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Mister Market Is Cheery For Now
There was no news from Greece today, although optimistic journalists penned excited articles indicating “progress” such as the idea that the ECB (headed by Mario Draghi, not Mario Monti as I incorrectly wrote yesterday) might exchange its Greek bonds for new Greek bonds. It is unclear to me if this is progress, but it certainly isn’t big progress. The latest rumor is that “the deal will be completed on Monday,” with a little asterisk that “the deal” is the offer to Greece that has 24 preconditions that need to be completed by the end of the month. And “the deal” doesn’t include the private sector initiative. And “the deal” hasn’t been signed off on by any of the legislatures that would have to actually approve it. To me, it doesn’t sound like a lot of progress, but investors are clearly predisposed to be excited by anything that anyone calls “the deal,” even if it’s not.
Mister Market was cheerful today, though, and looked kindly on the positive economic data. Initial Claims recorded a new post-Lehman low at 348k, and Housing Starts approached a new high by printing 699k. The Philadelphia Fed was good, except for the “Number of Employees” subindex, which actually looks a little weak at the moment (see Chart).
That small blemish is no reason to toss out the entire carton of apples, though, and investors were justifiably upbeat about the data. I have more trouble explaining why Mister Market was so willing to ignore the awful news that Moody’s is preparing to slash bank credit ratings soon. I don’t think investors understand the implications, perhaps figuring that since a downgrade of the US didn’t cause any alarm then why should a downgrade of Morgan Stanley? I explained yesterday why it should, but today bank and financial shares outperformed the rest of the market.
No doubt, U.S. commercial banks are further away from insolvency than they have been in a while, and loan growth is showing it. The chart below (Source: Federal Reserve Board, H.8 report) is updated as of the latest available data: commercial loan growth is now growing at a 4.2% pace year/year, the fastest pace since November 2008.
Incidentally, that also means that the enormous cache of sterile reserves the Fed has added is no longer just sitting there. It is starting to circulate, which is one reason that M2 growth is still at +10% y/y, where it has been essentially since August.
But, getting back to the market: while current loan volumes are better than they have been in a while, that’s partly because banks don’t have many other ways to make a buck these days. And this data is backward-looking, while a downgrade is negative in the future. It isn’t as if these banks are good values even before a downgrade: Goldman is at 16x earnings, with revenues down 20% over the last year and ROE is 5.5%. Bank of America is at 8x earnings, with revenues -14.6% and ROE of 0%. I should add that Goldman is up 27% year-to-date and Bank of America is up 45%. (This is not an investment recommendation, and I’m not long or short either stock.)
The rally in stocks helped push bonds lower, and the 10-year yield again reached for the 2% level. Since November, the 10-year note hasn’t been outside of a 1.80%-2.10% range, which is amazing quiescence. There are two obvious pressures on bonds. On the bullish side, you have the fact that Europe is and will continue to be a basket case for some time. But on the bearish side, you have 2.2% current (core) inflation and the Fed targeting approximately that level; 2% nominal yields is clearly a losing proposition and clearly too low absent a significant deflation. At some point, this tension will be resolved and yields will move sharply. I will observe that the inflation and Fed targeting arguments aren’t going to go away for a long time, while the Europe story will eventually fade. I remain short fixed-income.
The crowning economic data point of the week (well, at least from my perspective) will be the CPI, released tomorrow. The consensus call for headline inflation month/month is +0.3%, and +0.2% on core inflation, leading the headline figure to drop to +2.8% year/year and leaving the core year/year number unchanged at +2.2%.
That actually implies that the market forecast for core is for a “soft” +0.2%, meaning something that rounds up to that figure. A true 0.2% should cause the year/year core rate to rise to 2.3%. Since we haven’t had a true 0.2% since August, this seems like a reasonable guess. I think it is a reasonable guess, but not because of the recent below-trend prints. The housing subindex of CPI has been rising at a faster pace than it probably should be, given the inventory overhang, and last month it decelerated on a year/year basis. I think this will probably continue for at least a few months, keeping core apparently tame. That also, though, means that we need to be careful to look at core ex-housing. The expected softness in housing is a wonderful gift to the Federal Reserve here, who could point to the core number and pretend they don’t know it’s because the unwinding bubble is still dampening the cost of housing. It means there may not be much pressure to reduce their accommodation even if inflation in the non-bubble economy continues. Core inflation ex-housing rose at a 2.5% pace for 2011, up from 1.1% for 2010. I expect a continued rise there although probably at a lower rate of acceleration.
Tomorrow’s report also involves revised seasonal adjustment factors, which happen to suggest that either the m/m headline figure will be a little softer than 0.3% or else the actual CPI index itself will be a little higher than 226.573, which is the consensus estimate (this latter figure matters only if you own inflation-indexed bonds; the rest of you may ignore it).
The U.S. markets will be closed on Monday, which also means that this author is unlikely to write then (I will probably write something after the CPI report, but then use the weekend and Monday to work on our firm’s Quarterly Inflation Outlook). Thanks to all of the readers who made last night’s article one of the most-viewed I have written in a long time. Do pass along these articles, or better yet links to them, to your friends. Tweet them! (And follow @inflation_guy. On Bloomberg, you can type NH TWT_INFLATION_GUY<GO> for my Twitter feed, something I just discovered). And let me know what you think about them.
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?
No Pushing In The Default Line, Please
Europe continues to smolder, but it is about to burst into outright flame. The ‘private sector initiative’ (PSI) discussions, which were supposed to be completed the Friday before last, continue. The leaks of an imminent deal continue, and eventually I am certain that a deal will be announced because eventually we will be down to just one bondholder still represented by the IIF. It is pretty clear by now – or it should be – that the PSI is no panacea. The only ray of hope to that process is that the approval of a ‘haircut’ (in the same way that Hannibal Lecter gave haircuts) would give the EU a fig leaf to approve a deal to send good money after bad, if it could overlook the failure to implement austerity measures that currently has German Finance Minister Schaeuble in a tizzy.
It would be a colossal mistake to agree to another €130bln bailout, even if the chances of it actually being disbursed would be slim (after all, remember the PSI process is necessary for the disbursement of the past-due tranche of the current bailout). And, honestly, I think the only reason they are continuing the charade is to give themselves more time to ready the Plan B default and/or Euro exit.
However, the market may not give them the time. Today Portugal’s 10-year rate rose nearly 200bps (see Chart, source Bloomberg), likely triggered in part by a headline saying “ECB cuts off bond buying as pressure mounts.” 
It didn’t actually cut off bond buying, but it bought very little last week. It seems fairly clear that the limits of the ECB’s ability to sterilize the transaction are nearby, if they have not already been reached, and no doubt some cooler heads have pointed out that failing to have enough buyers for a 7-day ECB tender would be much worse than allowing bond yields to reach free-market levels. After all, what’s the difference to Portugal of 15% or 17% on 10-year notes? Neither level makes Portugal’s situation even vaguely sustainable.
Now, I still think that U.S. equities rally once Greece formally announces it is defaulting, after a knee-jerk selloff. That’s a harder call now than it was when I first made it October 4th with the S&P at 1124, though, and investors need to be aware that if Greece also leaves the Euro at that time (as is likely) then that creates a chance of the ‘unzipping’ trade I talked about here. However, back in October the VIX was also at 41, and it’s now at 19.4. I think buying medium-term out-of-the-money calls on equities, especially with all central banks working the inflationary bellows, is a viable strategy here (and that’s coming from someone who has spent most of the last decade either out of the market, or short, to good effect).
In the near-term, be aware that Portugal is scheduled to sell 105-day and 168-day bills on Wednesday. The LTRO makes that operation basically risk-free for many banks, so the auctions will go fine (look at the Bloomberg chart below for one of the weirdest yield curves you have seen in your life, except for the fact that it’s becoming normal in much of Europe). And when the auction goes fine, the headlines will trumpet the fact that Portugal raised money around 5% or wherever and is doing just fine, thank you. You shouldn’t believe it, but some investors will use that as an excuse to relax.
Back in the U.S., our economy continues to do reasonably well. Personal Income beat expectations slightly with a +0.5% rise. The core PCE deflator (remember, that’s what the Fed targets) rose from 1.7% year-on-year to 1.8%. This was a surprise, as the consensus forecasts prior to the number were for the number to be unchanged at 1.7%. At 8:32ET or so, Bloomberg re-published the consensus as 1.8%. Wow, those economists are pretty good once they have the number. You can see below the chart (Source: Bloomberg) of the core PCE Y/Y (which is now just another inflation index that the Fed thinks is “contained”), which has just risen to three-year highs.
Today was a ‘risk-off’ day (I am so tired of that phrase), and so commodities suffered along with equities with the DJ-UBS down 1.1% with every category (softs, precious, industrials, etc) down. The dollar was up slightly. And yet, TIPS rallied yet again, with the new 10y TIPS down to -0.26%. Nominal rates continue to trade in my face, with the 10y falling to 1.85%, but absent an unzipping I am happy to remain short in an unlevered way (TBF) and to be long inflation through commodities (primarily USCI) and breakevens (via new ETFs INFL and RINF).
Tuesday’s data includes the Employment Cost Index for Q4 (Consensus: +0.4% from +0.3%) along with the Case-Shiller Home Price Index, the Chicago Purchasing Managers’ Report from January (Consensus: 63.0 from 62.2), and January Consumer Confidence (Consensus: 68.0 from 64.5). I expect to see the Chicago PM express some strength but would not be surprised to see the Consumer Confidence figure, which has risen rapidly over the last few months, fall short of expectations. Obviously, European actions are in the immediate picture more important once again.
