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Curious Becomes Furious
The only thing that kept this from being Freaky Friday is that it wasn’t Friday. But it certainly seemed as if everything was reversed suddenly between when we went to bed last night and when we woke up this morning. U.S. equity futures were up 15 points before we woke up, and 38 points above the lows set on Sunday night. Plainly, some traders were either covering shorts or initiating longs before the ECB meeting.
But incredibly…the ECB did not cut rates. In fact, they did almost nothing (and certainly nothing that wasn’t fully expected). Putting on my monetary policymaker hat, I can’t think of any reason for not cutting rates if they actually believe what they profess to believe about economic growth and inflation. Obviously they’re not really worried about deflation, because if they were worried about that then they’d be aggressively cutting since if inflation gets to zero before rates get to zero, it means you can’t ever make real policy rates negative. And they clearly don’t really believe that inflation, using that tired policymaker phrase that Draghi produced again today, is constrained by “firmly anchored” inflation expectations,[1] because if they did then they wouldn’t have any concerns about triggering inflation through adding too much liquidity. True, cutting interest rates doesn’t provide much stimulus compared to a trillion Euros of LTRO, but it is at least a relevant signal.
On the other hand…we already know that Draghi is no Trichet. And we know that under Draghi the money supply is already growing more-briskly (although not exactly briskly) than it did under Trichet, and the current ECB President has done some distinctly non-Bundesbank sorts of things. Maybe keeping rates at 1% are just the cheapest “hawk” credentials he can buy?
I am sure I am coming across as flustered and confused – because I am. I felt like I had had a bead on what was going on, and today doesn’t fit my mental paradigm.
The overnight curious rally turned into a daylight furious rally as the market continued to melt up on light volume (760mm shares) throughout the day, despite the ECB’s relative intransigence and no other news of note. It was nothing short of a desperate grab for risk assets of all stripes as the Euro rallied, the DJ-UBS Commodity Index jumped 1.4%, European stock markets soared, benchmark financial bond spreads tightened 20-30bps despite the downgrade overnight of German and Austrian banks by Moody’s, and yield spreads of periphery bonds compressed (10bps for Spain, 7bps for Italy, 21bps for Portugal in the 10y area).
But why? I feel like the kid who keeps bleating questions until Dad throws up his hands in exasperation and says “because I said so!” Maybe there isn’t an answer, but I wonder if some investors are buying or hedge funds covering short bets just on the thought that Bernanke tomorrow might be dovish when he testifies before Congress at 10:00ET. It just seems like there’s more conviction when buyers are chasing the stock market 2.3% higher than it was yesterday, with no additional information except that the ECB is not easing as aggressively as they might have.
Now, the real equity risk premium, which we define as the expected 10-year real return of equities compared to the real return on 10-year TIPS, did advance a couple of days ago to the highest level in a couple of years. That’s significantly because TIPS yields are low, though, rather than equity returns looking particularly robust. However, I can imagine that some investors who were overweight in fixed-income might have chosen today to get into equities, thinking that the spike low in yields was not likely to persist. That seems like a rotten reason to get into a risky asset class – just because the safe asset classes don’t offer big returns – but there are definitely investors who think that way. Stock bulls, hold your water when you look at the next chart (Source: Enduring Investments).
Realize that although it appears that equities offer the best value relative to TIPS that has been seen since a brief period in early 2009, and more than has been seen for many years before that, we are looking at a period in which equities were congenitally overvalued. TIPS yields only go back to 1997, so I can’t look at the real equity premium from the early 1990s, or the 1980s. However, I can look at the expected 10-year equity real return from back then (and further), using the same methodology I use to produce the numbers in the chart above. The result is not as exciting. The chart below (Source: Enduring Investments using Shiller data) shows that the current projected forward real return of 2.8% is only interesting in the context of the last decade and a half, and only in the context of the poor range of investing alternatives. I included the actual subsequent real return, with dividends reinvested, that is associated with each point up to May 31, 2002 (which 10-year period just finished with a compounded real return of 2.01%).
With the exception of the equity bubble, which produced better-than-expected returns for cohorts starting in the late 1980s and worse-than-expected returns for cohorts starting in the late 1990s (but, you already knew that), the method has a pretty decent track record since 1972. So, while equities are a better real asset than TIPS right now, that’s not saying a whole lot!
None of that solves the conundrum of why stocks spiked today, but it makes me feel better by reminding me to keep focusing on the long-term! There will be wiggles, and my guess is that the next downward wiggle in stocks and upward wiggle in bonds won’t be long in coming. As soon as tomorrow, a bad Claims number (Consensus: 373k from 383k) could set a bad tone. Here’s a surprising statistic: since February 17th, economists’ estimates have been lower than the actual Claims figure – including subsequent revisions, that is – for every week but one. If Claims actually rise from 383k, it is bad news since we ought to be well beyond the weather give-back by now.
However, any reaction on Claims will be tempered by the fact that Bernanke’s testimony begins at 10:00ET or so. That clearly is the important event of the day, and it seems investors are quite confident that Ben will have cheerful things to say about the nearby course of monetary policy. After the ECB whiffed today, I am not so sure. While I think policymakers will respond with alacrity in the event of an actual emergency, I don’t think they are prepared to try to be pre-emptive (and anyway, if they tried to be pre-emptive and failed because Europe imploded anyway, it would look bad). So while the Chairman may be generous with his assessment that “we stand ready to help,” I don’t imagine we’ll get enough concrete promises that the market’s bounce will be validated.
[1] “Firmly anchored inflation expectations” are to monetary policymakers what “auras” are to ghost-hunters. It’s not possible to disprove that expectations are anchored, if you believe they are, because we don’t have any way to measure them one way or the other. But their existence is very important to the believers.
Not Again
Once again, dawn broke on Thursday with great excitement. A Greek deal was at hand! Stocks were higher, although not very much higher, and commodities were bid as well as disaster was at last averted.
Now, this next part probably won’t surprise you as much this time as it did the first two dozen times: the deal was something less-than-advertised.
Yes, there was a Greek deal. But the deal in question was a deal among the leaders of the various parties in Greece about how to promise austerity. That deal must then be discussed with and approved by the Troika (ECB, EU, IMF). Oh, and this has nothing to do with the private sector initiative (PSI) discussions, which are still not done. So this great deal that we waited breathlessly for was pretty much the first stages of an agreement that would be meaningful even if doomed to failure.
You probably also won’t be so surprised when I tell you that the deal the Greeks agreed to among themselves did not pass muster with the rest of Europe, who are the ones who are supposed to put up the money for Greece. “In short: no disbursement without implementation,” said Jean-Claude Juncker, in summary of the EU policymakers’ meetings. According to the Bloomberg story, “he set another extraordinary meeting for Feb 15.” I wonder how many extraordinary meetings you can have, before they become ordinary? Apparently the Greeks left a little wiggle room, in that their parliament needs to vote on this new deal in a vote that the finance minister says is tantamount to a vote on membership in the EZ. This is all supposed to be done by February 15th. Don’t these guys have any respect for Valentine’s Day?
Love is definitely not what is in the air at the ECB. The central bank held policy steady today, but ECB President Mario Draghi said as his press conference that he no longer sees substantial downside economic risks. (And yet, like the Fed, inflation should stay above 2% for “several months” and then decline, I guess because that would be convenient to him.) Whatever is in the air at the ECB, they should pass it around.
Let’s try and work through the logic here:
- There is no substantial downside economic risk.
- For Greece to default or to leave the Euro would mean the end of life as we know it.
therefore There is no substantial risk that Greece is going to either default or leave the Euro.
I think I have the syllogism (oh, that word comes from Greek) right, although it’s probably not important that I do so since neither 1 nor 2 is correct.
From logic to mathematics we travel: Draghi did say generously that the ECB is willing to give up its “profits” on Greek bonds in order to help the solution, as long as they don’t sell at a loss since that would involve monetary financing of governments. In what la-la land are these guys living that buying bonds at $50 and selling them at $25 produces a profit? It would make my job a lot easier if I could use Draghian math. Unless the ECB bought bonds at $50 and then marked them at par, or carried them at cost rather than marketing them at all and is counting as “profit” the coupon income, this is nonsensical. So I conclude that the ECB is in fact doing one of those two things, either of which would get them jailed as a private investor.
Maybe I am too cynical (also a word that comes from Greek and means literally “doglike, currish”), but if this is how they steer ships in Italy then…oh, too soon?
Meanwhile in other central bank follies, the Bank of England tossed another £50bln log on the fire, bringing the QE total to £325bln. You know, core inflation in England is only at 3%ish, so it’s important to guard against incipient deflation!
In the U.S., Initial Claims was again a little lower-than-expected at 358k. We can probably at this point reject the null hypothesis that the underlying rate of claims is still around 400k, where it was until the second week of December; until now, the error bars around the estimate prevented such a conclusion at least in a statistical sense. Is the level now 375k or are Claims still improving? It’s too early to say. I expect that it is still improving, but I also expect it’s not going to continue that way.
Bigger news was that the Justice Department reached a settlement with Wells Fargo, Citigroup, Bank of America, Ally, and JP Morgan over the ‘robo signing’ flap. Those firms are on the hook for $26bln between them. JPM fell -1.2%, Citigroup dropped -1.7%, Wells was -0.2%, and Bank of America, which took the biggest hit, of course rose 0.6%. I do not understand the fascination of buying financial dinosaurs now that there are big dinosaur hunters around, but investors are delighted to jump into BofA at an 0.5% dividend yield. I’ve been saying it since 2008, and it hasn’t changed yet: the business of large trading banks has fundamentally changed, I think forever. Return on Equity is going to be much lower in the future in the past because (a) volumes of all products are lower, (b) balance sheet leverage is lower, and (c) margins have not widened, and if anything are under further pressure as most products move to exchanges. Banks sell the product with the most elastic demand curve in the world: money. If your bid for the five year note is 100-04+ and the market is 100-05/5+, you will print essentially zero business. (This is why banks love highly-structured product for which a price is not readily available many times.) You cannot count on margins going up, ever. And those three parts, (a), (b), and (c), are the three parts of RoE. Bank stocks may be great trading vehicles, and some banks may gain at the expense of other banks, but as a whole the industry is dead money, in my opinion.
The Treasury today announced that they will auction 30-year TIPS next week. The auction size was only $9bln, compared to expectations generally of $10bln, but the roll still opened quite wide (implying that you get more yield to roll forward to the new issue than you ‘should.’ The Street is either quite concerned about trying to auction 30-year inflation-linked bonds at a real yield of 0.75%, and they probably should be, or dealer risk budgets have been so desiccated that the limited number of bona fide TIPS dealers aren’t sure they can underwrite the issue at something close to the current price. In any event, after the announcement the long end of the TIPS curve was crushed, before bouncing and ending only 4bps higher in yield on the day. The nominal 10-year note sold off 5bps to 2.04%, and 10-year breakevens were down 2bps.
Commodity indices gained 0.5% despite a very soft performance from grains and softs. The energy group rose 1.2%, industrial metals put on 1.5% (now up 10% over the last month), and precious metals rose 0.6% (+8.2% over month ago).
The only data of note on Friday is the University of Michigan confidence number for February (Consensus: 74.8 vs 75.0). I predict that we will head into the weekend expecting a deal to come out of Europe over the weekend, as we will be told it is “imminent.” Why not try that old chestnut again?
