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Global Gridlock
It’s hard for me to truly grasp the reality of a world in which the downgrade of the British Empire’s credit (late on Friday) was the third most-important story, but so it is.
The UK was dropped from AAA to AA1 (one notch, but an important one) by Moody’s on Friday, and sterling dropped to the worst level against the dollar since 2010. In the grand scheme of things the drop to $1.51 was not critical, and the cable is still almost in the range it has held for the last few years, but some technicians are sure to see the breakdown as an ugly technical development (see chart, source Bloomberg).
But, fortunately for Britain, the Italians were drawing global attention to themselves and the Euro. As ballots were counted in the election to establish the balance of power in that nation, global markets careened up and down depending on the latest tallies. Ultimately, it appeared that a split government was in the offing, with a general repudiation of the politicians which have been party to austerity measures. The party of Berlusconi, who ran opposing the austerity measures, combined with the “Five Star Movement” party of Grillo, who advocates suspending interest payments on Italian debt and holding a referendum on Italian membership in the Euro, would represent an outright majority in the Senate although the lower house ends up in the hands of Bersani because of a “bonus premium” that guarantees the winning coalition will have a majority.
In the end, the reason the Italian election matters more than the downgrade of the UK isn’t because the election raises questions about whether Italy is committed to austerity; it’s that the election raises questions about whether Italy is committed to the Euro. This isn’t Greece. With a $2 trillion economy, Italy is the third largest member of the Eurozone, behind Germany ($3.4T) and France ($2.6T). It is the size of the other four PIIGS combined. And they’ve also issued a lot of inflation-linked bonds, by the way, so look carefully if you own an inflation-linked bond fund that invests in non-US bonds, just so you know.
Now, Italy isn’t going to default any time soon. They’re going to have another election, and in the lead-up to that one there will be more concern and angst. But then the leaders will use that as a bargaining chip, etc. etc.. We’re a long way from a default or exit of Italy from the Euro. But we’re probably not as far from fear of default or exit.
Still, the immediate uncertainty is past. The markets will calm back down reasonably quickly (which doesn’t mean they’ll rally, being overpriced to begin with). Each successive fire drill will cause a shorter and less-intense period of instability in Europe, until eventually the crisis completely passes, or one episode turns out to be qualitatively different and the whole thing breaks down.
And speaking of episodic crises brings us to fiscal cliff redux. The U.S. will hit the sequester barrier in a few days, with almost no chance that it will be averted. The Republicans seem comfortable that this isn’t such a big deal, and that if it turns out they are right then the scare tactic they feel is being used against them will be defanged. The Democrats seem to believe (and intent on making sure everyone else believes) that any cut in expenditures is tantamount to the End of Days. I don’t think the market ought to react very seriously to it, because we’re only talking 0.25% of GDP, but that all depends on how much hyperventilating we get from the media.
Still, it’s an interesting story because if it turns out that the budget can be cut by 2% (albeit 2% from baseline, which is still an increase over last year) without the economy going into the loo, then we’ve moved the goalposts for future negotiations. And if both sides can understand that, then cutting spending (even real spending!) by 2% per year will slowly get the budget back on a course that, while not sustainable, at least doesn’t lead to immediate immolation.
I am not sure how stocks will react to all of this (have I mentioned they seem expensive?), but I know that all three stories should be bond-bullish. The 10-year yield made it all the way back to 1.87% today after peeking over 2% several times the last few weeks. I think there is further upside to bonds for now, and that may mean that breakevens can also retreat some from near all-time highs. If I am right, then selling 10yr notes if they approach 1.65% or buying 10-year BEI near 2.40% represent better placement for the long term trades, which I expect to be higher in yield and in breakevens over 2013.
A Bad Day At The Federal Reserve
There will be many more days ahead for the Fed, and many of them will have plenty of good news. It is a mistake to trya and read too much into one day’s economic releases. With that said, here is my attempt to do exactly that.
I tweeted the following real-time reactions (@inflation_guy) following the CPI release this morning:
- Ready for an exciting day…CPI, Claims, Philly Fed, a 30-year TIPS auction, wild commodity swings, 3 Fed Presidents…buckle up!
- Hello! Core inflation +0.3%, higher-than-expected. Look out above.
- Apparel +0.8%. Some will pooh-pooh the number on that basis, but Apparel has been trending higher for more than a year.
- To be fair, core inflation BARELY rounded up to +0.3%. But the market was looking for +0.16% or +0.17%.
- Core Services remains at +2.5% y/y, but core goods ticks up to +0.4%. The recovery of core goods has been something we’re looking for.
- Somewhat surprisingly, the +0.251% rise in core inflation did so without having a rise in Owners’ Equiv Rent. Went from 2.1% y/y to 2.08%
- Accel Inflation: Housing, Apparel, Educ/Commun, Other (54.7% of basket); Decel: Food/Bev, Transp, Med Care, Rec (45.3% of basket)
- In Transp, the drag was almost all fuel. New/used Cars, maintenance, insurance, airline fares, inter- and intracity transp all up.
- What’s amazing in the CPI today is how much it did with how little from the main driver of housing. That uptick is yet to come.
- …and, next month, headline will get upward pressure from the steep rise in gasoline, which also dampens discretionary spending.
The primary takeaway from the CPI release is this: yes, core inflation surprised a little bit on the high side. But it did so without the support of the main factor that I think will push core inflation almost certainly higher going forward: housing. Rents (both primary and OER) neither accelerated nor decelerated this month from the prior year-on-year pace. And yet, there is really no temporary factor that pushed inflation higher this month. It was fairly broad-based. Apparel stood out on the month-to-month change perspective, but here is the chart (source Bloomberg) on Apparel:
This month doesn’t appear to me as too much of a true outlier. The underlying dynamic there has simply changed.
So this month core inflation stayed at 1.9%; next month it is very likely to return to 2.0% as we are dropping off the weak February change from last year. And all of that, before the housing inflation hits the data.
Speaking of housing inflation, there is no sign yet of that abating. In today’s Existing Home Sales report, the year-on-year change in Median Existing Home Sales Prices rose to 12.61%, another post-2005 record, and the highest real price increase ever, outside of 2005. This is happening because the inventory of new homes has dropped to almost a record low – really! Sure, the chart below (source Bloomberg) ignores “shadow inventory,” but it is starting to look more like the inventory of new homes now.
Some of that is seasonal, but there’s no doubt that lower inventories are now helping the home pricing dynamic. And, as I’ve shown previously, the inventory of existing homes actually has a nice relationship with shelter inflation 1-2 years later (Source: Enduring Investments):
The current level of inventories translates into a 3.6% expected rise in CPI-Shelter over the course of 2014. So you see, we’re not only firing inflationary rounds but we’re also continuing to feed more ammunition into the gun for next year. Our model of housing inflation projects Owners’ Equivalent Rent no lower than 3% by year-end 2013. And if that happens, there is no way that overall core inflation is going to be at 2%.
Now, in addition to the bad news on prices and the news on home prices that are probably seen at the Fed as a guarded positive (after all, it means the mortgage crisis is essentially over as more borrowers will be ‘above water’ again every month hereafter), there was also a mild surprise on the high side from Initial Claims (362k versus 355k) and a bad miss on the Philly Fed index for February. This latter was expected at +1.0 after -5.8 last month; instead it dropped to -12.5. Philadelphia-area manufacturers have reported softening business conditions in three of the last four months, suggesting that December’s pop to +4.6 was the outlier. Now, there were similar one-month dips in August of 2011 and June of 2012, so we’ll have to see if it is sustained…but it is consistent with the report out of Wal-Mart and the worsening of business conditions in Europe.
Higher prices (and more coming, on the headline side, as retail gasoline prices have now risen in 35 consecutive days) and lower business activity. This is exactly the opposite of what the Fed wants. It has been a bad day at the Fed.
However, it is exactly what traditional monetarism expects: accommodative monetary policy leads to higher prices (check), and has no effect on real activity in the absence of money illusion (check). So score one point for Friedman today.
And so, what else would you expect after such a day? Bond yields are declining, inflation breakevens are narrowing, and industrial commodities (metals and energy) are sliding. As with so much else these days, that makes no sense, unless you just don’t know what’s going on. When we encounter these bouts with irrationality (or, more fairly, thick-headedness), the market can be frustrating for a long time – and the ultimate denouement can sometimes be jarring. As I said earlier in this post: buckle up!
Gravity Still Works, After All
Mild weakness in housing data (Housing Starts fell to only the second-highest level since 2008) seemed to be a sufficient excuse today to send stocks lower, but really the main culprit was gravity. We will have to see if the market corrects more than the 1.25% it dropped today, but it shouldn’t be all that surprising!
It actually looked a little bit like one of the classic “risk-off” trades we have seen in recent years. Commodities fell, especially precious metals, energy, and industrial metals while agriculture rallied. The dollar leapt to the highest level since November. Inflation breakevens declined a touch, and interest rates slipped a couple of basis points. What’s more, the VIX jumped to match its highest closing level of the year.
Searching for a new story on why commodities fell, a rumor passed along the market (memorialized by Bloomberg here) that a hedge fund was being flushed out of commodities positions. But that made little sense, unless the fund had been long energy and short agriculture – and if they had been, they would have been winning over the last several months, not blowing up! More likely, it was just gravity, which seems to operate more heavily on commodities than on stocks these days. I guess stocks are from Mars, commodities from Venus.
I think this is all part of a corrective move, but the corrections are a bit out-of-sync and that makes me nervous. In the article I wrote on January 31, I pointed out that the dollar index, 5-year inflation breakevens, and commodities were all nearing critical breakout or breakdown levels. I thought they were all about to break those levels and continue trends, but what actually happened was quite the opposite: the dollar index is up significantly (back to near the November highs, as I said), 5-year breakevens are a couple of basis points cheaper (although not much) and commodities have done what commodities have done all too often over the last year: slid to lower nominal, and even cheaper real, levels. Although I didn’t show it on January 31st, the 5y CPI, 5y forward – an important metric for the Fed – has also declined slightly from 3.09% to 3.04%.[1]
I expect the markets to return to the levels they held at January month-end, however. The FOMC minutes out this afternoon showed that while there continue to be dissenting, hawkish voices at the Fed (notably, Esther George cast the lone dissenting voice this month – how I like this Fed President!), they continue to be completely drowned out by the doves. Again looking for an angle to explain the stock market decline – which started this morning, long before the minutes were released and probably even before they were leaked to Goldman[2] – market headlines bleated about how the “Fed Minutes Show Debate Over Stimulus,” about how the Fed is “uneasy” over QE, and about how several officials suggested varying the pace of QE over time.
This wild and crazy debate, this uprising of the inflation hawks, produced (I note again for the record) one dissenting vote. Remember, even non-voters can participate in debate and appear in the minutes even if they don’t vote. In this case, the “several members” likely included George and Richard Fisher of Dallas (non-voter), with some chance that a third, also non-voting, member joined them (maybe Plosser?) But they are arrayed against a very dovish core of the FOMC, and the minutes contain a clear indication that the Committee prefers to err on the side of keeping accommodation too long rather than remove it too soon:
“A number of participants stated that an ongoing evaluation of the efficacy, costs, and risks of asset purchases might well lead the Committee to taper or end its purchases before it judged that a substantial improvement in the outlook for the labor market had occurred. Several others argued that the potential costs of reducing or ending asset purchases too soon were also significant, or that asset purchases should continue until a substantial improvement in the labor market outlook had occurred. A few participants noted examples of past instances in which policymakers had prematurely removed accommodation, with adverse effects on economic growth, employment, and price stability; they also stressed the importance of communicating the Committee’s commitment to maintaining a highly accommodative stance of policy as long as warranted by economic conditions. In this regard, a number of participants discussed the possibility of providing monetary accommodation by holding securities for a longer period than envisioned in the Committee’s exit principles, either as a supplement to, or a replacement for, asset purchases.”
I similarly wouldn’t read much into the “number of participants” asking for ongoing evaluation of the efficacy, costs, and risks of asset purchases. This sort of debate has been occurring in the minutes of almost every meeting since the Fed first began QE, and it would be striking if there was not any discussion of efficacy, costs and risks – especially considering that the efficacy of this unprecedented policy action has been fairly unimpressive, to be kind.
I see no reason to doubt the Fed’s word that they will keep accommodation until the Unemployment Rate improves or inflation moves enough higher to concern them. But there is certainly no concern, even among the hawks, about the current level and trajectory of inflation:
“Nearly all participants anticipated that inflation over the medium-term would run at or below the Committee’s 2 percent objective.”
Unless you’re talking about the vague concern expressed by “a few” participants about inflation over the long run:
“Participants generally saw recent price developments as consistent with their projections that inflation would remain at or below the Committee’s 2 percent objective over the medium run. There was little evidence of wage or cost pressures outside of isolated sectors, and measures of inflation expectations remained stable. However, a few participants expressed concerns that the current highly accommodative stance of monetary policy posed upside risks to inflation in the medium or longer term.”
This continues to be where the whole house of cards is vulnerable. A series of bad inflation numbers (and I am sure it would take a series, not just one or two) could alter the debate later this year. Tomorrow’s release of January CPI (Consensus: +0.1%/+0.2% ex-food-and-energy; +1.6%/+1.8% y/y) is not likely to be the first of those bad numbers, but it is coming soon. The consensus expectations are quite soft, essentially +0.05% on headline inflation (the energy spike didn’t really start until February) and +0.16% or 0.17% on core CPI.
But the housing price data are unequivocal: a large portion of the consumption basket is going to see prices rising at an accelerating rate, soon. Our models seem to suggest the inflection point could be another couple of months away, but it is dangerous to get too caught up in model minutae. The big message from the models is that the unambiguously higher home prices (in Existing Home Sales, New Home Sales, the FHA’s Home Price Index, the Case/Shiller index) are leading to higher rents (judging from surveys of apartment rents from REIS and CBRE) and this reflects higher shelter costs that will show up in core CPI within a few months. If it happens tomorrow, then stocks are vulnerable – but if not, then Martian gravity isn’t going to be enough to hold down stocks for very long.
We know that in low-gravity environments, human skeletal structure gradually weakens so that a return to normal gravity can be very dangerous for someone who has been in space for a long time. The stock market has been in space for a very long time. At some point, when “normal gravity” (in the form of a neutral Federal Reserve policy) returns, equities will have a rough transition to make. But that day isn’t yet, so while I don’t have expectations of much higher equity prices from here I also wouldn’t get too excited about looking for a 20% decline, either.
[1] Technical note: when looking at breakevens, and especially forward breakevens, over a long period of time, it is important to use inflation swaps whenever they are available because there are fewer idiosyncrasies with the structure of the inflation swaps curve than with the breakeven curve. As a case-in-point, while 5y inflation, 5 years forward taken from inflation swaps has fallen 5bps since January 24th, Bloomberg’s 5y, 5y BEI has dropped some 30bps over the same period, due to changes in which TIPS and nominal bonds make up that index.
[2] I’m kidding, sorta.
Too Much Fuel Will Extinguish The Fire
Stocks continue to climb inexorably: 21 of the 33 trading days this year have seen stocks end the day higher. About the only market that is doing appreciably better is gasoline. Retail gasoline prices have risen 33 of the past 33 calendar days, and front Unleaded has risen 22 of the 33 trading days in 2013.
This brings us, of course, to the question: if gasoline rises every day, then how long will it be until higher gasoline prices start to affect equity prices?
The question is not quite as straightforward as it appears. On the surface, we have two competing effects: first, stronger economic activity will tend to support both gasoline prices and corporate earnings, giving a lift to equities. And some recent data, such as last Friday’s hefty upside surprise in the Empire Manufacturing figures for February (+10.04 when -2.00 was expected), suggests that growth in Q1 may not be slowing too much further although the European, Japanese, and US economies each contracted in Q4.
(By the way, did you realize that? Each of the three biggest First World economies contracted in Q4 and the US equity markets declined -1.0%).
Not that equities necessarily must pull back when growth lags (if they did, then all good economists would also be good traders), but when you’re talking about markets that are pricing in a continuation of historically wide margins and historically high price-earnings multiples, it would seem that a pullback when there is weakness economically is as good a time as any. Stocks can’t go up in a line forever, can they?
Actually, they can, but we’ll get to that in a minute. I mentioned two competing effects that are apparent, with one of these being the stronger economic activity will tend to support both gasoline prices and earnings. The other is that higher gasoline prices have a depressing effect on discretionary expenditures. Along with the higher payroll taxes which manifested in January and the lower Q1 incomes as a result of dividends being pushed into Q4, the higher gasoline prices may have contributed to what a finance VP at Wal-Mart described as “a total disaster” start to February. This is an “automatic stabilizer” effect at work: higher growth tends to produce higher energy prices, which tend in turn to dampen economic growth – and vice-versa.
So which effect dominates? Can gasoline prices and stock prices keep going up together?
The answer is that their nominal prices can absolutely continue to rise together, but their real prices cannot. If I double the price level, then no matter what happens to growth or the marginal rate of substitution between gasoline and all other discretionary goods and services, both nominal gasoline prices and nominal corporate earnings (and therefore, quite likely equity prices) will both rise. However, higher real energy prices imply lower real equity prices eventually. But that’s not a day-trade; in the fairly short run (say, several months) the price level is roughly constant so that one of these two markets is likely to decline in nominal terms.
Frankly, the odds in my mind are on stocks breaking first. But as the chart below (source: Bloomberg) shows, the ratio of gasoline to stocks is not really out-of-whack one way or the other. This is unleaded regular gasoline divided by the S&P level…and what’s fascinating to me is how regular the relationship has been (especially in 2010!).
By the way, the distinction about nominal and real prices also is relevant for the observation some have made that gasoline inventories are reasonably adequate, but prices continue to rise. Gasoline prices are high in nominal terms, but not as high in real terms. In nominal terms, unleaded has risen 105% since the second Bush inauguration, but only 65% in real terms. That still sucks, mind you, and is one reason that growth hasn’t been robust in a while. As of December 2004, gasoline was 3.934% of the average consumption basket; according to the BLS (new numbers are out today!) that became 5.274% as of December 2012.[1] Therefore, we spend about 1.34% less of our total consumption on other things than we did in 2004.
With gasoline, medical care, and college tuition all squeezing us (not to mention taxes, which is not a consumption item and therefore not in the CPI), it isn’t surprising that we’re spending a smaller proportion of our consumption basket on apparel and housing than we used to (for a longer-term view, see my comment from a couple of weeks ago “Fun With the CPI”). These are long-term, secular trends. What could hurt the market in the shorter-run is that when there is a significant move in energy prices, we can’t change the amount of housing we consume to compensate. We stop buying the Wal-Mart things. And we save less.
And eventually, we stop buying stocks. Don’t we?
[1] N.b.: that doesn’t mean we spend 35% more on gasoline now; as noted, gasoline has doubled in price. But 35% more of our consumption is spent on gasoline, than we spent previously. It is interesting that with a 65% increase in the real price of gasoline, our gasoline consumption has only risen 35% (due to smaller cars, better gas mileage, more air travel, more mass transit, etc).
The Currency War Is Not New: It’s Merely Escalating
A quick summary of where we are in the “global currency war:”
For several years now, global central banks have been engaging quietly in this war. Each central bank has been implicitly playing “beggar-thy-neighbor” by making its currency relatively plentiful, and therefore relatively cheaper, than its neighbors. In one case, that of Switzerland, the currency issue became explicit rather than implicit, though not to weaken its currency but rather to stop it from strengthening without bound (see Chart, source Bloomberg). It is instructive that, in order to accomplish this end, the SNB had to pledge to print unlimited quantities of Swiss Francs to sell – essentially saying that if it can’t beat ‘em, it would have to join ‘em.
Now, in January some well-known asset managers muttered the ‘currency war’ phrase, and Japan’s Economic Minister Akira Amari suggested that the Yen could fall 10% (and Japanese officials have implied that they are looking for such a move to help end deflation). Since then, both the G20 and the G7 have discussed whether countries ought to be engaging in currency adjustment as a means of confronting macroeconomic challenges. Searches for the term “currency war” on Google (see chart, source Google) have risen appreciably. But again, this isn’t really new; what’s new is that people are actually talking about it.
Earlier this month Adair Turner, chairman of the Financial Services Authority talked about “permanent monetary easing” and said that central bankers “may need to be a little bit more relaxed about the creation” of money. By permanent, he means that the central bank would print money with the express intention that the printing would never be reversed. Ignoring history, Lord Turner said “the potential benefits of paper money creation [to stimulate the economy] should not be ignored.” Today, the Bank of England released its quarterly forecasts, showing policymaker expectations that inflation will stay higher than the Bank’s target for longer than expected, and growth will be weaker than expected. Even less surprising, given talk about “permanent” easing, is that 10-year UK inflation swaps are now back above 3.40% (see chart, source Bloomberg). The first 30bps of this jump was due to the decision by the ONS to maintain the current definition of RPI for existing contracts (I mentioned this here), but some amount of it is probably due to the currency wars talk.
It bears noting too that the 10-year US inflation swap is within a handful of basis points of its post-Lehman highs.
The UK inflation market has been around longer than other inflation markets. Index-linked Gilts date back to the early 1980s. So I wonder whether we shouldn’t be a bit more curious about how much of the rise in UK inflation expectations actually reflect a rise in global inflation expectations due to the currency wars that are (and have been) underway.
Because to some extent, the question of “who will win” the currency war is difficult to discern, and to some extent the question is moot. Like in the movie “WarGames,” the only thing that has been certain since the currency war started a couple of years ago is that there will be a lot of scorched earth. The only real “winners” are debtors, relative to lenders.
Who will win? To change the analogy: if you’re in a bay surrounded by people in boats who are pumping water in so that they can see who can sink his boat the fastest, the winner is the one who is wearing a life vest. All the others are just some varying grade of loser. Don’t be the last one to grab a life vest.
More Reactions to the Fed’s Exit Possibilities
I have said it before, and I will say it again: one of the most important reasons I write these articles is to test my ideas on paper, and put them in front of other minds who comment (sometimes derisively, but that goes with the territory) and help me find things I would not otherwise have found – flaws in my thinking, other applications of the thought process, additional facts outside of my own fact-gathering sieve, and the like. It is a lot of work to produce these columns, but it is generally worth it.
Here are three examples, all of which flow from comments received on yesterday’s article about the implications of the size of the Fed’s balance sheet and the likelihood that the market may make it difficult, if not impossible, to drain all of the excess reserves in a timely fashion so that traditional tools of monetary policy are once again efficacious.
One: Reader “Cyniconomics” pointed out, regarding my blithe dismissal of the convexity of the Fed’s portfolio, that the negative convexity of the MBS portfolio is likely small, since these are short-dated MBS, and probably fades back into positive convexity quickly after a large move (since the negative convexity of a mortgage-backed security is due to the fact that higher interest rates cause borrowers to stop pre-paying; but once pre-pays have gone to zero you’re done with that effect).
As a result, I went back and estimated the convexity of the SOMA portfolio. And it is, in fact, reasonably large – large enough that for the Fed to exhaust its portfolio before Excess Reserves were drained, interest rates would have to rise more like 500bps, rather than the 313bps I originally estimated. Now, I still question whether the Fed could unwind in practice a $2 trillion portfolio with only that amount of impact: in the early 2000s, the bond market saw several 125bp selloffs on mortgage extensions of a mere 200bln. But it’s at least more likely than I originally thought.
Two: In responding to reader “bbro,” it occurred to me that there is another possibility for soaking up Excess Reserves that I hadn’t previously considered (and would not have, but for the discussion): the Fed could, in principle, raise the reserve requirement. It hasn’t changed since 1992 (read a history of it here), but that doesn’t mean it cannot change. And the more I think about it, the more crazy sense this makes. One reason the Fed never changes reserve ratios is that it uses up a lot of reserves very quickly, and creates volatility where none was previously. But in this case, those reserves are already in place, and it could potentially reduce volatility. It would be, as this article points out, a tax on financial institutions and would damage banking shares by making permanent the decrease in leverage that is already de facto. And doing this would also reduce the risk attendant on moving the Interest On Excess Reserves and trying to guess what effect that would have. The more I think about it, the more I think this might well be at least a part of the right strategy, although I think it’s also quite unlikely to be implemented by the FRB.
Three: Finally, reader “Jim H.” brought to my attention a very recent working paper by researchers at the Fed, entitled “The Federal Reserve’s Balance Sheet and Earnings: A primer and projections.” What is really fascinating about this article is how devoid it is of rational connection to the markets.
The authors examine the effect on the portfolio of interest rates rising in line with the Blue Chip consensus forecast of economists, which bravely forecasts 10-year yields to rise to near 5% by 2017 (and never exceed 5%, even though presumably there would be a tightening cycle in there somewhere). And it assumes that the Fed can sell its agency securities over three to five years and normalize the balance sheet over two to three years, without pushing market rates higher than the levels implied by the Blue Chip consensus forecast. In other words, either the Blue Chip economists were forecasting a sub-5% 10-year Treasury rate despite expecting the Fed to completely flush the SOMA, or the forecast is based on the evolution of interest rates that would occur without any adjustments to SOMA. The latter is more likely, since something slightly below 5% is close to the “neutral” Treasury rate if the economy is growing at potential with contained inflation.
But they consider an alternative scenario where interest rates follow a path 100bps higher than the Blue Chip consensus. Be still my heart! Can such a calamity actually come to pass? Well, the authors specifically state “although this shock – particularly the parallel shift – is an unlikely outcome, we present it to show the interest rate sensitivity of the portfolio…Of course, to the extent that inflation expectations have become better anchored over time, this increase in interest rates may be even less probable than the historical record may suggest.” Apparently 100bps lower is equally likely in their minds, as they also consider that scenario.
I suppose it is unreasonable to expect a public working paper to include a scenario where the Fed breaks the buck, but it is almost laughable to assume no impact, or only 100bps of impact. Frankly, I think you get 100bps in the month or two after the Fed says they’re done buying, long before they begin to sell.[1]
The article does discuss the impact of higher interest rates…on Federal Reserve net income, not on the market value of the SOMA. Essentially, the Fed ends up booking large capital losses, which live on its balance sheet in the form of future earnings they will not be remitting to Congress. It actually becomes an asset. Brilliant. Their calculation has the “deferred asset” getting as high as $125bln in the “high interest rate” scenario, which is actually plausibly close to the estimate of DV01 I made yesterday.
I personally don’t care whether the Fed has a net loss or a net gain. What I’m interested in is whether there are plausible scenarios under which the Fed would be unable to normalize policy using the method of shrinking SOMA. I believe there are – but this article is a fun read anyway.
Again, all three of these points represent good feedback and have richened my thought process about the possible routes the Federal Reserve may take to exit the extraordinary policies implemented over the last several years. I conclude that there are more tools available than I’d believed, but that (while it’s theoretically possible that the Fed could normalize policy by actually selling securities) outright sales of securities are likely to be insufficient of themselves. Moreover, it remains the case that politically, it will be much harder to be seen as pushing rates higher with asset sales, raising IOER, or increasing reserve ratios. Unless the Federal Reserve Board is made of much sterner stuff than the authors of this last Fed paper are – and there’s not much evidence of that, although I’ll pin my hopes on Esther George and Richard Fisher – it is still far more likely that they move too little and too late than too much and too soon.
Keep those cards and letters coming.
[1] I confess that I don’t fully understand how they get their numbers. According to one of their charts, SOMA Treasury holdings, which were in the ~$700bln range prior to the crisis, would fall until 2019, getting down to $1.2T or so, then rise back to $2.5T by 2027. I’m not sure what assumption is being made that requires the Fed’s balance sheet to remain permanently a multiple of its pre-crisis level. I believe it may be based on the assumption that Federal Reserve capital grows at 15% per year.
Limits On The 500-pound Gorilla
Well, here’s an interesting little tidbit. (But first, a note from our sponsors: some channels didn’t pick up my article from last Wednesday, “Fun With The CPI,” so follow that link if you’d like to read it.)
The Fed adds permanent reserves by buying securities, as we all know by now. The Open Market Desk buys securities and credits the Fed account of the selling institution. Conversely, when the Fed subtracts reserves permanently, it sells securities and debits the account of the buying institution.
As of February 6th, the Fed owned $1.782 trillion in face value of Treasury and agency mortgage-backed securities. At the closing prices from Friday, those securities are worth $2.069 trillion, plus accrued interest which I didn’t bother to calculate.
So let’s revisit for a second the question of how the Fed would unwind the quantitative easing and actually tighten policy. In order to do that, the Fed would first need to vaporize the $1.58 trillion that exists in excess reserves, before they could actually affect the required reserves which is where the rubber meets the road for monetary policy (at least, in the absence of the “portfolio balance channel”).
We have reviewed some of the options before: sell the securities held in the System Open Market Account (SOMA); conduct massive and long-dated repo operations; sell bills or pay interest on deposits at the Fed (or raise IOER). Some people have suggested that the Fed could just “let the securities in the SOMA roll off”: i.e., let the bonds mature and don’t reinvest the proceeds. I was curious how long, after Operation Twist, such a passive approach would take.
The current value of Excess Reserves is $1.58 trillion. If Excess Reserves did not move for any other reason, it would take until November of 2039 before we saw that many bonds mature. To be fair, with coupon payments and such it would take less time, but we’re still looking at a couple of decades. So that’s not an option, at least by itself.
Then I noticed something interesting. Some economists have suggested that when the economy begins to improve, the Desk could simply start selling securities into the market, since with a stronger economy the Treasury would presumably be running a smaller deficit (now, that’s blind faith if ever there was such a thing) and auctioning fewer securities, so the Fed could take up the slack without impacting the market very much. Leaving aside the question that it isn’t clear that market rates would be in the range they are now if the Fed actually stopped buying (after all, that’s the whole point of the portfolio balance channel – that investors won’t pay the high price the Fed has set so they buy riskier securities), I’m not sure it’s even possible that the Fed could drain the excess reserves even if they sold every single bond on their balance sheet. Here’s why.
The SOMA portfolio has a DV01 of approximately $1.56billion, based on the reported holdings and Bloomberg’s calculated modified duration. For those unfamiliar with bond math, this means that every 1/100th of 1% rise in interest rates causes the value of the Fed’s holdings to decline $1.56bln.
The current market value of the portfolio, as I said, is $2.07 trillion, while Excess Reserves are $1.58 trillion. But the problem is that the ‘market value’ of the portfolio assumes the portfolio is liquidated at mid-market prices. Ask the London Whale how well that works when you are a big player. Ask Long Term Capital.
But forget about the market impact. Suppose interest rates were to rise 300bps, so that the 10-year was around 5% and, with expected inflation remaining (again, let’s go with the blind faith argument) around 2.5%, real interest rates were up to around 2.5%. That would be a fairly neutral valuation for an economy with decent prospects and contained inflation, growing at its sustainable natural growth rate.
The SOMA portfolio, valued 300bps higher in yield, would be worth $2.07T – $1.56B * 300 = 1.60T. In other words, if the Fed sold every single bond in its portfolio, 300bps higher, it would just barely be able to drain all of the excess reserves. Yes, I did ignore the question of convexity, but since the MBS tend to have negative convexity that balances the positive convexity of the Treasuries, I suspect that isn’t a huge effect over this small a move.
So the Fed, in this circumstance, would have used all of its gunpowder just getting back to the point where traditional tools would begin to work again. This is an entirely natural outcome, by the way! If a behemoth market participant lurches into the market to buy securities, and then lurches to sell them, and repeats that pattern over and over, it loses value because it is consuming liquidity in both directions. It is going to be buying high (and again, that’s the Fed’s goal here: to pay more than anyone else wants to pay) and selling low. So in this case, if rates rise 300bps, the Fed will be unwinding its entire portfolio and have no securities left to sell to actually drain the liquidity that matters.
This is obviously a thought experiment – I can’t imagine the Fed could unwind that sort of portfolio with only a 300bp market impact. But it just highlights, for me, the fact that the ‘end game’ for the FOMC almost must involve raising the interest paid on excess reserves – the other tools aren’t only impractical in size, but may be de facto impotent (because, remember, the first thing that needs to happen is that Excess Reserves are drained, before policy has traction again through the traditional channels).
I am sure someone else has pointed out this little mathematics dilemma before, but I don’t think it had previously occurred to me. I guess I’d always stopped at the mechanics/feasibility of selling $2 trillion in securities, and never asked whether that would actually do the job. I don’t think it would! It is not actually true that a 500-lb gorilla sits “anywhere he wants,” as the old joke goes – he can’t sit anywhere that won’t hold a 500-lb gorilla.
Now, the Committee doesn’t really seem to believe in traditional monetary policy any more, so it may be that they figure the reverse of the “portfolio balance channel” effect will be good enough: raise the returns to the ‘less risky’ part of the market enough to pull capital out of the risky parts of the market. But I find it hard to convince myself that, as much as they clearly intended to push housing and equity market prices higher, they’d be willing to do the opposite. And I do believe that other stakeholders (e.g., Congress) would be less accommodating in that direction. Which brings me back again to the conclusion I keep coming to: does the Fed theoretically have the tools to reverse QE? Yes, although they have one fewer than I thought yesterday. But is it plausible that the Fed will have the will to use those tools, to the degree they’d need to be used, to reverse QE? I really don’t believe they’d be willing to crash the housing and stock markets, just to cool down inflation.
We do live in interesting times. And they will remain interesting for a long, long time.
Fun With The CPI
As the markets gyrate, trying to decide on just what the next move is going to look like, I thought I’d answer a question a friend posed to me recently. He asked “what does the consumption basket look like today, compared with 25 years ago?”
The question was something of a challenge to me (well, more precisely to the BLS, who puts together the CPI) because my friend – like so many others – had heard that the BLS assumes that when the price of steak goes up, you eat more chicken, and that the CPI doesn’t capture what may be construed as a decline in consumer welfare due to this effect.
The BLS doesn’t in fact make such determinations. In 1999, the BLS started using a geometric mean formula that captures the fact that consumers in fact tend to switch their consumption patterns towards items that have fallen in relative price. But that only affects items in the same very low-level “basic” category (the example the BLS gives is “different types of ground beef in Chicago”), and not at the higher levels like chicken-for-beef.
Moreover, an important point is that consumers will buy more of the item whose price relative to other goods has declined (say, chicken) even if the consumer is compensated for that change. Suppose a consumer pays $10 per week for soda, $5 each for Coke and Pepsi (which he considers interchangeable). Now suppose the price of Pepsi doubles, but the American Society for the Promotion of Cola Products sends the consumer $5. With the additional $5 he could continue to buy equal amounts of Coke and Pepsi, but will he? Of course not; the consumer will spend his $10 all on the cheaper brand and keep the extra $5, or buy more total cola by spending the entire $15—but all on the cheaper brand. The consumer’s utility/dollar is now much higher with one (formerly interchangeable) brand.
It is important that the BLS attempt to get the consumption basket to look as much like the average consumer’s consumption basket as possible, in order that the price index resembles as closely as possible a true cost of living index. So it doesn’t spend a lot of time guessing. Every few years, the BLS conducts a “Consumer Expenditure Survey” to collect information about spending habits from around 60,000 quarterly interviews and 28,000 detailed weekly purchase diaries gathered over a two year period. From these, the base weights are determined for about 200 item categories in dozens of cities and regions. These are then aggregated up into successively larger groups up to the eight “major groups” (Food & Beverages, Housing, Apparel, Transportation, Medical Care, Other, Recreation, and Education & Communication) and the overall CPI-U.
In short, the BLS does everything possible to avoid making value judgments about what is being spent. That being said, studies have assessed the aggregate effect of substitution adjustments to be around 0.3% per year.[1]
So with that all said, how much have our spending patterns shifted in the CPI? Are we spending money dramatically differently than we did 25 years ago?
You can find the CPI weights for 1988 here, and compare them to current weights found on p. 11 of the monthly CPI report, for example here. Be aware that the categories sometimes change over time, so that for example in 1988 there was not an “Education and Communication” major category. But here are some comparisons:
| Category |
1988 weight |
2012 weight |
| Food and beverages |
17.72% |
14.96% |
|
Food at Home |
9.98% |
8.47% |
|
Alcoholic Beverages |
1.545% |
0.93% |
| Housing |
42.30% |
40.21% |
|
Primary Rents |
7.85% |
6.36% |
|
Owners’ Equivalent Rent |
19.33% |
23.49% |
| Apparel |
6.35% |
3.49% |
| Transportation |
17.21% |
16.54% |
| Medical care |
5.97% |
6.92% |
| Tobacco and Smoking Products |
1.35% |
0.79% |
| Energy |
7.33% |
9.49% |
| College Tuition |
1.17% |
1.66% |
| Beef and veal |
1.05% |
0.54% |
| Poultry |
0.48% |
0.33% |
| Pork |
0.57% |
0.37% |
| Fish and Seafood |
0.39% |
0.30% |
| “Other meats” |
0.41% |
0.27% |
| All Items Less Food & Energy |
76.50% |
76.49% |
In summary? Surprisingly, while we get a lot less for our money than we used to, our patterns of expenditure haven’t changed much, in aggregate. Sure, some of us are spending less on education while others spend more, simply because our patterns change as we go through life (and the BLS has some age-related indices as well). We spend, not surprisingly, less of our money today on clothes, food, alcohol, cigarettes, housing, and transportation – even with higher energy prices. Overall, though, we spend more on energy itself, on medical care, and on tuition. You can see the effect of the ‘home ownership movement’ in the greater basket weight of “Owner’s Equivalent Rent” compared to “Primary Rents”. But overall, the spending patterns are evolutionary, not revolutionary.
Oh, and we do spend less, as a portion of our total expenditure, on beef and veal! But we also spend less on chicken, pork, fish, and “other meats” (shudder).
[1] I won’t talk here about quality adjustments, including so-called “hedonic” adjustments, except to say that the aggregate effect of quality adjustments is so small as to be hardly worth considering. Hedonic adjustment lowers the CPI for a number of categories whose weight total to around 0.7% of the index, but increases the CPI for Rent, Owners’ Equivalent Rent, and Apparel, plus some smaller categories, totaling about 32% of the index. So large downward adjustments on lightweight categories are balanced by very small upward adjustments on large categories. The net effect is thought to be less than 0.01% per year (see Johnson, Reed, and Stewart, “Price Measurement in the United States: a Decade after the Boskin Report”, 2006).
Increasingly Wary
Monday’s decline in global equities wasn’t exactly a wrenching selloff, except for one thing: it seemed to be completely unexpected. While the S&P only fell 1.2% – reversing almost every penny of that decline today – European equities was where the pain really was. The Eurostoxx 50, representing a pan-European collection of big firms such as Siemens, Volkswagen, Nokia, etc (about 25% Financials, 18% Consumer Goods, and other sectors weighted 10% or less), fell 3.1% on Monday and rebounded only 1% on Tuesday.
Don’t go to sleep, Americans! We have not necessarily heard the last of the crisis in Europe!
In the U.S., stocks remain up 6% since December 31, but on Monday’s close the Eurostoxx was actually down for the year. And don’t blame it all on Spain’s Prime Minister Rajoy and the scandals currently swirling about him; Italian 10-year bond yields are also up 30bps in the last week and a half. It isn’t entirely clear where the sudden case of the jitters is coming from, but it certainly doesn’t help the global economic recovery that Brent Crude is nearing $120/bbl again, up nearly 30% from the June lows realized in the teeth of the crisis.
(Incidentally, Carlo Rosa at the New York Fed just published an interesting paper that argues “monetary policy news has economically important and highly significant effects on the level and volatility of energy futures prices and trading volumes.” He finds that the Fed’s LSAP1 and LSAP2 programs “have a cumulative financial market impact on crude oil equivalent to an unanticipated cut in the federal funds rate of 155 basis points.” I have no confirmation of the rumor that Mr. Rosa has been disinvited from the Fed’s President’s Day bash this year.)
Now, economic data has been weaker in January than in December, at least in the U.S., but so far at least not by as much as I thought. Still, stock markets are priced for something more than “not as bad as I thought,” and having February gasoline prices at record highs (see chart, source Bloomberg) for this time of year – albeit not by much above last year’s record, yet – is a buzzkill for anyone hoping for a 2013 blastoff.
It also is a buzzkill for Federal Reserve members, I am sure. While the Fed concentrates on core inflation, since it is less volatile (and better-related to 2-year forward inflation than headline inflation), consumers notice and set their expectations based on the whole consumption basket. The best possible outcome for the Fed would be that both core and headline inflation decline, while they work to juice the system. The second-best possible outcome is that core rises, but headline stays low as lower fuel prices help both growth and inflation perceptions. The absolutely worst outcome is that core rises because Fed easing is pushing asset prices (for example, in homes) higher while headline prices scream past even faster because of higher energy prices…and those higher energy prices also serve to retard growth.
One-year headline inflation swaps are currently priced at 2.03%. While core inflation is currently at 1.9%, for reasons I’ve cited here before that is very unlikely to persist for any length of time, and if energy prices sustain any kind of rise at all, a 2.03% headline inflation over the next year seems optimistic to me. To be fair, I should note that the gasoline futures curve is reasonably backwardated, so an easier way to make the same trade is probably to buy March 2014 gasoline futures at $2.69 compared to $3.04 for prompt March.
Although it seems all is well in the U.S. stock market, investors should be increasingly wary. I wrote last week that there are signs some markets are catching the scent of inflation; while growth in the U.S. looks okay and our stock market is riding high, let this note be a warning that other markets are catching the scent of something still stinking in Europe. Implied volatilities are still low, and this may be a good time to buy protection.
