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Wrapping Up – And Some Portfolio Projections
Whether it’s with a bang or with a whimper, the year is drawing to a close. So too is this author’s year; I expect that this will be my last post for 2012. Let me take a quick moment to thank all of you who have taken the time to read my articles, recommend them, and re-tweet them. Thanks, too, for your generous and insightful comments and reactions to my writing. One of the key reasons for writing this column (other than for the greater glory of Enduring Investments and to evangelize for the thoughtful use of inflation products by individual and institutional investors alike) is to force me to crystallize my thinking, and to test that thinking in the marketplace of ideas to find obvious flaws and blind spots. Those weaknesses are legion, and it’s only by knowing where they are that I can avoid being hurt by them.
In my writing, I try to propose the ‘right questions,’ and I don’t claim to have all the right answers. I am especially flattered by those readers who frequently disagree with my conclusions, but keep reading anyway – that suggests to me that I am at least asking good questions.
So thank you all, and I hope you have a blessed holiday season and a happy new year. And now, back to our regularly-scheduled article.
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It seems likely, although not a sure thing, that 2013 will be a better year in terms of economic growth. Certainly, we are ending 2012 in better shape than we entered it. One way or the other, the budget deficit will come down – at least partly because the prospective rise in tax rates has moved forward some realization of taxable gains – and, although that is a negative from a classical C+I+G+(X-M) perspective, I believe a smaller deficit will help assuage some business and consumer fears and be no worse than neutral … if, in fact, we get a smaller deficit! A bigger point is that while Europe is far from out of the woods, a near-term exit of Greece from the Euro finally seems unlikely. Stay tuned for Italian and Spanish dramas in 2013, and plenty of other pressures on the continent, but the worst case that we feared a year ago has been at least kicked down the road a piece.
Domestic growth to end 2012 is looking better, too. Today the Philly Fed index showed its highest print since March (8.1 versus -10.7 last month and expectations for -3.0). Existing Home Sales came in at 5.04mm, the first time above 5mm (without a government program, such as got Existing Home Sales up there briefly at the end of 2009) since 2007. The inventory of existing homes fell to the lowest level since 2002 (see chart, source Bloomberg).
Yes, there is additional “shadow inventory,” and so this isn’t the “true” inventory once you include bank REO property and other wannabe sellers who are waiting for the market to pick up, but that shadow inventory will clear a lot faster now that prices are rising. The monthly Home Price Index from the FHFA was released today, showing that nominal home prices in October rose 5.5% over last October (see chart, source Bloomberg).
Even in real terms, home prices are rising. Over time, residential real estate has roughly appreciated at the rate of inflation plus 0.5% (so that in real terms, home prices tend to just tread water). Between 1997 and 2007, however, real home prices rose some 50% before collapsing 28% between 2007 and 2011. But this latest bounce is real (see chart, source Bloomberg; I’ve merely divided the HPI by the NSA CPI price level and multiplied by 100), and it comes thanks to profligate monetary policy. To the extent that tax rates rise but the mortgage deduction persists, fiscal policy too will probably support home prices going forward. It isn’t a sustainable rise in real prices, but if it is merely sustainable in nominal prices it will heal a lot of upside-down borrowers.
On the topic of profligate monetary policy, I ought to note that M2 growth has been reaccelerating, and has grown at a 9.8% pace over the last 13 weeks. Over the last 52 weeks, M2 is +7.6%. Assuredly, it isn’t the sustained 10% pace we saw at the beginning of 2012, but it is still far more than is needed to keep prices stable with a 2-3% real growth rate…as long as velocity stabilizes or heads higher. So, while the unemployment part of the “misery index” has been improving, the inflation part of the index is likely to continue to worsen. That will be the story in 2013, I suspect, as quantitative easing continues by central banks around the globe (and continues to accelerate in places: the Bank of Japan last night increased its purchasing program by another ¥10trln) and prices or real assets are not only no longer falling, but rather starting to rise.
Where to invest in this environment? Nominal bonds are the worst of all worlds; Treasuries are priced for a -1% real return over the next 10 years, and corporate bonds are even worse with a -2.1% expected real return. (Incidentally, you can compare these estimates to those I produced in 2010 and 2011 via these links. They’re mostly worse, following a better year from asset markets than we had a right to expect!) TIPS produce a -0.74% real return for the next 10 years. Stocks are at +2.44%, which looks good by comparison but is only fair given the risk, and low compared to historical norms – and also more expensive than they were at the end of 2011 (2.57% expected 10 year real return) and 2010 (2.58%). Commodities are cheaper: by my metric, diversified commodity indices are now expected to return 5.43% per year, after inflation, over the next decade (2010: 4.30%, 2011: 4.78%, so you can see this is not an exercise in forecasting the next year’s returns!). Residential real estate has richened slightly but is priced roughly at the long-run average, so I expect returns to be around 0.2% per year for the next decade. The chart below summarizes these estimates (source: Enduring Investments).
Our Fisher model is flat inflation expectations and short real rates; our four-asset model remains heavily weighted towards commodity indices; and our new metals and miners model is skewed heavily towards industrial metals (53%, e.g. DBB) and precious metals (43%, e.g. GLD) with negligible weights in gold miners (2%, e.g. GDX) and industrial miners (2%, e.g. PICK). (Disclosure: We have long positions in each of the ETFs mentioned.)
Feel free to send me a message (best through the Enduring website) or tweet (@inflation_guy) to ask about any of these models and strategies. And otherwise, have a happy holiday season and a merry new year! I look forward to a great 2013, a robust inflation market that continues to grow (the CME is likely to list both TIPS and CPI futures in the coming year), and no small amount of volatility to navigate. This column will return circa January 3rd or 4th.
What Will the Fed Do When It’s Finally Time to Tighten?
Housekeeping note: if you missed my comment on CPI from Friday, you can find it here. And if you missed my Bloomberg Radio interview with Carol Massar on Monday, don’t worry! I will post it when Bloomberg makes it available on their site.
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One of the busier sessions in recent memory (although still well short of 1bln shares traded on the NYSE, which was the standard not that long ago) resulted in a sharp rally in the equity market with the S&P +1.2% on the day.
The trigger for this holiday treat was the “progress” in the budget talks and what investors see as the increasing likelihood that the ‘fiscal cliff’ is averted. Be careful, however; whatever progress there was is fairly speculative, and I suspect we will see a bad news wiggle before all is resolved.
It is ironic, perhaps, that what is moving the process closer to resolution is the Republicans’ sudden refusal to be steamrolled, and to instead try and play the game rather than try to negotiate as if both parties were trying to reach a fair resolution. I refer to the fact that Speaker Boehner has begun plans to start a separate legislative track in the House of Representatives by passing a bill that would keep the Bush tax cuts in place for most Americans; the bill would not avert the spending cuts that would take effect as part of the “fiscal cliff,” but would keep the government from reaching more deeply into citizens’ pockets on January 1st. It is, therefore, just exactly what the Republicans would want in these circumstances: spending cuts without tax increases (although fewer spending cuts than they would like).
The fact that this is a good play from the standpoint of the Republicans was immediately apparent from the fact that Democrats wasted no time in accusing Boehner of not negotiating in good faith with the President, and the President himself abruptly began to try and compromise slightly from his heretofore rigid position.
Of course, the Boener plan won’t pass the Senate because it will produce exactly zero Democrat votes, and if it somehow passed by luck it would be vetoed by the President, so it has no chance to become law. However, by putting the Democrats in the position of having to vote against tax cuts, it greatly increases the chances that both parties might negotiate to something that all parties hate, and therefore passes with flying colors.
In the US system, by Constitutional writ all revenue bills have to start in the House of Representatives, so by the very nature of this process the Republicans, who dominate the House, hold the serve in this negotiation. Incredibly, this is the first time they’ve shown any desire to use that advantage to produce a bill that represents something closer to their views.
As noted above, equities reacted very well to the Republicans’ show of spine. I’d noted several weeks back that I thought the Republicans had little incentive to negotiate, since going over the fiscal cliff represents smaller government and this may be the only opportunity that party has to get smaller government in the next few years. If this move persuades the Democrats of this fact, and the President moves to address the spending problem rather than just trying to soak the rich, then the fiscal cliff may be averted. It’s really important in a negotiation, especially if a true compromise is to be reached, that your counterparty knows that you may walk away.
Personally, I think the odds are still against this happening before year-end, but some resolution fairly early in the new year is probably odds-on. However, with the debt ceiling also approaching, 2013 may well see more of these cliffhanger negotiations.
Bonds, interestingly, sold off. You would think that the prospect for a smaller deficit, even marginally, would help the Treasury market but in this case I think investors are reacting to the fact that if the fiscal cliff is averted, it lessens the chance of near-term recession and brings forward the day of reckoning for the Fed. Today, 10-year Treasury yields rose to 1.82%, which is near the highest level since early May, and 10-year real yields rose to -0.73%. Over the last five days, nominal yields have risen 16bps, and all of that has come from real yields. That is, inflation expectations have barely moved and 10-year breakevens remain at 2.50%. Ten-year inflation swaps are at 2.77%, and the important 1-year inflation, 1 year forward has risen to 2.23%.
So, whether the ‘day of reckoning’ for the Fed is near, or far…what do they do, when they’ve hit that point? And, more importantly, what does it do to the market?
Let’s assume that we are at some point in the future and either the Unemployment Rate has dipped below 6.5%, the forward PCE inflation rate has risen above 2.5%, or inflation expectations have become “unanchored.”[1] The first thing that the Fed will do is to stop unlimited QE: the statement does not imply that they will immediately start trying to get out of the hole they are in, only that they will stop digging the hole. But suppose that inflation continues to tick up – since the evidence is that inflation is a process with momentum. What does the Fed do next? This is the real question. How quickly can the Fed react to adverse inflation outcomes?
The traditional option is that the Fed raises the overnight rate. The Fed announces this move, but the important part is what happens next: the Open Market Desk (aka ‘the Desk’) conducts reverse repos to decrease the supply of reserves, or sells securities outright if it wishes to make a more-permanent adjustment. This causes the price of reserves (also known as the overnight rate) to rise, and the Desk adjusts its activity so that the overnight rate floats near the target rate.
The problem is that this won’t work right now. There are far too many reserves in circulation for the overnight interest rate to be increased by reverse repos or small securities sales. In fact, if it wasn’t for the interest being paid on excess reserves, the overnight rate would certainly be zero, and might even be negative because the supply of reserves greatly outweighs the demand for reserves. They are called “excess” reserves for a reason – the bank doesn’t need them, and will lend them overnight for pretty much any available rate.
So in order for the Fed to push the overnight rate higher, it must first soak up all of the excess reserves in the system – about $1.5 trillion at the moment – by selling bonds. Obviously, this is not something that can be done in the short-term.
But this misses the point a little bit anyway, because it isn’t the rate that matters to monetary policy but the amount of transactional money (such as M2). The Fed can set the overnight rate at 1% by simply agreeing to pay 1% as interest on excess reserves (IOER). But that won’t do anything at all to M2, because it won’t change the amount of reserves in the system and doesn’t change the money multiplier that relates the quantity of those reserves to M2.
So the short rate is dead. It isn’t going to move for a very long time, unless the FOMC decides to help the banks out by paying a higher IOER. And if they do that, it’s not going to affect inflation so it would just be a sweet present to the banks.
Okay, so perhaps the Fed can sell those long-dated securities and push long-term interest rates higher, slowing the housing market and the economy and squelching inflation, right? That’s partly right: the Fed can sell those securities, and it can push long rates higher (although the Fed has oddly claimed that if it sold those bonds, interest rates wouldn’t rise very much, which makes one wonder why they did it in the first place since presumably the opposite would also be true and buying them wouldn’t push rates down), and that would slow growth. However, it wouldn’t affect inflation, because inflation is not meaningfully affected by growth (I’ve discussed this ad nauseum in these articles; see partial arguments here, here, here, and here). But you don’t have to believe all of the evidence on that point; just play it in reverse: if driving long rates down didn’t cause a sudden jump in inflation, why would driving long rates up cause a sudden dampening in inflation?
Fama, in that article I quoted last week, had a very good point which I thought it was worth developing in more detail. The Fed has its hands off the wheel with respect to inflation…which isn’t a problem, except that they’re sitting in the back seat. The back seat of a very, very long bus.
In any event the issue isn’t when the Fed starts its tightening, but when inflation stops going up. These are not the same things. If core inflation were to start ticking higher today, at a mere 1% per year, I think it would take 6-9 months for the Fed to stop QE (core PCE is at 1.6%), probably another 3 months at a minimum before they started to tighten, and then at least 1-2 years before they could have any meaningful impact on the money supply and cause inflation to slow. Maybe I’m being pessimistic, or maybe I’m being a bit generous by assuming that after a year the FOMC would start doing something very dramatic to sop up reserves, like issuing a trillion dollars in Fed Bills, but even assuming that everything works out just about as well as it conceivably can, if inflation started heading higher in that way then you’re looking at a core CPI figure of 4-5% before it stops rising. Like I said, it’s quite a long bus, and that translates to long “tails” of inflation outcomes.
How would markets react to this? Obviously, bond rates would be much higher, but would this be good or bad for equities? The conventional wisdom holds that equities are good hedges for inflation, because over a long period of time corporate earnings should broadly keep pace with inflation. While that is true, it is also the case that earnings tend to be translated into prices at lower multiples when inflation is high (a fact that has been known for a long time; in 1979 Franco Modigliani and Richard Cohn described this as an error but there isn’t consensus on that issue) so that stocks tend to do relatively poorly when inflation is rising and better when inflation is falling from a high level. Moreover, stocks do especially poorly in the early stages of inflation when short-term inflation is surprising to the upside, as the chart below (Source: Enduring Investments) illustrates.
This chart highlights headline inflation, rather than core, but the point should be clear: nominal bonds and equities produce good real returns when inflation is surprising to the low side (even if that means that inflation is just going up slower than expected), and very poorly when inflation surprises to the high side (even when the overall level is low).
In my mind, this means that every investor needs to have some inflation protection, but especially now when the chances for an ugly inflation surprise are significant. For the record, the best asset class when inflation is surprising to the high side as measured here? Even inflation-linked bonds have produced negative real returns in such circumstances, because the real yield increase outweighs the higher inflation accruals in the short run. But commodities indices historically produced a 4% real return over that time period when inflation surprised at least 2.5% to the upside.
[1] It isn’t clear to me why you would want to wait until they were unanchored, if anchoring matters, since presumably it isn’t easy to anchor them again. After all, the whole reason the Fed wants anchored inflation expectations is because a regime change is thought to be hard – so if they are unanchored, you’ve just made it really hard to get inflation back down. In any event there’s not much evidence that “anchored” inflation expectations matter to actual inflation outcomes, but it’s just weird to me that the Fed would imply that they’d wait until expectations get loose from the anchor.
Bloomberg Radio – Scheduled Appearance Today
I will be on Bloomberg Radio with Carol Massar today at 11:48ET.
Summary of My Post-CPI Tweets
The following is a summary of my post-CPI tweets. You can follow me @inflation_guy.
- Core CPI only 0.11% unrounded, 1.94% y/y. Large fall in apparel prices partly to blame.
- Suspect there may be some seasonal issues since last 3 months were weak in both 2011 and 2012.
- Key thing looking forward is that rents and OER both continue to motor higher…and no sign of stopping.
- also big drop in ‘lodging away from home.’ Always some quirky stuff out of 200 item indices, and I don’t like to ‘ex out’ everything.
- Core services inflation remains +2.5% y/y; core goods inflation drops from +0.7% to +0.5%.
- Owner’s Equiv Rent y/y went from 2.140% to 2.125%. Primary Rents went from 2.75% to 2.73%. That’s 30% of consumption right there.
- Accelerating: Food&Bev, Housing, Recreation (61.1%) Decel: Apparel, Transp, Med Care, Other (32.2%). Unch: Educ/Comm (6.7%)
- Transp fell because of Motor Fuel, of course. Apparel because Girls Apparel plunged. Really.
- Nothing here disturbs what we see as the underlying dynamic for inflation. Our 2013 forecast range for core remains 2.6%-3.0%.
Most forecasters are projecting a decline in core inflation over the next year. However, the chart below, which I’ve shown before, illustrates why almost a third of the consumption basket (and 40% of core inflation) is very likely to continue rising. Home prices and direct rents have responded very well to the Fed’s aggressive easing campaign, and (with a lag) the 5% rise in the FHI Home Price Index and the 11% rise in the median prices of Existing Homes are being reflected in primary rents and OER.
I’ve put together a little press release/summary that may be useful for journalists, as we’re trying to generate more exposure (and new client inquiry) in 2013 for Enduring Investments. Please drop me a line if you know of someone in the media who ought to be on that list!
Objects In Mirror May Be Closer Than They Appear
The Fed delivered QE4, as expected, on Wednesday as it pledged to continue buying longer-dated Treasuries even though it will no longer sell shorter-dated Treasuries in Operation Twist. In other words, they will accelerate the balance sheet expansion from $40bln (all mortgages) to $85bln (Treasuries and mortgages) per month, beginning next month.
What was unexpected was that the FOMC decided to parameterize the “soft Evans rule” that has been in place since the summer but which has grown gradually more specific since then. The relevant passage from the statement was this:
“In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”
The financial chatterverse immediately set about guessing how quickly the economy could reach 6.5% unemployment, and variously asserting that this was a hawkish or a dovish statement based on their assessment of the likelihood of reaching that level soon. (According to the Fed’s projections, released somewhat after the FOMC statement, they expect to reach that level sometime in 2015.)
But that isn’t the binding parameter. As I showed yesterday, longer-term inflation expectations are arguably not very well-contained; moreover, 1 year inflation, 1 year forward is currently around 2.15% in inflation swaps. Inflation swaps are based on CPI, not PCE, so this equates to roughly 1.90% in forward PCE versus a 2.50% barrier for the Fed. As the chart below shows, 1y inflation 1y forward hasn’t been above 2.75% in a while (equivalent to 2.50% on PCE), but it has gotten pretty close in recent years. It doesn’t seem like a bad level to target, but it’s much closer than the market seems to understand.
Here also is 5y, 5y forward, but from inflation swaps rather than breakevens (source: Bloomberg). The Fed prefers breakevens, because they imply a lower level of inflation; market participants know (at least, most of them know) that this is due to quantitative phenomena that distort Treasury yields low and that the inflation swaps market typically gives a better indication. Note that the upward trend I identified in yesterday’s column is still there, although somewhat less monotonic.
Street economists in the immediate aftermath of the FOMC announcement made lots of pronouncements but in generally were looking at the wrong thing. I saw economists look at the 10y spot BEI at 2.4% when the 5y, 5y forward inflation swap – more relevant to examining is around 3.20%. This is wrong. The right numbers to look at are now 1y, 1y forward and 5y, 5y forward.
The Fed in this statement is no less dovish than they had been. They are led by a super-dove and Lacker still dissented as the lone voting hawk. But the Committee is increasingly painting themselves into a corner as they have parameterized the Evans Rule. They’ve drawn a line in the sand now, and when inflation bursts higher and 1y1y is trading at 3.5%, it’s going to be hard for the Fed to keep forecasting 2% for next year with any credibility. In his press conference, Chairman Bernanke listed as indicators the Fed will look at on the inflation side: median and trimmed mean CPI, the views of outside forecasters, and econometric models of inflation. He didn’t mention market prices at all! So, we can expect that the Fed will try to ignore (as they are already ignoring) market indicators of inflation expectations…but at some point, this will become more or less untenable.
On the fiscal cliff front, there was again no progress. JPM Chairman Jamie Dimon said on CNBC that the economy will boom if the fiscal cliff is averted: the same unsubstantiated assertion that the President and members of Congress have been making recently.
Here is my question: isn’t it in a booming economy that we’re supposed to reduce the deficit? If the economy is really as strong as they say it is, then the fiscal cliff is timely. I mean, if we increase the deficit in recessions and don’t reduce it in booms…do you have to be able to do much math to see where that leads? Even a CEO who mistook a big punt for a hedge ought to be able to do THAT much math.
So all the good news is out, unless the fiscal cliff is averted. I suspect the stock market will slide from here, and interest rates will rise into year-end. With volumes this low, that’s a perilous call to be sure, but in my mind the risks outweigh the rewards of betting the Santa Claus rally will continue.
The Stocking Is Mostly Full
With the exception of a resolution to the budget crisis, Tuesday probably saw the best combination of possible news and expectations that we could have for the remainder of 2012. The stocking is mostly filled with all of the gifts we are likely to get this year.
It started with the announcement that Greece managed to meet its goal for the bond buyback, as it attracted some €31bln in tenders. As it turns out, they had to pay more than the absolute highest price they were supposed to pay (the closing price on November 23rd), but as I noted at the time there was little to no chance of Greece completing the buyback without paying above-market prices, unless the sellers were coerced in some way, so that wasn’t really news.
Now, according to the Bloomberg story, the Euro finance ministers get to meet on December 13th to decide whether to release the €34.4bln tranche of the rescue which was contingent on a successful buyback. But the deal is almost done. Given the interest holidays and the lengthened maturity of Greece’s debt, it is looking increasingly likely that they’ve managed to delay the day of reckoning substantially. Sure, they did that by moving all of the debt to official institutions, who will carry it at par although it will eventually be defaulted on. Sure, this creates the risk of me-too-ism from other PIIGS who would like a lengthy payment holiday and hundreds of billions of Euros in support. But the risk that Greece will need to default in the near-term is passing. Of course, so is the need for Greece to continue austerity, once they’ve gotten everything they need from the Eurozone finance ministers. Maybe they were more clever than I gave them credit for…
So Greece was good news, and we’re also cheerfully waiting for tomorrow’s FOMC meeting. The results are so widely expected as to lead one to expect the intentions of the Fed had been carefully vetted beforehand. The overwhelming consensus is that the Fed will announce that they will cease half of Operation Twist: the half that has them selling short-dated Treasuries, of which the Fed now has almost none. The consequence is that the Fed will now be outright buying about $45bln in long-dated Treasuries, over and above what they were already purchasing in QE3, per month, without end.
Obviously, equities liked this idea because we all know that the script says stocks are supposed to ramp up into QE. More surprisingly, long-dated Treasuries actually slipped a bit lower. The 10-year yield is at 1.65% and 10-year real yields at -0.89%.
Now, here’s the problem as we roll into Wednesday. There’s really no chance that the Fed is going to do more than $45bln per month in Treasuries purchases, especially with the inconvenient (albeit cosmetic) downtick in the Unemployment Rate this month. Therefore, what is priced into the stock market is pretty much the best-case for QE.
Is there any chance that the Fed might actually do less, or even defer until the next meeting the decision about whether to pursue an acceleration of QE? The chart below (Source: Bloomberg) shows the 5-year inflation breakeven, 5-years forward, taken from TIPS and Treasuries.
Clearly, while inflation expectations are “contained” in the Fed’s view, they are plainly becoming steadily less-contained. The 5y, 5y forward BEI has been rising in a trend for fourteen months now, and it is above 3%. In inflation swaps, which don’t have embedded the financing advantage of nominal Treasuries over TIPS, the 5y, 5y forward is 3.17%. In short, the market is currently pricing expectations that the Fed will fail in its mission to keep core CPI inflation around 2.25%, and that there will be a long-lasting deviation from that target.
(As an aside: we can’t tell just from the point estimate taken off the yield curve whether market expectations are for a steady miss, or whether the expectation is for something fairly close to target, but with considerably “option value” because the upward tails are a lot longer than the downward tails. It appears that both are currently contributing to the high forward breakevens because implied inflation volatilities have been rising.)
Now, like everyone else I expect that the Fed will stay on the course that has been laid out for them by the market, and endorse a QE4 plan tomorrow. And I don’t think we’ll get Evans Rule parameters tomorrow. But, as I said, all likely surprises from that expectation are negative for equity markets, and even if the Fed delivers what has been writ then I’m not sure where we get a further rally unless the fiscal cliff is averted.
Fama on the Fed and Inflation
I don’t agree with Eugene Fama on everything, but I’d be a fool if I didn’t agree with him on quite a bit. Fama wrote the paper which, back in the early 1980s, pointed out that if you modeled inflation as a result of monetary factors and Keynesian factors (unemployment, e.g.), the Keynesian factors didn’t add anything. Since then, economists have pretty much forgotten that lesson, so that we have to continually battle the Keynesian “let’s just expand government spending” crowd.
Many of his views about efficient markets are pretty extreme, and that’s where I can’t agree wholeheartedly. However, I read with interest the discussion between Fama and Bob Litterman in this month’s issue of the Financial Analysts Journal. The full interview, called “An Experienced View on Markets and Investing,” is located here, and since the FAJ has made the entire interview available for free I am going to quote liberally from the last page. Indeed, I am going to print three of the last four questions, because they correlate exactly to things I have written in this space, and echo almost exactly the views I have expressed. Considering Fama is one of the godfathers of modern finance, I take this as indication I am on the right track, at least sometimes.
In the passages below, I have added all the emphasis marks.
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Litterman: What impact will the big expansion in the Federal Reserve’s balance sheet have on the markets?
Fama: It has basically rendered the Fed powerless to control inflation. In 2008, when Lehman Brothers collapsed, the Fed wanted to get the markets moving and made massive purchases of securities. The corollary to that activity, however, is that reserves issued by the Fed and held by banks exploded. An explosion in reserves causes an explosion in the price level unless interest is paid on the reserves. So, the Fed started to pay interest on its reserves, which means that the central bank issued bonds to buy bonds. I think it’s a largely neutral activity.
Before 2008, controlling inflation was a matter of controlling the monetary base (currency plus reserves). But when the central bank pays interest on its reserves, it is the currency supply that determines inflation. But banks can exchange currency for reserves on demand, which means the Fed cannot control the currency supply and inflation, or the price level, is out of its control. The Fed had the power to control inflation, but I don’t think it does under the current scenario.
[Ashton’s note: Fama identifies why the monetary base is no longer tied to inflation – the link to transactional money has been severed thanks to IOER. See some of my remarks on this here.]
Litterman: But isn’t one way out of our debt problem to inflate it away?
Fama: Yes, that’s one way to handle it, but it’s far from a great solution. If the Fed were to stop paying interest on its reserves, we’d probably have a big inflation problem. The monetary base was about $150 billion before the Fed stepped in in 2008. Currency plus required reserves are still in that neighborhood, but the Fed is holding $2.5 trillion—trillion!—worth of debt financed almost entirely by excess reserves. The price level could expand by the ratio of those two numbers, and that translates into hyperinflation. Economies typically do not function well in hyperinflation. The real value of the government debt might disappear, but the economy is likely to disappear with it.
Litterman: What would your suggestion be for monetary or fiscal policy at this point?
Fama: Simple. Balance the budget. I heard a very prominent person say in private that we could balance the budget by going back to the level of government expenditures in 2007. The economy is currently about the size it was then. If you just rolled expenditures back to that point, I think it would come close to balancing the budget.
[Ashton’s note – just this month, I commented that all you have to do to get the budget back into a semblance of balance was to reverse most of the things that were done over the last decade.]
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The whole FAJ article is pretty good, but I wanted to make sure that everyone caught this part of it!
The End-of-Year Downshift Is Beginning
With the last major central bank meeting of the year (the Federal Reserve’s) due on Wednesday, and few important pieces of data ahead aside from Friday’s CPI, markets seem to be starting the inevitable downshift into the end-of-year holidays. Admittedly, it is somewhat hard to tell. It looks like aggregate equity volume in 2012 will be down a stunning 28% or so from 2011 (see chart below, source Bloomberg). This continues a recent trend, but accelerates it as well.
I’ve discussed in these articles in the past the possible causes of this seemingly-secular decline. I believe that there are at least two causes. One is not particularly worrisome; there was probably already a trend in place for volume to move off of organized exchanges to “dark pools” and the like. But the recent drop in volumes seems more likely to be caused by recent events, and judging from anecdotal evidence I’ve seen – namely, that market-makers are reducing the scale of their operations across almost all products because of the regulatory difficulties of maintaining those operations – a big part of the recent decline is likely to be attributable to the gradual implementation of Dodd-Frank and the Volcker Rule. This is something less than shocking. What hasn’t yet happened, but I suspect may, is that asset prices themselves decline if liquidity is meaningfully impacted by declining volumes. For any given asset, the fair price is a direct function of liquidity (as well as many other things, of course), which is why there is such a thing as a ‘liquidity discount’ enshrined even in tax law. The decline in liquidity itself is probably non-linear (since market-makers will be less aggressive as they perceive other market-makers being less aggressive), and therefore the decline in asset values is likely non-linear as well.
Not to mention being totally unpredictable as to timing, I might add. But there is something to the old rule of technical analysis rule that markets can go down on big volume, but they can’t typically go up for an extended period on low volume.
Global political events haven’t yet left town for the holidays. Italian Prime Minister Mario Monti announced on Saturday that he plans to resign after former Prime Minister Berlusconi withdrew his support. 10-year Italian yields jumped 30bps to 4.81%, but remain considerably below the levels associated with any serious concern about Italy (see chart, source Bloomberg).
Across the Ionian Sea, Greece extended the original deadline for its debt buyback by two days, signaling that it hasn’t reached its target. According to reports, the government has received tenders for €26bln (in face amount) versus its target of €30bln. However, the important number is the difference between the face amount of the debt offered compared to the price paid by the government. That number needs to get to €20bln, and there is no way to know if the government is close. If they have overpaid relative to the 33 cents on the dollar they were expecting to pay, and have spent, say, €10bln to get those €26bln in tenders, then they’re not really all that close. If they have spent €7bln, then they’re very close and I would guess close enough. I’m not sure we know.
In the U.S., no apparent progress has been made on the fiscal cliff.
But here’s a little story that caught my eye. “NYC Base Subway Fare May Rise to $2.50, Board Members Say.” I only point it out because the 11% hike in base fares seems out-of-place with a weak economy…if, that is, you think that economic growth causes inflation. Personally, I don’t believe in that old, discredited notion, but some people do.
Looking forward over the balance of the month, I don’t expect that we will see a Santa Claus rally in equities. Although we got such a rally in 2010 (+6.5% in the S&P 500), and smaller ones in 2009 (+2.8%) and 2011 (+0.9%), there seems to me to be too much uncertainty for investors to make significant bets into the end of the year. The outcome in December is likely to be decided by a coin flip – if the fiscal cliff is resolved, then equity markets will rally (and that rally probably should be sold, since the underlying fundamentals are still very poor); if the fiscal cliff is not resolved, stocks will slide into the end of the year (and that selloff is probably worth buying, if it’s deep enough, since there’s a reasonable chance that the issues are resolved after both sides realize the other side isn’t going to blink). I’m not sure that’s a market I want to have a strong commitment to right now, in either direction.
If You Want To Do Instant Replay Right
This article is very unlike anything I have written on this blog before. It has nothing whatsoever to do with the market, the economy, or finance. It involves something that is far more important: football. (It therefore is likely to be my most-popular blog post ever.)
A great frustration for any fan of American football is the process known as “instant replay,” where an official’s live ruling is questioned and potentially reversed by means of careful study of video taken of the play from a bunch of different angles. The process slows down the game, adds a layer of odd strategy and introduces some quirky rules (such as the bizarre rule, obviously introduced by sadists, that a scoring play is always reviewed automatically, unless it’s challenged by a coach in which case it cannot be reviewed no matter how bad the call was).
But the real problem with instant replay boils down to this: it was introduced as a way to “correct” heinous calls made on the field, and it is marketed as such. The idea is to correct Type II errors – correcting the on-the-field failure to make the right ruling – but without introducing Type I errors – incorrectly changing an on-the-field ruling that was in fact correct. Consequently, the rule states that the ruling on the field stands unless there is “indisputable visual evidence” that the ruling was made in error.
But in practice, this standard doesn’t work. Moreover, it cannot work. “Indisputable” is an impossibly high standard that should ensure that calls are very rarely overturned; however, if they are very rarely overturned then there is little point to allowing so many challenges. And, in practice, something far different from “indisputable evidence” is actually implemented.
Consider the following play, which occurred at the end of a furious comeback by the Dallas Cowboys against the New York Giants in week 8 of the current NFL season. The Cowboys, at one point down by a score of 23-0, scored an apparent touchdown to take the lead with 10 seconds left when receiver Dez Bryant made a catch in the end zone. It was ruled a touchdown on the field, but on further review the catch was waved off and ruled an incomplete pass, after inspection of the video concluded that there was “indisputable evidence” that Bryant’s pinky finger had brushed the grass out-of-bounds before his elbow landed, making the play dead and the pass incomplete. Here are two images of the catch. Keep in mind that in order to overturn the call, you must be able to state without fear of dispute that the white-gloved pinky grazed the white-painted grass out-of-bounds.
Now, it is very likely that Bryant was out-of-bounds on this play, but the standard is “indisputable.” Given the rule, that was an incorrect call.
Yet it is very likely that Bryant was, in fact, out of bounds. In a room of ten (neutral) observers, probably seven or eight would say he was out while two or three would say he was not, or that they couldn’t tell. That’s not close to indisputable, but it is probable. The legal standard would be “preponderance of the evidence” rather than “beyond a reasonable doubt,” and if that was the standard the Cowboys still lose the game. In a cosmic sense, that’s probably a just result although it’s the wrong football ruling given the current rules.
This happens, and is going to continue to happen, as long as the replay rules are enforced in this way. But there is a better way to do it.
The way instant replay is currently implemented involves an official or officials “up in the booth” as well as the referee on the field. It is the referee who makes the call, after looking at the reply, about whether his own call (or the call of someone on his team) was correct or not. This is absurd on two levels: first, that one person makes the call, and second, that the official makes a re-judgment of his own rulings.
If I were designing an instant replay system, here is how I would do it:
- I would hire, say, 50 officials, trained in the rules as referees, to sit in a room at NFL HQ. (Technologically, there is no reason they couldn’t be located around the country rather than in one room, but this helps the image).
- When a play comes under review, each official looks carefully at the play and without consulting the other officials presses one of three buttons: “let play stand,” “reverse play,” or “indeterminate.”
- A tally is taken, and if the vote exceeds a predetermined threshold then the play is reversed.
The advantage of this system is that we can set the dial on the “pre-determined threshold” wherever we want. If we truly want “indisputable” evidence, then it needs to be unanimous to overturn. But more reasonable is that we set a supermajority level like 75% or 80% to overturn. This recognizes the fact that almost nothing is “indisputable,” and allows the league to set the evidentiary standard wherever it wants to. The referee could even report the result: “with only 55% of officials disagreeing with the call, the play stands as ruled on the field.”
In fact, this opens up more neat options. We could have different evidentiary standards for scoring plays compared to turnover plays, for first-quarter plays compared to fourth-quarter plays, for playoff games compared to regular season games. It wouldn’t cost the league very much at all, because the “upstairs replay official” at each game could be eliminated. The technology certainly exists to do this. And it could be done more quickly than the current method allows.
That is how to do instant replay correctly. I think it’s indisputable!
Summary Of My Post-Payrolls Tweets
The following are my post-Payrolls tweets (@inflation_guy), along with some charts and added thoughts.
- Payrolls number close, expected 85k was actually 146k but 49k of downward revisions. Amazingly good guesses given Sandy.
- Unemployment Rate drops to 7.746% from 7.876% (so really 0.1 drop not 0.2 drop), due to sharp particip drop to 63.6 from 63.8
- Not a particularly good report; haven’t had >200k jobs since March, after these revisions. But chatterverse will say it’s bullish stocks
- Goods producing jobs -22k; service-providing +169k. Retail trade +53, allaying some fears that weak Xmas season could hurt #s.
- Here’s some good news: Aggregate weekly hours rose to a new post-2008 high of 104.1, which is higher than it was in 2000. [Note: chart below]
- “Not in labor force” rose again: second highest total ever. Not in labor force, want a job now also rose. This is “shadow unemployment.” [Note: charts below]
- The chatterverse will say it’s a good report, but in my view it isn’t good enough, and we’ll quickly turn to fiscal cliff again.
As noted, this isn’t a great report. It continues the theme of tepid recovery, but without the people leaving the labor force the unemployment rate would be much higher. The chart below (source: BLS via Bloomberg) shows the “not in labor force” numbers going back decades.
Now, the thing is that I’m not sure this is a temporary phenomenon – some of these people are leaving the labor force because they’re giving up, but some of them are leaving the labor force because they’re retiring, or retiring early. We would be expecting some rise in this number anyway, due to the fact that Baby Boomers are starting to retire. So I think the chart below (same source) is a better view of the part of this rise that’s truly disturbing. It shows the category “not in labor force, but want a job now.” These are people who are not counted in the labor force because they’re not looking for a job, but if someone called and offered them a job they’d take it. Presumably, when the job market starts visibly recovering, these people will start to look again.
Finally, let’s not lose sight of the fact that the economy is still stumbling, but at least it’s stumbling forward. The chart below (same source) shows the aggregate weekly hours worked by production or nonsupervisory employees (2002=100).
As I say above, this isn’t a great report, and it isn’t a bad report – in my view, it’s good enough so that the CNBC talking heads can tell everyone to buy but not so good that it will re-direct the narrative from the fiscal cliff. And it certainly isn’t good enough to claim that there’s any evidence the economy is “ready to explode” once the fiscal cliff is resolved.
