last 19th months is challenging. In May 2011, core CPI threw the highest print since 2008: +0.252% (rounded to +0.3%). That being said, this month’s print was the third-highest since 2008, so it’s not a complete reach.
Some observers will focus on the last 3 months of core CPI, which were +0.098%, +0.230%, and +0.242%, projecting to a relatively-calming 2.3% annualized – which is what it appears we’ve done, stabilize right on the Fed’s target. But it appears the February number was the aberration. Annualizing the last four months would give us 2.4% (January’s change was +0.218%), and annualizing just these last two months gives us 2.8%. I don’t recommend playing around too much with annualization, but I point this out because popular opinion will try and pretend the +0.098% was wasn’t an outlier.
Another way you can get a sense for the acceleration of inflation, and the easy potential for further inflation, is to look at the median monthly print and annualize. (This isn’t the same as the Cleveland Fed’s “Median CPI” – that indicator is looking at the median one-month change of all of the goods and services prices collected by the BLS.) What I am doing in the chart below is looking at the median month-on-month print from the last 12 monthly releases, and annualizing that figure. You can see that the number no longer looks like it has leveled off.
What that suggests is that the recent failure of inflation to continue rising on a year-on-year basis is due to the low prints that are “tail events” on the downside, and not because the overall process of inflation has somehow been magically arrested at the Fed’s target.
A Time To Refrain From Embracing
Today’s bit of wisdom comes either from Ecclesiastes, or from The Birds (depending on your religious background): to everything there is a season, whether for casting away stones or for gathering them together, whether for embracing or for refraining from embrace.
This too is good market wisdom – and in the current circumstance, it appears it is a time to refrain from embracing. Two sovereign wealth funds have apparently stopped buying European sovereign debt, according to stories out today. One is China’s CIC (which is interesting: I suppose they figure that their pledge to the IMF is more than sufficient exposure to the region! If that is the case, then surely this falls in the category of an unintended consequence!). The other is Norway’s $610bln oil fund, which will actually divest holdings of Eurozone sovereigns. It had held 50% of its total bond holdings in Eurozone sovereigns and has cut (or maybe will cut – the story is unclear) its exposure to under 39%, according to this story on Reuters.
Frankly, if I was another sovereign wealth fund, I would read these stories and wonder whether it is time for me to cut my exposure as well, since I surely don’t want to be the last one out. As I said, perhaps this is a time to refrain from embracing.
That being said, as I wrote on Tuesday “I think it’s likely that European prices will rise at least as fast as US prices” and opined that “I think Europe is going to be catching up to the U.S. in the monetary-profligacy race.” I wrote that, and today a story appeared in Der Spiegel: “Breaking a German Taboo, Bundesbank Prepared to Accept Higher Inflation.” The ECB is already losing its “Bundesbank DNA” since being taken over by Mario Draghi. Now it looks like the Bundesbank itself is losing its singlemindedness when it comes to inflation.
This is a game-changer, obviously, when it comes to inflation in Europe (German inflation carries about a 25% weight in the calculation of Euro inflation) but also when it comes to inflation globally. I noted yesterday that Euro M2 accelerated to a 3.1% pace in the year ended March, and that that was the highest pace since September of 2009. I can’t imagine these two things – an acceptance by Germany of potentially higher inflation, and faster Euro-area money supply growth – are unrelated.
This may or may not be an error. If Germany is acceding to higher inflation because she believes that faster inflation will be a result of faster Euro-area growth, it’s an error since inflation derives from money growth, not real growth. But if Germany is allowing inflation to rise in Germany relative to the rest of the Eurozone, as a way to ‘rebalance’ her economy relative to the Eurozone, then it’s not a bad idea; the only problem is that since Germany doesn’t have a lever to pull on monetary policy that’s separate from the ECB’s lever, I don’t see how they can raise Germany’s inflation rate relative to the other nations. Between countries with flexible currencies, this adjustment happens through the money supply and currency. How do you effect such a ‘rebalancing’ in this case? I don’t know.
Speaking of errors, JP Morgan announced a whopper today after the close. About a month ago, a story circulated about a trader at JP Morgan who had amassed positions in corporate credit-related derivatives that were so large they were affecting the indices of credit risk. Today, JP Morgan revealed that the unit where the trader works (the chief investment office, which is meant to hedge firm-wide risks rather than to take positions) had lost $2bln on synthetic credit instruments. JP Morgan CEO Jamie Dimon said on a call today that the losses could ‘easily get worse,’ implying that the positions remain open for now.
There will be many questions about how the bank amassed a $2bln loss in the short time that has passed since quarter-end, especially given relatively sedate trading in the credit markets. There are both positive and negative fact sets that could apply. On the positive side, we could posit a smart risk-management officer that read those earlier stories and investigated whether the book was being marked at levels that were being affected by the trading of those instruments by the book, or whether they were fairly considering the likely loss in the event of liquidation. Discovering that they were not being marked conservatively, Risk Management and the CEO decided to disclose the loss as soon as they knew it should be. If that is what happened, it would be hard to fault the bank’s disclosure even if you could fault some of their controls. But Dimon is also a pretty crafty fellow, and I can certainly imagine a circumstance where the bank figured “if we announce the loss on the credit hedge now, then when the gain on the other side shows up in the regular earnings we might be able to persuade analysts to treat this as an ‘item.’”
So what I’d want to know if I was a regulator, or a reporter, or an investor, is whether the error here was that the chief investment office departed from its hedging function and made some bad prop trades. If the answer is yes, then I want to know how that happened in large size without senior approval. If the answer is no, then the next question is whether this loss was offset by a gain somewhere in the bank, since it must be a hedge. If the answer to that question is no, then we simply have some stupid hedging. If the answer to that last question is yes, then I want to know why an announcement was made at all because the hedge worked! Sometimes hedges lose money, after all…when the thing being hedged shows a gain.
On Friday, Dallas Fed President Fisher is speaking on the topic of “Too-Big-To-Fail.” How timely.
Also due out on Friday are Michigan Confidence (Consensus: 76.0 from 76.4) and PPI (Consensus: 0.0%/+0.2% ex-food-and-energy), neither of which is an important release. Have a nice weekend.
Now It Begins…Again
Well, there are quite a few things we have to discuss, aren’t there?
On Friday I had a couple of tweets about the Employment number (I’ve discovered that publishing a full article on Friday is seldom a useful thing to do) that I posted along with a chart of the labor force participation rate. It turns out that the participation rate was the part of the report that really stood out, and a number of commentators reflected on it. An article on Bloomberg this weekend discussed the problem of “hysteresis,” which means that after a long period of weak economic growth, a group of workers finds that their skills have deteriorated (or are assumed by employers to have deteriorated) and so they are unable to find a job – so that these people become chronically unemployed. The Bloomberg article said that this problem is a “focus” of the Bernanke Fed, and a reason to keep extraordinary stimulus in place a while longer.
This is a real phenomenon, and it shows up partly in the series I’ve shown here previously: the strangely-named count of people who are “not in the labor force, [but] want a job now.” Since to be considered part of the labor force basically all you have to do is to look for a job, these are people who want a job but don’t consider it even worthwhile to look. As the chart (source: BLS) shows, the number of such people exploded in the crisis, and continued to climb into 2011 before leveling off. But it’s not falling. Yes, this is a concern, and it’s one reason the Unemployment Rate is as low as it is despite an employment market that is fairly described as very weak.
Over the weekend, of course, the French Presidency was ripped from Sarkozy (as was generally expected) and the Greek Parliament was completely scrambled (as was not necessarily generally expected). The effect of replacing Sarkozy with Hollande won’t be insignificant, but firebrands tend to moderate once they actually hold the key to the city so the impact of Hollande’s ascension will probably not be immediate – however, the next time there is a crisis that requires France and Germany to quickly agree to something, the fact that Sarkozy is no longer the one meeting with Chancellor Merkel (assuming she’s still around, which is not a sure thing given how her party has been doing recently) will make the process more dicey.
But the more immediate problem is Greece…again. The two parties which had previously formed a coalition government were soundly whipped, and the message from the electorate seems clear. Greece has had for some time a simple choice: leave the Euro, and someday get your country back, or stay within the Euro, and be indentured servants. The last “rescue package” actually increased the notional amount of Greek debt, and the previously-dominant parties were seen as complicit in the mortgaging of Greece’s future. Since the election, no governing coalition has been formed. Meanwhile, more debt payments are soon due, and the country has not made any movement towards fulfilling the “requirements” of the last bailout. I suspect that whether they mean to or not, Greece will be calling the bluff of the Troika. And it is unclear, given the condition of the Germany-France relationship, whether the Eurozone is ready to send more money with essentially no strings attached. For a long time I’ve said that Greece would end up leaving the EZ; after the last bailout I thought they’d pushed that off for a year or two. As it happens…probably not.
As the Continent has digested these events, Spanish and Portuguese yields (which had been healing modestly) have started to head back up, and Continental equity markets took a beating today. (It’s actually a little surprising that they hadn’t taken a beating yesterday, but markets globally were very quiet on Monday.)
And of course, pressure remains on commodities, especially energy. NYMEX Crude fell below $100/bbl (closed today at $97.35) and gasoline futures fell below $3/gallon before rebounding today after a very large draw on gasoline inventories – among the 10-20 largest in the last decade – in the weekly API report. Prices at the pump are still $3.76 nationwide, so while they have retreated some they’re not exactly plunging.
In domestic markets, the S&P broke below last month’s lows before clawing back to close with just a narrow loss. The selloff was contained by the 100-day moving average, but I don’t think it’s going to be for long. Apple (AAPL) is also back to nearly the April lows. After the ill-advised spike higher on the April 24th earnings report (you know, the one with severely negative forward guidance), the stock has drifted lower almost every day since. I wonder how all the people who chased it feel? I’d written prior to that release that the market’s ability to look past weak reports would be considered a good sign, and it was – but that was then, and we’re now looking at a skein of what are likely to be economic reports of decreasing strength for a while. For of course, we cannot avoid feeling the European recession. Bonds know this; the 10-year yield fell to 1.85% with the 10-year real yield at -0.35%.
On the monetary policy front, there was an interesting development in that year-on-year M2 money supply growth finally declined in the U.S. to under 9% (to 8.85%), the first time this has happened since last July. However, we should also note that European M2 as of the end of March (the last available data) accelerated to 3.3% year-on-year, the highest level since September of 2009.
Indeed, if you are surprised that the robust M2 money growth has not resulted in faster inflation in the U.S. (I am not; in fact core inflation is running ahead of where my models expected it to be), you should remember that in a global economy money is fungible! Adding liquidity in the U.S. pushes up prices everywhere – but holding it down in Europe dampens price increases everywhere. In fact, if you run the contemporaneous correlation of year-on-year core US CPI versus year-on-year US M2 money growth back to 1999, you get 0.44. But if you run the correlation of year-on-year core US CPI versus year-on-year Euro and US M2 growth (adding together European M2 and US M2 and then computing the growth rate), the correlation rises to a whopping 0.60. The chart of this relationship is shown below.
This is hardly definitive; the quality of the single-variable unlagged relationship breaks down back in the 1980s and early 1990s (of course, the global financial system was less-integrated then, too). But I hope it makes the point that if US money growth lags, it ought to be more than made up for by Euro money growth. Frankly, I don’t expect US money growth to slow very much, or to stay down, because corporate credit is growing well and the Fed isn’t about to try and restrain money growth. But I do expect European money growth to accelerate, since 3.3% in the current economic conditions is going to be viewed as too tight.
Actually my next chart is pretty interesting. It shows Euro M2 and US M2 separately. Which country do you think had a central bank with Bundesbank DNA?
The Fed clearly has, to date, done the heavy lifting of staving off deflation, while the ECB worked at restraining inflation. But now with the ECB under new management, they are pulling on the rope in the same direction.
In this context, it is comforting that the initial results from the poll I posted last week show that only 3% of respondents report that they are not concerned about inflation and have no plans to take any explicit inflation-protection steps. Fully 73% report either that they feel they have completed taking steps to protect their wealth against inflation (17%) or that they have taken some steps, but plan to do more (56%). Nineteen percent of respondents have not yet taken inflation-defensive steps, but plan to do so by the end of 2012 (12%), or in 2013 (7%). The poll is still open – feel free to log your perspective!
With European M2 rising relative to the U.S., and the increasing likelihood that the Euro’s membership will come into question soon (and once one adjustment to the roster has been made the second is much easier) and weaken the Euro versus the dollar, I think it’s likely that European prices will rise at least as fast as US prices. And yet the 10-year Euro inflation swap is at 2.09% while 10-year US inflation swaps are at 2.54%. That difference may have made sense when the ECB was run by Trichet and it was the US fighting a banking crisis. But now the ECB is run by Draghi and it is Europe with the banking crisis. While I think inflation is going to continue to head up everywhere (Japanese 10-year inflation swaps are at +0.50%!), I think Europe is going to be catching up to the U.S. in the monetary-profligacy race.
Employment Report: Summary Of My Tweets
Tweets from @inflation_guy on the Employment release, and added detail:
- It’s starting to be almost comical: weak jobs growth (115k, though close to expectations with revisions)…but Unemp Rate falls to 8.1%
- …again, although unemp fell it looks significantly due to fall in the labor force. Partic. rate fell to another new post-83 low.
- At a 63.6% participation rate, we’re perilously close to 1970s standards. The low in the 1980s was 63.5% in 1981.
- …and back in the 1970s, some women were still entering the workforce for the first time!
Here’s a chart of the participation rate. It’s really dreadful when you consider the secular increase was due to a broadening of the workforce. I doubt women are leaving the workforce in droves now – so in a real sense the current employment situation is worse than it was in the 1970s. So the government is doing a great job of pushing down the Unemployment Rate…by pushing people out of the workforce altogether.
Of course, at some level this is good news for companies, because the “industrial reserve army of the unemployed” is toothless. Pressure on corporate margins will have to wait since labor doesn’t have the teeth to reclaim its share. That doesn’t mean inflation is dead, though – margins can also expand simply by having prices of labor rise slower than prices of consumption goods. Remember: wage inflation results from, it does not cause, broad price inflation.
