Getting The PIIGS Out Of The Mud
It is Thursday, which means that tomorrow we will hear reports and rumors about how a package will be put together to save Greece over the weekend. After all, it happens every Friday. Maybe that’s why stocks rocketed higher (although Bloomberg tells me it’s earnings), up 1.3% today.
Don’t get me wrong, I’m glad Bristol-Myers Squibb (BMY) was up 4.2% today, because it’s one of only a handful of stocks I own – a 5% dividend in a stable company is attractive to me. But I scratch my head as to why these earnings are so salutatory for the stock price. The company reported a strong quarter, but revised its estimate for full year earnings (which presumably includes the quarter) down by a nickel. To me, that’s a miss. Moreover, that lowering of the estimate consisted of plus 7 cents from normal operations, minus 12 cents due to the health care bill, for the net nickel. It said the healthcare bill cost them 1% of sales in Q1 and that these costs will increase. This is good news? I will give some thought to selling this security.
Initial Claims was 448,000, about what was expected. This is a little bit below the 8-week moving average of 455k and a little above the lows for the year of 439k. In other words, still firmly within the range for this year. As the chart below illustrates (Source: Bloomberg), that level is just about exactly where claims were just prior to Lehman’s bankruptcy on September 15, 2008. In other words, we can think of the roundtrip from 450k to 650k and back as being the measure of the financial crisis; the economic faults that pre-dated that crisis, and precipitated it, still persist. Now that Claims have begun to go sideways at the 450k level, we can’t even say that the return trip from the depths of the crisis generated any ‘positive momentum’ in employment. Simply, we’re still in a tight spot and we can’t reject the null hypothesis that employment is basically going nowhere.
Despite the exuberant equity rally, the bond market bounced back with a gain of 14/32nds (1o year yields at 3.73%). Yesterday I noted that equities had recovered only a little of their recent selloff while bonds had retraced much of their recent rally; today’s move corrects that situation so I was evidently wrong to read much into that.
Inflation swaps were up 4-6bps today despite the decline in yields – that implies a pretty lusty performance by inflation-indexed bonds. TIPS have been trading well for a few days, amid some reports that liquidity in that market has been getting a bit sketchy. Since European banks are such active players in the inflation market, liquidity can sometimes suffer when risk budgets are being cut for reasons peculiar to European institutions (a couple of years ago, the sharp inversion of the Euro swap curve caused big losses at some institutions and led indirectly to thinner conditions in US inflation). I don’t know if that’s happening in this case, but it wouldn’t surprise me.
But the real question is, why are inflation markets rallying as the specter of a sovereign default is rising?
Here’s the debt dynamic. The first thing you should realize is that historically, societies with a high level of private debt tend to deflate; societies with a high level of public debt tend to inflate. Over the last 20 years and more, ours has been a society that has lathered on private debt with a vengeance, while prior to 2008 the level of public debt was rising, but manageable. Thus, for a long time I was a bear on inflation: it is very hard for a producer to raise prices to increase margins on a lower level of sales, if a certain level of cash flow is needed just to service debt.
That dynamic shifted just a couple of years ago when governments the world over took a lot of that private debt and made it public through direct bailouts as well as the indirect bailout of fiscal stimulus. Trillions and trillions of it. Now, when a country is laden with public debt, it tends to inflate because that’s the easiest way to effectively default. That’s the dynamic we are in now.
The problem is, I am not sure how to think about Greece. Because she doesn’t have control over her own currency, she cannot “effectively” default. And that basically means that from the standpoint of the debt dynamic, we probably should think of her (and all of the Euro member states) as private entities whose default has a deflationary impact.
…Except that Greece isn’t alone. Several other members of the EU are in direct trouble and would print money if they could. Moreover, if EU member states bail out Greece, then they are all becoming more indebted (just as happened here when the federal government took over Fannie Mae, Freddie Mac, General Motors, AIG, and Citigroup) collectively, and pressure will begin on the EU to “temporarily abandon” its inflation-targeting regime. An increase in Euro inflation might not be a horrible thing to the ECB if it helps get the PIIGS and their saviors out of the mud, although of course it would hurt the “credibility” of that central bank. Such a move may not even weaken the Euro that much, assuming that the Fed didn’t choose to respond with tight money to a desperate situation in Europe…although if the Euro needs to weaken in order to save the Union, then I imagine the thinking will be “so be it.”
Accordingly, while I thought the U.S. would probably lead global inflation higher, it may be a follower. Right now, 10-year inflation expectations from inflation swaps are 2.80% in the U.S. and 2.15% in Europe. That’s as wide as that spread has been in quite a while, because the ECB’s inflation target effectively keeps implied inflation from rising too far. I suspect people are giving them a bit too much credit for sticking to their guns through the next round of crisis, which seems likely to focus on European institutions. European linkers may be a bit cheap here.
On Friday, other than the obligatory trumpeting of an imminent deal off the Continent, we’ll get our first look at Q1 GDP (Consensus: +3.3%, with Core PCE at +0.5%). The Employment Cost Index (Consensus: +0.5%) will be released at the same time. If the consensus is correct and both Core PCE and ECI print at around 0.5%, we may see some wind taken out of TIPS’ sails. It is hard to buy inflation at 2% for 3 years, 2.3% for 5 years, or 2.8% for 10 years if it’s currently printing at 0.5% (even if that would be the right thing to do in the grand scheme of things).