Archive for September, 2012

Good News, For Now

September 25, 2012 2 comments

First, an observation: yesterday’s article, “Incredible Inflation Bond Bargain,” received more hits than any other article I have written in recent memory. Apparently, people still are looking for bargains, and still looking for bond bargains as well. This is heartwarming to a bond guy, and of course even more to an inflation guy. But then, true bargains are rare, and true bargains offered by the government are even more rare. A belated hat tip to “Gratian”, who asked me what I thought about I-bonds and provoked that article. Thanks for the suggestion!


There was some mild good news today. Consumer Confidence rose more than expected, to 70.3 and only a couple of points below the post-Lehman highs set in early 2010 and 2011. Yes, 70.3 is still very low (the series is set so that confidence in 1985 equals 100, and in the recessions of the early 1980s and the early 1990s it was generally in the 55-80 range), but the longest journey begins with a single step. On the bright side, there’s lots of room for improvement (see chart, source Bloomberg).

The internals of the Confidence number are not as good. Both “current conditions” and the 6-month ahead outlook improved, especially the outlook (when ‘my guy,’ whoever your guy happens to be, will be in the White House six months from now, surely things will be better), but the “Jobs Hard to Get” subindex, which is highly correlated with the level of the Unemployment Rate, barely nudged lower. Still, as depressing as it sounds, consumer confidence is a relative bright spot among recent data.

Home prices, as we have documented several times, are rising and the S&P/Case Shiller Home Price Index confirmed that by reaching the highest level it has seen since 2010. The 20-city composite is now rising at 1.2% year/year, which doesn’t sound much but is the highest rate of change since the dead-cat bounce of 2010. Keep in mind that the index methodology involves a fair amount of smoothing, so it lags the actual improvement in the market. By comparison, the RadarLogic 28-day composite index as of the end of July recorded the highest year-on-year change since 2006 (see chart, source Bloomberg).

Also relatively good news was the Richmond Fed Manufacturing Index, which rose to +4 – not as good as it was earlier this year, but 23 points above its July low. The Richmond Fed district includes the “toss-up” battleground states of North Carolina and Virginia and the “leans Romney” state of South Carolina. It is encouraging that manufacturing in this region (with its 28 toss-up electoral votes) is outperforming activity in the Dallas Fed district (Texas, northern Louisiana, and southern New Mexico, none of which are considered toss-ups), the Chicago Fed District (which includes Michigan, most of Illinois and Wisconsin, and 6-electoral-vote-toss-up Iowa) and the Philly Fed district (which is Pennsylvania, NJ, and Delaware, and no toss-ups). This is merely an observation, and even if there were clear indications that the Administration was directing money towards projects in battleground states I wouldn’t object to it – that’s one of the prerogatives of incumbency. If you want that prerogative, work hard so that you can get to be the incumbent.

While the data points today were good, stocks gave up the ghost and managed to lose most of the post-FOMC rally. That doesn’t really shock me so much. Commodities, which should be more sensitive to inflationary monetary policy, are down outright since the Fed declared an unbounded easing policy, and both markets have rallied since June on the growing expectation of QE3. The fact that QE3 was larger than many observers expected caused some short-covering on the news, but I suspect most investors who thought QE3 was coming were already long their preferred assets. The actual open-ended Fed buying will definitely buoy commodities (which remain undervalued relative to past QEs) and might lift equities (which, however, offer fairly weak prospective real returns given the current market valuations), but we had already priced in some expectations.

And in the meantime, while today’s numbers were not bad, the overall picture remains pretty weak. I think the threat of sequestration at the end of the year will start to affect growth more seriously in October, because the end of the fiscal year for government expenditures is September 30th. Businesses that have the government as a significant client recognize that they may well be in Limbo on October 1st. This is what happens when government spending is 40% of GDP! The sequestration doesn’t happen until January, so spending from October until December in theory will be unaffected. But, in practice, the government enters into contracts (for equipment and construction, for example) that cover many months, and it isn’t entirely clear whether for example the Defense Department can enter into a one-year contract if it isn’t known that the money will be there. I know several people in businesses that are directly affected by this issue, and they’re concerned about it now, not just in January.


I saw an interesting study by State Street Global Advisors mentioned in a Pensions & Investing Online article. According to the study, about ¾ of institutional investor executives consider a ‘tail-risk’ event in the next twelve months to be likely. But here is the interesting paragraph in the P&I article:

“Survey respondents — money managers, family offices, consultants and private banks — expect the five most likely causes of a tail-risk event in the next year would be a global economic recession (36%); a recession in Europe (35%); the breakup of the eurozone (33%); Greece dropping the euro (29%); and a recession in the U.S. (21%). (Percentages total more than 100% because respondents could select multiple causes.)”

Apparently, ‘inflation’ isn’t even on the radar as a tail risk. Of course, as an investor, what is more important than the tail risks you can estimate the probabilities of are the tail risks you aren’t even thinking about or can’t estimate the probabilities of. Incredibly, not only has the myth that recessions cause disinflation and deflation failed to weaken during the last few years, when weak growth has been accompanied by accelerating core inflation, it seems to have strengthened! While investors, as evidenced by the performance of inflation-linked bonds and of breakevens (and inflation swaps) and commodities, believe that inflation might well be a risk, it doesn’t seem that many investors are focusing on it as a tail event. That is, they expect that a “bad” inflation outcome might be 2.5% or 3.0% core inflation. An outlier event to them may be 3.5% or 4.0%.

But what we know about inflationary outcomes is that if anything, they have tails that are quite long. And there’s plausible reasoning which can produce very high numbers for that tail; see for example my article from late last month – before QE3 – called “What Keeps Me Awake At Night.” I always take care to say that these concerns aren’t predictions, but they are plausible possibilities, and the bottom line is that we don’t really know how these relationships work at this scale. No central bank has ever dealt with numbers like this. It is a known unknown, and thus a source of a tail risk of indeterminate length.

In my opinion, when it’s cheap to insure against such risks then it ought to be done. Presently, you can (as an institutional investor) protect against the risk that inflation will compound at greater than 4% for the next ten years for roughly 2.2% of the notional amount, or 22bps per annum. There are multiple ways to do this, some of which may be cheaper and all of which are beyond the scope of this article – but the point is that we have investors enumerating downward “tail risks” on growth while equity margins and valuations are high, and largely ignoring “tail risks” on inflation that could damage a number of different asset classes. I see lots of potentially dangerous scenarios for equities in October, several (but not all) of which are also dangerous for bonds.

Incredible Inflation Bond Bargain

September 24, 2012 24 comments

The economic data continues to drip weaker. Today’s Chicago Fed index was the lowest since 2009, and while the Dallas Fed index rose, it remains negative. These aren’t major indicators, but the general tone of data recently has been weak and nothing recently stands out as positive…except for Existing Home Sales, which raises other issues as noted last week. A friend in the southwest U.S. describes the local housing market in Phoenix as “definitely bubblicious” and passed along this link, describing how rental properties in Phoenix are seeing aggressive bidding from would-be renters.

Now, economic activity is also not exactly falling off a cliff, and some Americans insist that the economy is doing just great (these seem to be the Obama voters but I can’t tell which way the causation runs – are they Obama voters because they think the economy is doing well, or do they think the economy is doing well because they are Obama voters and that’s the story?). But to listen to Fed speakers, you would think economic collapse is imminent. Last week, Minnesota Fed President Kocherlakota[1] advocated keeping monetary policy extraordinarily accommodative until the unemployment rate gets down to 5.5% or until the medium-term outlook for inflation rises above 2.25% (on core PCE). Today, San Francisco Fed President Williams said that he expects the Fed to end asset purchases “before late 2014” (which, for those of you scoring at home, would imply the Fed has about a trillion dollars to go) and shouldn’t raise rates until mid-2015.  I wonder what it is that Fed officials are forced to check at the door: their brains, or their optimism?

No wonder that inflation-linked bonds are so expensive these days!

Which brings me, actually, to the main topic I wanted to discuss today. A reader asked me the other day about I-series savings bonds from the U.S. Treasury. For those of you who aren’t familiar with them, I-bonds are like regular savings bonds except that they pay a real interest rate. That is, instead of getting a fixed coupon, you get a fixed coupon plus inflation, which is added to the principal and compounded until the bond is redeemed. You can buy them on Treasury Direct and keep them in electronic form, and in fact that’s the best way to buy them. You can buy up to $10,000 per Social Security number per year.

And that limit turns out to be a good thing, because if it weren’t for that limit hedge funds would be going nuts on series I bonds right now. Because the people who created I bonds never contemplated a negative real interest rate, or else thought the marketing angle of selling bonds at a negative real interest rate would be too bad, the fixed part of the I bond coupon is floored at 0%. This is significant, since the market rate for a 5-year TIPS bond right now is -1.59%. The coupon rate on the I-bond is set for the next six months of new sales (the fixed coupon stays the same for the life of any given bond) every May and November, and typically is set very close to the 5-year TIPS rate (see chart below, source Treasury Direct and Bloomberg).

Notice, though, that at the far right-hand part of the chart the last few I-bonds issued have had coupons of 0%, since the actual TIPS rate has been considerably below that. And that means that if you are going to buy TIPS, then before you spend a single dollar on the April-2017 TIPS you should buy your full $10,000 limit on I-bonds, because you save 1.59% compounded for at least 5 years. That’s an extra 8.2% total return on your money over that period![2]

Occasionally, there can be good deals when the TIPS market moves between the setting of a coupon and the next coupon set. When the current series coupon was set at zero, back in May 2012, the advantage was only about 125bps and it’s now 159bps. But the current advantage is in good measure structural, rather than due to timing. As a consequence of that structural mistake (not allowing a negative real coupon), combined with the TIPS market’s rally since May, the current spread is actually the highest ever seen for the program (see chart below, source Treasury Direct and Bloomberg).

I don’t regularly recommend specific trade ideas in this (public) space, for a whole host of regulatory reasons, but I can say this: look into series I-bonds unless you (a) don’t care about inflation, (b) feel like you need to take lots more risk, (c) feel comfortable that if you wait long enough, you’ll get a better investment opportunity in inflation-linked bonds, or (d) have so much money that $10,000 per member of your household, per year, simply isn’t meaningful.

And if it’s case (d), then please write because I need more friends like you!

[1] Kocherlakota is described by some as a hawk, but he can most accurately be described as ‘confused.’ He once explained that the Fed might have to raise interest rates, even if inflation expectations were low, to force them higher, getting the causality exactly backward.

[2] Note that if you do not intend to hold the I-bond for at least 5 years, there is a penalty associated with early redemption – you lose some interest accrual. Even with that, it’s not a terrible deal given how cheap these are now, and most investors should have some inflation protection in their portfolios to diversify the risk of all of those investments (equities, nominal bonds) that do poorly in inflationary environments. So, for the buy-and-hold part of your portfolio, these are terrific.

Central Bank Groupthink

September 19, 2012 7 comments

Lest anyone be confused about the unanimity and collective will of central banks globally on the question of how aggressively to pursue a dovish monetary policy, the Bank of Japan on Wednesday surprised even the Japanese finance minister by increasing the size of its own quantitative easing program. After many years of pursuing a half-heartedly dovish monetary policy, the BOJ is now fully on board with asset purchases that will total some $1 trillion. Why not? The Fed’s aggressive asset purchases moved core inflation from 0.6% to 2.3% before a recent softening – and a rise in core inflation is what Japan has been working on for years. Five-year inflation swaps in Japan now are quoted around 0.80%, indicating that at least some investors think the BOJ’s stated policy of provoking 1% inflation has some chance of being achieved.

It is no surprise that there is great intellectual exchange between the economists at all of the central banks. While this can be a good thing (after all, Japan finally caught on that they can’t kill a rhino with a flyswatter), it is also dangerous in that it provokes groupthink. Since the Fed has clearly lost any of its monetarist leanings, in favor of an experimentalist “anything but Friedman” (ABF) philosophy, this isn’t really a good thing. If I have to groupthink – and, after all, it is hard to resist that tendency when one is in a group – I want to groupthink with Albert Einstein and his colleagues; I don’t want to groupthink with the cast of “Jersey Shore.”

Despite this obvious fanning of the inflationary flames, inflation breakevens softened again today and commodity prices slipped a bit further. The latter was mainly due to energy prices, as Crude has now dropped over 8% this week. The trigger for this correction has been the statement from the Saudis that they’ll supply lots of oil to the market, and a surprising rise in crude oil inventories. But the Saudis frequently boast that they can pump all they want, and crude oil inventories are highly variable. It seems odd to me to have what amounts to a negative “Middle East unrest premium,” but some too-smart-by-half observers speculated today that the chance of an attack of Israel on Iran has lessened since the moon will be waxing soon and providing too much light for a nighttime attack. Um…let me say that I’m just reporting this idea, not supporting it. I think if the dollar continues to weaken, oil prices will continue to rise. That basic relationship has held for most of a decade now. The chart below (Source: Bloomberg) shows the dollar index versus the front NYMEX Crude contract, weekly closes, for the last six years or so (the last point is Friday’s). The simple R2 is about 0.57.

While aggressive monetary easing from other central banks will help support the dollar, the Fed is still by far the most aggressive central bank. If the crisis continues to recede, then the dollar’s safe haven bid will continue to fade. I’m not so sure of the former, but I don’t want to bet on dollar strength here with the Fed dedicated to providing unlimited quantities of reserves.

In other economic news, and not at all unrelated to that, today’s Existing Home Sales figure was the strongest since 2009-2010, at 4.82mm units. Inventories of existing homes rose slightly, but still remain around 2003-2005 levels rather than the 2006-2011 levels. To be sure, there is plenty of shadow inventory still around, but these levels of existing home inventories have historically been low enough to allow home price appreciation.

In fact, as weird as it sounds housing has gone from being a systematic drag on core inflation to being a supportive factor in core inflation going forward. The levels of inventory should help support home price dynamics going further, but we needn’t look far into the future. Over the last year, the 9.5% rise in the median existing home sales price compares more favorably with the rates of 2002-2005 than it does to the 2006-2011 experience (see chart, source Bloomberg).

So don’t look now, but we’re in the midst of a home price rally. This is remarkable given the difficulty, still, of securing a home mortgage compared to the crazy days of the early ‘Aughts. Yes, perhaps the crazy credit terms followed the bubble’s inflation, rather than preceding and causing it. But if that’s true, then we’d have to lay the blame for the bubble more directly on the central bank’s doorstep.

Well, re-inflating the housing bubble is after all one of the things the Fed is unabashedly trying to do. Rising home prices frees trapped homeowners and solves the problem of underwater mortgages. It is just one way that inflation saves a lot of grief for policymakers.

Existing Home Sales is not the only place we see signs of percolating housing prices and warnings of continued buoyancy of housing CPI (Owners’ Equivalent Rent of Residences has been up at a 2% pace over the last year, actually higher than core CPI for the first time since 2009. Prior to that, y/y OER had been higher than core for all but one month of the period 1993-2009.[1]

This upward pressure on housing inflation will continue. I have previously documented the connection between rents and OER, which has suggested that OER could be headed to over 3% soon. The connection between rents and Owners’ Equivalent Rent is obviously pretty close, but here is another way of looking at the same thing. The chart below (source: Bloomberg) shows OER versus the National Multi Housing Council’s “Market Tightness” index, lagged four quarters. Tight housing conditions, no surprise, lead higher rents.

This regression is not as tight as the one between rents and OER, but the R2 is still about 0.48 since 2003. Moreover, the current level of the Market Tightness index points to an OER over the next year just a bit above 3%.

The final piece of the puzzle that you need to know is this: OER is 23.5% of the overall CPI, and roughly 30.7% of core inflation. Throw in “Rent of primary residence,” which is in fact direct rents, and the total is 29.9% of overall CPI and 39% of core. If housing inflation is returning, then there are two possibilities: either we are entering another housing bubble, which I think would be unprecedented (have we ever had back-to-back bubbles in the same asset class?), or else this rise will be accompanied by a rise in other prices so that nominal home prices will be rising while real home prices do not (or not as much). Either way, it looks like the Fed is getting what it wanted – and I wonder only how long it will take before people realize this isn’t an accident.

[1] In another sign ignored by those who believe there is a conspiracy (by the government, the Masons, or maybe the Knights Templars) to lower CPI, the BLS adjusts the value of the housing stock for wear-and-tear in a negative quality adjustment that has the tendency of pushing up inflation by just about the same amount that the oft-reviled positive quality adjustments push down inflation.

TIPS Are No Longer Cheap, But Still Preferable

September 18, 2012 3 comments

TIPS have gone from being rich on an absolute basis, but cheap against nominal bonds, to (still) rich on an absolute basis, but fair versus nominal bonds as nominal yields have risen. That statement is based, however, on a static equilibrium – given where nominal yields are now, after a 40bp selloff since July, real yields have fallen slightly (see chart, source Bloomberg – nominal yields in yellow, real yields in white) and are about right.

I have previously documented this move, pointing out the rise in breakevens and/or inflation swaps. However, because I was traveling I didn’t write anything following Friday’s skyrocketing breakevens, which followed through on Monday to within a couple of basis points of all-time highs (see chart, source Bloomberg).

That leap seemed exceptionally surprising to some, given the weakness of core CPI on Friday. But inflation expectations on Friday were still reacting to the Fed’s open-ended QE move, which had moved 10-year breakevens to near 2.50% on Thursday. After sleeping on it, many investors realized what we realized immediately: there is nothing deflationary about buying bonds without limit, using money printed for the purpose. The Fed professes to be concerned about the negative tail risk to growth (which they can do nothing about), and ignores the positive tail risk to inflation (which they could do something about, if they chose). It is not at all surprising that breakevens leapt.

As I said, these recent gyrations have moved TIPS to being approximately fair value relative to nominal bonds, given the yield of nominal bonds. But the further question is whether those nominal yields are themselves at fair value, or are on the way to higher or lower levels.

A reasonable question to interpose here is this: is this as good as it gets for bonds? What could be better than unlimited Fed buying? Well…I suppose unlimited buying in Treasuries, as opposed to mortgages, would be better, but with 10-year yields at 1.81% one would think that both a considerable amount of buying and a considerable amount of bad economic news is priced in. To be sure, the news continues to be bad; Friday’s -10.41 print in the Empire Manufacturing Survey was the lowest since the dip in 2008-09. Lower than the “cash for clunkers” hangover in 2010. Lower than the post-Japanese-tsunami drag in 2011.

But consider this: in the throes of a much worse crisis (especially demographically), and with the Japanese central bank making only timid efforts to resist deflation – and certainly not buying every bond in sight, as the Fed is – the average yield of 10-year Japanese government bonds (JGBs) from 1997-2007 was 1.51% (see chart, source Bloomberg).

Even if you take the crisis-on-a-crisis period of post-2008 for Japan, the average 10-year yield is about 1.15% – and that’s with deflation in full bloom and the central bank until the last year or so doing little to fight it.

In Japan, core inflation is at -0.6% over the last 12 months, and 10-year yields are at 0.81%. Our core inflation is 1.3% higher and our nominal yields only 1% higher. There is a lot of disinflation and/or Fed buying that is already in the price. I am not saying that we ought to be selling nominal bonds here; I’ve gotten burned on that call in the past, and anyway we are in the middle of the strongest bullish seasonal period of the year for bonds. But the Fed just added to the length of the possible “high inflation tail” outcome – and I fail to see what the offsetting bullish tail is. I can’t imagine why anyone would buy nominal bonds at these levels, given what the Fed and their pals at other central banks are doing.

But if nominal yields do rise further, this means that TIPS yields will eventually start to rise as well. I still prefer TIPS to nominals, and I still want to be long breakeven inflation, but admittedly it is a more difficult trade at these levels than it was back on August 7th, when I first noted that our Fisher model indicated a short position in TIPS and a long position in breakevens.

I say this, going into a TIPS auction tomorrow with 10-year TIPS yields near all-time lows and 10-year breakevens as I noted near all-time highs. It’s not going to feel like a bargain for anyone, but a year from now, it may seem like it.

Now, make no mistake: the core inflation print on Friday of +0.052% was a definite surprise on the weak side. But it wasn’t quite as weak as it looked. In fact, thanks to Housing and Transportation, 62% of the CPI major subgroups saw their year-on-year rates of change rise, while only 38% (Food/Beverages, Apparel, Recreation, Education/Communication, and Medical Care) saw those rates decline. Much of the weakness in core inflation came from apparel (which is interesting and worth watching to see if it continues) and large moves in used cars and airline fares. Moreover, as I observed last week, the year-ago comparisons get much easier for the next four months, so that the current 1.9% core inflation print is likely to be the lowest for this year. If it’s not, then we’ll need to re-assess what is going on, but for now nothing has changed about my forecast. Do note that the Cleveland Fed’s Median CPI was unchanged again up at a 2.3% y/y rate of change, reinforcing the fact that the core decline over the last few months has been driven by some outlier price movements rather than by a shift in the central moment of the distribution.

Mercedes Ben

September 13, 2012 Leave a comment

On Wednesday, Fox News was showing live video of police in Los Angeles chasing bank robbers escaping in an SUV. The bank robbers began to throw cash out the window (see picture below), apparently hoping to have the streets behind them blocked by the scores of people scooping up free money.

It didn’t work, and the robbers were apprehended. Of course it didn’t work – that money isn’t worth what it used to be, and anyway the Federal Reserve today was on schedule to throw a heck of a lot more money than that out the window.

And throw they did – in fact, in recognition of the similarity between the money-flinging bandits and the Federal Reserve chief, I move that we retire “Helicopter Ben” as a moniker in favor of “Mercedes Ben,” which anyway has a better ring to it (and a built-in song). Interestingly, despite all indications – quite deafening indications to anyone who has listened to Fedspeak for any length of time – that the Fed was planning another dose of QE, a surprising number of investors were evidently surprised. There were no bad bets from the long side today: stocks launched higher on the news, gaining 1.6% to four-and-a-half-year highs. The DJ-UBS commodity index rose 0.7% to a one-year high (up 18% since mid-June). Treasuries gained (although it is hard to fathom exactly why, since the Fed will be buying mortgages, not Treasuries), with the 10-year note rallying 4bps to 1.72%; but TIPS launched higher with 10-year yields falling 13bps (to an all-time low of -0.76%) and the 5-year TIPS dropping 16.5bps to -1.62%. This sent breakevens sharply wider, with 10-year breakevens up 9bps on the day to 2.48%, the highest since last May. The all-time high for 10-year breakevens is around 2.78%, which is still a fair bit away; but, by the same token, 10-year breakevens touched 0% in late 2008, had lows of 1.52% in 2010 and 1.71% in 2011, and are up 41bps since July 26th (see Chart, source Bloomberg).

Meanwhile, 5y inflation, 5 years forward, extracted from inflation swaps quotes (which is the proper way to do it, rather than looking at a pair of idiosyncratic bond breakevens), is at 2.98%, threatening to break the 3% level for the first time (other than during a quick spike in March) since last year. And that’s as the Fed starts QE3.

One thing is sure, and that’s that at least one investor out there is very, very unhappy today. That’s because over the last few days someone bought at least $2 billion in 0% zero coupon inflation floors, in 5-year and 10-year tenors, in the interbank market over the last few days (and who knows if more traded directly on a dealer-to-dealer basis). A 5-year 0% zero coupon inflation floor will pay off only if there is net deflation over the next 5 years; for the 10-year 0% floor, the deflation will have to persist for a full decade. These floors are analogous to what is found in TIPS themselves, so there is a chance that the dealer buying these floors is preparing a TIPS-like inflation-linked bond issuance buying them on behalf of a punter (these days, since banks can’t engage in proprietary trading, it is very unlikely this is a bank bet). The interbank market is anonymous except to the actual counterparties who consummate a trade (and regulators, of course), so we are left to wonder whether there is some plan here or whether some investor just made a very big bet at exactly the wrong time.

So what was so surprising about the Fed throwing money out the window? The FOMC statement said, in relevant part:

“The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation over the medium term likely would run at or below its 2 percent objective.

“To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.

“The Committee will closely monitor incoming information on economic and financial developments in coming months. If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.”

The Evans Rule is no longer soft, as it has been since June. It is still non-parametric, but it is explicit. The Fed will keep easing (in MBS, “additional asset purchases,” and using “other policy tools”) until “the outlook for the labor market” improves “in a context of price stability.”

Bernanke said in his post-meeting presser that the Fed will be following a “qualitative” approach to easing, and said that if the economy becomes weaker, “we’ll provide more support.” More support? More support? They’re going to run out of things to buy. He said the Fed won’t be “premature” in removing accommodation (translation: they’ll keep programs in place too long, rather than risk being too brief), a determination echoed elsewhere in the statement:

“To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.”

Have no fear, however: Mercedes Ben said comfortingly that the Fed has the “tools and the willpower” to keep inflation low. Because, you know, if you just have enough willpower everything will work out just fine!

The purchase of mortgages as opposed to Treasuries is most likely not primarily driven by a desire to lower mortgage rates, which are already absurdly low anyway. I suspect that, in a rare moment of thinking ahead, the Fed realized that since there is already something of a concern about a shortage of Treasury collateral with which to margin derivatives trades, leading to a new Wall Street business “transforming” collateral, it will be less disruptive on market function to buy non-Treasury collateral.

I had expected, as I wrote back at the end of August, that the Fed would do QE “perhaps in mortgages instead of or in addition to Treasuries,” and might change the formulation of the ‘extended low rates’ promise (which was extended to 2015, but that doesn’t mean much now) to be a hard formulation of the Evans Rule. We didn’t get the hard formulation of the Evans Rule, but as I say, it’s explicit.

It appears that we have not yet gotten a cut in the Interest on Excess Reserves (IOER), which would probably be the most-potent easing measure. The IOER is technically not decided by the full Federal Open Market Committee (FOMC), but by the Board of Governors only – that is, excluding the regional Federal Reserve Presidents. However, politically speaking, if the BOG were to cut IOER without the tacit agreement of the rest of the FOMC, it would make the next meeting a mite testy (plus, there is the risk of running out of alphabet letters).

So, lump the IOER cut into the “other policy tools” bucket.

The positive response in markets to what was a fairly obvious policy move – although evidently not obvious to all – suggests that more is ahead. That is less clear with equities, which have to face considerably headwinds of European volatility yet, but I would expect breakevens and commodities to continue to do quite well going forward.


Tomorrow, the CPI will be released. The consensus call is for a +0.6% rise in headline prices and +0.2% on core inflation. That will take the year/year change in headline CPI from 1.4% up to 1.7%. Core inflation is expected to fall from 2.1% to 2.0% y/y, which indicates that Street economists are expecting a “soft” 0.2% (one that rounds up to that figure) of 0.16% or 0.18%, since anything higher than that would cause the y/y change to round up to 2.1% and appear unchanged. If we do not get the round-down to 2.0%, we probably aren’t going to see it for a while. The next four months that will slide off the year-on-year comparison for core inflation are all +0.17% or less. Thus, August is likely to be a local low, although given the big downside surprise (for quirky reasons) last month, and given that the median CPI is still at 2.3%, I frankly think there’s a good chance that core inflation y/y stays at 2.1%.

The next year will be very interesting for inflation. Adding QE3 when core inflation is already at 2% is gutsy, or foolhardy (depending). At some point, surely the water overtops the dam – no matter how much “willpower” is applied to stop it. It isn’t as if inflation hasn’t been rising already!

Also tomorrow we’ll get Retail Sales (Consensus: +0.8%/+0.7% ex-autos). It seems incongruous to me, given the economic weakness of late, that economists are looking for a second straight strong print from core Retail Sales. Also out tomorrow are Industrial Production/Capacity Utilization and the University of Michigan Confidence survey, neither of which matter much.

Slow Motion

September 11, 2012 4 comments

Everything is moving in slow motion. To some degree, this is normal on 9/11, when many Americans, and especially those in the financial markets, have trouble concentrating fully; however, this goes beyond the anniversary of the attacks. Market volumes, which I expected to begin to pick up last week, remain anemic by any recent standard. Volumes last Friday, on the day of the Employment report that could well be the deciding factor in provoking QE (although I was already on record before the data as saying I thought the Fed would ease in September), were actually lighter than on Thursday. Only 641mm shares changed hands on the NYSE.

That was similar to the volumes on the two previous Employment Fridays: in July 561mm shares traded at the end of July 4th week, and August 3rd‘s 712mm shares was the second-lowest total that week. But I thought those were summer numbers – it is beginning to appear I was wrong.

The decline in volumes is either bad news or worse news, depending on the cause. If the cause is that market-makers and high-frequency traders have pulled back from trading, then it is bad news because that implies less liquidity. Of course, one can argue that having slightly wider and slightly less-deep markets is a reasonable price to pay for having markets that don’t advantage fast-twitch trading over longer-term investing; I don’t agree with that point but it’s a normative assessment and I won’t quibble with it. If that’s the only reason volumes have declined, then it’s bad news for investors (and especially large investors), but a solvable problem.

What concerns me is that if that is the issue, we still should be seeing volumes rise now as there is more news to trade – Employment, the Fed, ECB, the German high court, and so on. I pointed out in early August that when markets are less-liquid, as they often are in August, it can lead to lower volumes because the larger cost of initiating any move implies that it takes more certainty of the result before it makes sense to re-allocate any meaningful amount of a portfolio. True enough, but surely the Employment report, which caused a number of economists to change their call from “QE possible but not likely” to “QE is virtually guaranteed”, is important enough to cause some re-allocation of portfolios?

Well, perhaps not. If there is other uncertainty, beyond just the liquidity itself, then the hurdle for re-allocation (and thus, more volumes) goes still higher. We have all had moments like that, when the stock we want to sell has an earnings report out tomorrow, and even though we want to add or subtract from our position we often will choose to wait until that information is released – even if the expectation for the information itself ought to already be impounded in the price.

The uncertainty I worry about it the continued political uncertainty. I don’t just mean at the levels of the Presidency, although Obama in his convention acceptance speech mentioned FDR and applauded “the kind of bold, persistent experimentation that [he] pursued during the only crisis worse than this one.” It was, many people (myself included) now believe, the experimentation that helped extend the Depression by many years – for an excellent exposition of this argument, see The Forgotten Man: A New History of the Great Depression, by Amity Shlaes. But while the President is clearly the experimenter-in-chief, the dramatically (and frequently) changing landscape for financial services firms is causing a tremendous amount of certainty among market-makers of all kinds.

If investors get the feeling “why bother? The market is completely manipulated/screwed up anyway,” then we’re probably pretty close to the next bear market, with the good news being that it could be the one that truly wipes out the ‘cult of equity’ and allows the basing of a real bull market thereafter. I’m not about to try to call the timing of the next downswing of magnitude. I’ve been somewhat more (tactically) positive recently although stocks remain overvalued and analysts optimistic that the extremely wide current margins can be maintained. But for a bull market, you need people to buy because they think businesses have great prospects, not because stocks don’t look too bad if your alternative is nominal bonds. While certain businesses have good prospects (that’s always true), business as a whole doesn’t feel very good or look very good. Whatever the timing, I still think that valuations will have to retreat a fair amount before we can have a strong upswing again.


There are other unsettling signs, involving inflation. The teacher strike in Chicago; the NFL referee strike: unemployment is at 8.1% (and practically speaking, the reality is worse than that), and yet unions are striking. This is why the data tends to show that wages follow inflation, and it’s also why I’m skeptical that the current high margins for businesses are sustainable. Now, teachers and referees don’t exactly work in free markets, but it’s still strange to see in this kind of environment. Or is it? The chart below (Source: BLS, and Devine, Janice M., “Cost-of-living Clauses: Trends and Current Characteristics”, Compensation and Working Conditions, December 1996.) shows the percentage of all employees under collective bargaining agreements covered (in the CBA) by a cost of living adjustment.

Incidentally, I should give a hat-tip to ING Capital Markets; I originally developed that chart for a presentation I was giving on their behalf.

The chart shows that in the weak, inflationary economic environment that prevailed in the 1970s, one of the things that happened is that even while the overall proportion of unionized workers was declining (as it has done more or less consistently since 1954), the unions were gaining strength relative to management and able to force into CBAs clauses that tended to institutionalize inflation. The key point here being that this happened even while the economy was in a growth malaise. When the economy is weak, the protections offered by unions seem more attractive, and businesses are less able to resist union pressures.

Surprise! A weak economy is actually bad for business, as well as employees. What is perhaps surprising to some is that workers don’t simply sit around and take what businesses dole out to them because they ‘re afraid of losing their jobs – they do in fact fight back. This is contrary to conventional wisdom, which occasionally defends the association of slow growth with disinflation by pointing to the fact that slack in the labor market implies workers cannot press for higher wages. As I’ve pointed out before, it is true that real wages can be slack when unemployment is high, but that is not the same as nominal wages being slack. This illustrates one mechanism by which employees can keep up, somewhat, in nominal terms when prices rise even if they lose on real wage growth.

Summary Of My Post-Employment Tweets

September 7, 2012 1 comment

Here is a summary of my post-Employment tweets at @inflation_guy, for those not on Twitter and those who just want to see them all together. I also include a chart and some commentary:

  • Ouch. #Canada added 1/3 as many jobs as the US did last month, and that nation has 1/9 of the population.
  • Awful payroll data – 34k lower than expected with an additional -41k revision.
  • Unemp rate fell from 8.254% to 8.111%, looks like a 0.2% fall but only b/c rounding. And it was all labor force shrinkage.
  • Saw comment that the unemp # matters politically. No it doesn’t. These are numbers. What matters is what people feel is happening. And
  • ..and with employment, the man on the street doesn’t need the government to tell him if the employment situation sucks.
  • Weekly hours back to where we started the year. And Participation Rate now at the lowest level since 1979.
  • One thing this ought to do is quiet the conspiracy theories about how Obama is cooking the numbers! Couldn’t have cooked up worse.
  • Internals even worse: I follow “Not in Labor Force, Want a Job Now”. Highest since they strted asking that qn: [Note: I include this chart below]
  • 7 million people aren’t even looking for work, but want a job and would take one if offered. 7 million!
  • Don’t worry too much about hourly wages meaning deflation is coming. Wages follow #inflation, they don’t lead.

Here’s the chart referred to in the second-to-last tweet (Source: BLS):

Republicans, don’t cheer because we got a weak number. It isn’t the number that causes trouble to the Obama campaign; it’s the perception of the job market and that’s not necessarily correlated to the number itself. Perceptions were already bad, and it’s more likely this number is slightly understated.

Democrats, don’t cheer because of the decline in the Unemployment Rate. You might think it makes a nice talking point, but if you crow about the improving labor market people will think you’re an idiot. The labor market isn’t improving. It’s stagnating, at best; at worst, the crisis in Europe and the weakening of growth in Asia is dragging our increasingly export-sensitive economy down.

In fact, both sides of the aisle should be crying. But watch stocks jump! It’s a little disappointing to me, actually, since more pundits will now get the QE3 call right. However, this number didn’t “seal the deal” – it was already sealed, and the Fed was going to be easing next week no matter what today’s number was.

Not Good Enough To Warrant That Reaction

September 6, 2012 Leave a comment

Stocks surged today, although still on fairly light volume, in a striking response to the ECB’s proposal of a plan we already knew most of the details of. The S&P rallied 2%, and Treasury yields rose 7bps at the 10-year point (1.67%), with 10y TIPS yields +5bps (-0.65%) and breakevens therefore 2bps wider. Commodities were relatively strong, outside of the livestock group.

The ECB’s plan is essentially as described in leaks previously, although apparently there are some minor asterisks that prevent the central bank from just going in to buy lots of bonds right away. The ECB didn’t cut rates, or make the deposit rate negative, as some 40% of economists expected according to Bloomberg. That cut wasn’t in the cards, for the nonce anyway. As I pointed out yesterday, if the ECB wants to sterilize bond purchases, they certainly can’t cut deposit rates and probably have to raise them (if they were serious about sterilizing). In theory, they could cut deposit rates and then offer short-term bank bills as a way to absorb the extra money in circulation, but that’s the same thing in the end: we hold your money and pay you interest. The fact that it isn’t reserves, but bills, is not relevant to the sterilization discussion, and that approach is actually somewhat more flexible since the ECB can more easily raise the rate it pays on bills to be sure of soaking up enough money than it can adjust the deposit rate to accomplish the same thing. The problem, though, is that bill sales occur in the open, and it will be really obvious if they aren’t able to sterilize the purchases.

It continues to be striking how resistant central bankers are to the notion that markets, and not central bankers, ought to set market rates. Bloomberg and other media sources wrote of the ECB’s “fight to wrest back control of rates…after nearly three years of turmoil.”  When, exactly, were rates in control of central bankers to begin with? Other than the trivial case of the overnight rate, that is. That’s just crazy talk.

There is, however, still the issue that sovereign governments need to formally request aid, and agree to conditions, before the unlimited buying can begin. It occurs to me that the unlimited buying might be tied to the conditions, and so not be unlimited after all. But the bigger problem is that governments (especially now that their rates have rallied a bit and the wolf has temporarily retreated from the door) insist on having the temerity to negotiate conditions, rather than to simply accept the gruel the EU says they’re entitled to. For example, according to the Spanish news outlet El Pais, Spain’s opening bid is for a full bailout without any extra conditions (hat tip to Andy F). At least that gives them plenty of room for concessions.

Now, perhaps the rally in equities wasn’t due to the ECB’s offer to buy bonds after all. Maybe it was because the economic data was slightly stronger than expected, although I’m skeptical of that. ADP showed a gain of 201,000 jobs, the highest gain since March, plus an upward revision to 173,000 last month. Initial Claims were a bit lower than expected, at 365,000. These are both on the better side of expectations, but negligibly so given the size of the error bars involved. The ADP report may have encouraged some shorts to cover in front of the Employment Report tomorrow, but the short-term correlation between changes in ADP and changes in the Employment Report is quite poor, as the chart below shows. The R-squared of the relationship is 0.165. That is, if you know that ADP accelerated 28k this month compared with last month, it tells you almost nothing about whether Non-Farm Payrolls will accelerate or decelerate from last month’s figure.

The correlation of the levels of the changes themselves is of course much better, with an R-squared of 0.857 over the same period, but the standard error is 93k. So, today’s 201k from ADP would produce a point estimate, based on the regression (not shown here), of 210k for Payrolls. But the error bar would make the expected range 117k on the low side to 303k on the high side. Ergo, it’s still a bit early to get over-excited about the Payrolls report tomorrow.

There’s a secondary concern here that is silly, but needs to be considered. If the number is strong tomorrow, there will be some investors (and perhaps quite many) who will be skeptical that the numbers just happened to improve right in the middle of the Democratic National Convention, hours after President Obama accepts the nomination. I am not one of those who will be skeptical, not because I think any particular Administration is above the idea of manipulating the data, but because I think it would be almost impossible to do so without the conspiracy coming to light. There are simply too many people involved in the generating of this government statistic (and, of course, the ADP figure is not remotely influenced by the government). But the same people who believe the government manipulates CPI will believe they manipulate the jobs report, and this has market implications: if the figure is weak, investors will have a higher level of confidence in the data (since it goes without saying that no one would manipulate the number to be worse) than if it is strong, which further implies – especially after today’s rally – that the price response in the equity market is likely to be skewed negatively. I don’t like taking positions ahead of major numbers, but in this case I’d be inclined to shade a bit short. But just a bit.

ADP was a bit stronger-than-expected, and Payrolls may be higher or lower. But either way, these figures do have the usual error bars, and it seems unlikely that this augurs an unexpected and durable improvement in the employment situation when the man on the street is still reporting that jobs are harder to get. Nevertheless, the economy seems not to be getting worse at the moment, either, and with traditional monetary policy there would be no cause whatsoever to ease. I suppose it goes without saying that those traditions are no longer being observed, however, and I continue to think we’ll see the Fed ease next week – almost regardless of what the data does.

Categories: ECB, Employment, Stock Market Tags: ,

Deserving It

September 5, 2012 4 comments

Does Chad “Ochocinco” Johnson deserve another chance?

That’s a question I saw several times bandied about today on the NFL Network. (It is, after all, kickoff night of the NFL and so you will perhaps forgive the digression.) But no one seemed to ask the question that I find much more interesting, and more relevant in other familiar contexts as well:

Does any other team deserve to be saddled with Ochocinco for another season?

Because really, it isn’t just a question of whether he deserves another chance. That would imply there is some objective standard by which his ‘deservedness’ should be measured. It seems to me that this begs the question. Shouldn’t the arbiters of whether he deserves another chance be the people who actually have to be saddled with the consequences of giving him another chance?

I’m just saying…


There is a very interesting development in inflation land: Deutsche Bank, which along with Credit Suisse distanced themselves from less-innovative firms earlier this year when they issued ETN/ETF structures that allow an investor to invest in a long-breakeven position, has created a tradeable index that proxies core inflation.

Now, it isn’t any mystery that you can create core inflation by taking headline inflation and stripping out energy (and, if you feel like torturing yourself with tiny futures positions, food) – for example, I presented a chart of ‘implied core inflation’ in the article linked here –  so the DB product doesn’t break any new theoretical ground. But it is a huge leap forward in that it allows more market participants to trade in a direct way something that acts like core inflation.

Why would an investor care about core inflation? Is it because he “doesn’t care about buying gasoline and food”? No, an investor may wish to buy a core-inflation-linked bond for the same reason that a Fed governor wants to focus on core even though all prices matter: core inflation moves around less in the short run, but in the long run core and headline inflation move together. The chart below (Source: Bloomberg) shows the core CPI price index, and the headline CPI price index, normalized so that they were both 100 on December 31, 1979. Since then, prices have tripled, whether you are looking at headline or core. The difference in the compounded inflation rate? Core inflation has risen at a 3.471% inflation rate, while headline inflation has grown at 3.415%.

This is why central bankers want to focus on core – headline provides lots of noise but almost no signal. And it’s the same reason that investors should prefer bonds linked to core inflation: you get virtually all of the long-term protection against inflation that you do with headline-inflation-linked bonds (like TIPS), but with much lower short-term volatility.

Now, Deutsche’s index isn’t truly core inflation, but a proxy thereof. It appears to be a decent proxy, but it is still a proxy (and we have some more theoretical/quantitative critiques that are beyond the scope of this column). And their product is a swap, not a bond (although it would not surprise me to see bonds linked to this index in the very near future). So it isn’t perfect – but it is a huge step forward, and Deutsche Bank (and Allan Levin, the guy there who has the vision) deserves praise for actually innovating. Innovation tends to happen on the buy side, and with smaller firms, not with big sell-side institutions, and we should cheer it when we see it.


Now, back to actual markets: tomorrow, the ECB is expected to announce a new program of buying periphery bonds when necessary. Actually, it is a bit more than expectation, since the plan was leaked today. Supposedly, the ECB will announce that they are going to do “unlimited, sterilized bond buying” of securities three years and less in maturity.

The Euro was somewhat buoyed by this news. The idea is that big bond purchases will bring down sovereign yields, but sterilization of the purchases will mean that it isn’t truly monetization and therefore not inflationary.

This seems ridiculous to me. I am not surprised at the idea that the ECB would conduct large purchases of bonds that no one else seems to want; they did quite a bit of that with Greece, after all. But I’ve lost track – are they still sterilizing the billions in bonds that they’ve already bought, as well as the two LTRO operations which they claimed to sterilize, but never explicitly did except through the expedient of paying interest on reserves to sop up the liquidity?

How are they going to sterilize more purchases? There are basically three straightforward ways for a central bank to remove liquidity from the market. We used to think that there were only two, because the only ways the central bank ever did it was to (a) conduct large reverse-repurchase operations in which the central bank lent bonds and borrowed cash, taking the cash temporarily out of the economy and (b) to sell bonds outright, to make a permanent reduction in reserves. Now we recognize a third option, although we’re not sure how efficacious it is: (c) raising the interest rate on deposits of excess reserves at the central bank, so as to discourage the multiplication of those reserves.

But for the ECB’s purchases to be effective in terms of their size, they will be far too large to use reverse-repos as a sterilization method; and it doesn’t seem to make much sense to be selling bonds when they’re buying other bonds, unless they want to try and push up the yields of countries like the Netherlands and Germany (which might not be politically too astute) at the same time that they’re lowering the yields of Spain and Portugal. And they just cut the deposit rate to zero in July…are they going to raise it again?

I can understand the political cleverness of such an announcement, if the ECB makes it: make the bond buys “unlimited” to suggest that they can’t be outmuscled, but also sterilized so it’s not printing. But these can’t both be true – because there is not unlimited capacity for sterilization.

That plan can only work if, in fact, the ECB doesn’t actually buy many bonds. In the past, they’ve tried to trick the market into rallying with “bazooka-like” comments so that they didn’t actually have to do anything. To date, it has never worked. I doubt this will, either.


Back in the U.S., the wave of Employment data is about to hit. Tomorrow morning, Initial Claims (Consensus: 370k) will be released; about Claims the only thing I want to note is that while it is down considerably from the peak of the most-recent recession, it is only slightly below where it was at the peak of the last recession. Over the last 52 weeks, Claims have averaged 381k; in May of 2002 that average reached 419k. Also due out tomorrow is the ADP report (Consensus: 140k), which is expected to weaken slightly from last month’s figure. On Friday, of course, the Payrolls report is expected to show a rise of 127k new jobs with the Unemployment Rate steady at 8.3%.

Some observers have made a lot of the fact that the Citigroup Economic Surprise index has risen from -65 or so in July to nearly flat now. But this is not a sign of improving economic conditions; it is a sign of improving economic forecasts. Remember that this index doesn’t capture absolute levels, but the degree to which economists are missing. The current level is near flat because economists adapted their forecasts to the weak data, not because the data improved to catch up with the over-optimistic forecasts. I wouldn’t draw much relief from that indicator.

Now, with the ECB and the Fed on the calendar over the next week, markets may well get some relief. But the economy, not so much, even if we do deserve it.

August Hangover

September 4, 2012 4 comments

Don’t begin to worry, just yet, about the continued low volumes. It isn’t unusual, following a long weekend, for the first day back to still be sluggish. People are catching up with e-mail, greeting friends (friends which, in Europe at least, they may not have seen for a month or more), and so on.

And anyway, we should put today’s light volume – 599 million shares on the NYSE – in context. The average for all of last month was only 581 million shares, and only 544 million for the last half of the month. Only eight days in August were busier than today’s total, and three of those were the FOMC meeting day, the last day of the month, and Employment day. That’s slim solace if you’re a broker, I am sure, but brighter and busier days are ahead. In fact, proximately ahead.

European bonds rallied strongly as details of the ECB’s plan to buy Eurozone bonds were leaked; ECB President Draghi told the European Parliament in a “closed door” (but apparently open-mic) session that the ECB simply must buy bonds because the traditional instruments of monetary policy are ineffective. “We cannot pursue price stability now with a fragmented euro area because changes in interest rates affect only one country, or two countries at most. They have no importance whatsoever in the rest of the euro area.” It is true that to a man with a hammer, everything looks like a nail, but Draghi was essentially arguing that in want of a hammer, anything that will pound a nail will do. In short, because the traditional tools don’t work, Draghi claims that anything else which accomplishes the same ends is allowed.

The Bundesbank will not agree.

But Draghi claims the Euro’s survival depends on his being allowed to buy bonds under 3 years to maturity (why there is a limit at 3 years is unclear to me; if it was necessary to extend the program to 5 years because buying everything less than 3 years wasn’t working, why won’t the same argument work?), and it seems unlikely that there will be enough opposition to dissuade him from this action. It is one thing to ask legislatures to write a check, but the costs of profligate monetary policy (as we have seen) are not as apparent and not as immediate; and anyway, the politicians can campaign later on the need to have them around to fix whatever new problem that is created as a result.

The continuing question should be – if there is no cost to buying huge numbers of bonds, then why should the central banks ever have eschewed that action? Of course, there is no such free lunch, as William White wrote last week.  But from the standpoint of a politician, it’s almost a free lunch. “I’ll glad you pay you next election cycle for a hamburger today,” as Popeye’s pal Wimpy might have said.

Or, better yet, chastise the monetary policymakers for not foreseeing the true cost of that hamburger today!

One more comment on that William White piece. In it, he discusses among other things the many ways in which overcapacity has developed last couple of decades in many countries and many industries. He does this to illustrate the concept of “malinvestment,” which mainstream economists these days pooh-pooh but which many Nobel Laureate economists (such as Hayek) did not.

However, like many of those earlier authors, White seems to take the existence of overcapacity as implying that deflation is a serious risk. I think this is based on a misunderstanding and misapplication of the original concept of malinvestment. Overcapacity implies that resources have been mis-allocated in the past, and this creates a cost in the future – but it only implies deflation in the presence of traditional monetary response (which, let’s remember, we haven’t had in a decade or more). Overcapacity implies declining real prices, and declining real returns to property, plant, and equipment relative to labor – and that is good news for consumers. But, if this overcapacity is coupled with ample money printing, this is not inconsistent with rising, rather than falling, price levels.

Remember that the original Keynesians and Austrians were writing in a period during which most of the historical record involved a money supply effectively, if not explicitly, limited by linkage to gold. In the presence of a fixed money supply, overcapacity most assuredly leads to deflation. But in the presence of a rising money supply, these are no longer automatically connected concepts: overcapacity is a statement of investments and returns in real space, while inflation measures a change in nominal prices.

And that’s why the malinvestment of the 1990s and 2000s need not lead to the same end result as the malinvestment of the 1920s. Indeed, unless something very odd happens – and I gave the parameters I would consider odd last week  – deflation, with or without the hangover effects of prior malinvestment, isn’t going to happen.

The next few weeks will be more increasingly more active, to a degree that we may long for the quiet days of August. Keep in mind that it is a very strong time of the year for bonds, seasonally speaking, and a weak one (although not as consistently so) for stocks. But I wouldn’t try to play those zig-zags. The DJ-UBS index reached a 6-month high this morning, before backing off; that’s where I would have (and do have) my money.

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