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Fed Gearing Up to Stand Down

July 30, 2014 8 comments

I guess it’s something about strong growth numbers and a tightening central bank that bonds just don’t like so much. Ten-year Treasury yields rose about 9bps today, under pressure from the realization that higher growth and higher inflation, which is historically a pretty bad cocktail for bonds, is being offset less and less by extraordinary Federal Reserve bond buying. Yields recently had fallen as the Q1 numbers doused the idea that the economic recovery will continue without incident, and as the global political and security situation deteriorated (maybe we will just say it became “less tranquil”). Nominal 10 year yields had dipped below 2.50%, and TIPS yields had reached 0.20% again. It didn’t hurt that so many were leaning on the bear case for bonds and were tortured the further bonds rallied.

Stocks, evidently, didn’t get the message that higher interest rates are more likely, going forward, than lower interest rates. They didn’t get the message that the Fed is going to be less accommodative. They didn’t even get the message that the Fed sees the “likelihood of inflation running persistently below 2 percent has diminished somewhat.” The equity markets ended flat. Sure, it has not been another banner month for the stock jockeys, but with earnings up a tepid 6% or so year/year the market is up nearly 17% so…yes, you did the math right: P/E multiples keep expanding!

My personal theory is that stocks are doing so well because Greenspan thinks they’re expensive. In an interview today on Bloomberg Television, Greenspan said that “somewhere along the line we will get a significant correction.” Historically speaking, the former Chairman’s ability to call a top has been something less than spectacular. After he questioned whether the market might be under the influence of ‘irrational exuberance,’ the market continued to rally for quite some time. Now, he wasn’t alone in being surprised by that, but he also threw in the towel on that view and was full-throatedly bullish through the latter stages of the 1990s equity bubble. So, perhaps, investors are just fading his view. Although to be fair, he did say that he didn’t think equities are “grossly overpriced,” lest anyone think that the guy who could never see a bubble might have actually seen one.

Make no mistake, there is no question that stocks are overvalued by every meaningful metric that has historical support for its predictive power. That does not mean (as we have all learned over the past few years) that the market will decline tomorrow, but it does ensure that future real returns will be punk over a reasonably-long investment horizon.

It will certainly be interesting to see how long markets can remain levitated when the Fed’s buying ceases completely. Frankly, I am a bit surprised that these valuation levels have persisted even this long, especially in the face of rising global tensions and rising inflation. I am a little less surprised that commodities have corrected so much this month after what was a steady but uninspiring move higher over the first 1-2 quarters of 2014. Commodities are simply a reviled asset class at the moment (which makes me love them all the more).

Do not mistake the Fed’s statement (that at the margin the chance of inflation less than 2% is slightly less likely) for hawkishness. And don’t read hawkishness into the mild dissent by Plosser, who merely wanted to remove the reference to time in the description of when raising rates will be appropriate. Chicago Fed President Evans was the guy who originally wanted to “parameterize” the decision to tighten by putting numbers on the unemployment rate and inflation levels that would be tolerable to the Fed (the “Evans Rule”)…levels which the economy subsequently blasted through without any indication that the Fed cared. But Evans himself recently said that “it’s not a catastrophe to overshoot inflation by some amount.” Fed officials are walking back the standards for what constitutes worrisome inflation, in the same way that they walked back the standards for what constitutes too-low an unemployment rate.

This is a good point at which to recall the “Wesbury Map,” which laid out the excuses the Fed can be expected to make when inflation starts being problematic. Wesbury had this list:

  1. Higher inflation is due to commodities, and core inflation remains tame.
  2. Higher core inflation due to housing is just due to housing prices bouncing back to normal, and that’s temporary.
  3. It’s not actual inflation that matters, but what the Fed projects it to be.
  4. It’s okay for inflation to run a little above 2% for a while because it was under that level for so long.
  5. Increasing price pressures are due to something temporary like a weaker dollar or a temporary increase in money velocity or the multiplier.
  6. Well, 3-4% inflation isn’t that bad for the economy, anyway.

I think the order of these excuses can change, but they’re all excuses we can expect to hear trotted out. Charles Evans should have just shouted “FOUR!” Instead, what he actually said was

“Even a 2.4 percent inflation rate, if it’s reasonably well controlled, and the rest of the economy is doing ok, and then policy is being adjusted in order to keep that within a, under a 2.5 percent range — I think that can work out.”

That makes sense. 2.4% is okay, as long as they limit it to 2.5%. That’s awfully fine control, considering that they don’t normally even have the direction right.

Now, although the Evans speech was a couple of weeks ago I want to point out something else that he said, because it is a dangerous error in the making. He argued that inflation isn’t worrisome unless it is tied to wage inflation. I have pointed out before that wages don’t lead inflation; this is a pernicious myth. It is difficult to demonstrate that with econometrics because the data is very noisy, but it is easy to demonstrate another way. If wages led inflation, then we would surely all love inflation, because our buying power would be expanding when inflation increased (since our wages would have already increased prior to inflation increasing). We know, viscerally, that this is not true.

But economists, evidently, do not. The question below is from a great paper by Bob Shiller called “Why Do People Dislike Inflation” (Shiller, Robert, “Why Do People Dislike Inflation?”, NBER Working Paper #5539, April 1996. ©1996 by Robert J. Shiller. Available at http://www.nber.org/papers/w5539). This is a survey question and response, with the economist-given answer separated out from the answer given by real people.

shillerQ

Economists go with the classic answer that inflation is bad mainly because of “menu costs” and other frictions. But almost everyone else knows that inflation makes us poorer, and that very fact implies that wages follow inflation rather than lead.

Put another way: if Evans is going to be calm about inflation until wage inflation is above 3.5%, then we can expect CPI inflation to be streaking towards 4% before he gets antsy about tightening. Maybe this is why the stock market is so exuberant: although the Fed has tightened by removing the extra QE3, a further tightening is evidently a very long way off.

Awareness of Inflation, But No Fear Yet

June 24, 2014 1 comment

Suddenly, there is a bunch of talk about inflation. From analysts like Grant Williams to media outlets like MarketWatch  and the Wall Street Journal (to be sure, the financial media still tell us not to worry about inflation and keep on buying ‘dem stocks, such as Barron’s argues here), and even Wall Street economists like those from Soc Gen and Deutsche Bank…just two name two of many Johnny-come-latelys.

It is a little surprising how rapidly the articles about possibly higher inflation started showing up in the media after we had a bottoming in the core measures. Sure, it was easy to project the bottoming in those core measures if you were paying attention to the base effects and noticing that the measures of central tendency that are more immune to those base effects never decelerated much (see median CPI), but still somehow a lot of people were taken by surprise if the uptick in media stories is any indication.

I actually have an offbeat read of that phenomenon, though. I think that many of these analysts, media outlets, and economists just want to have some record of being on the inflation story at a time they consider early. Interestingly enough, while there is no doubt that the volume of inflation coverage is up in the days since the CPI report, there is still no general alarm. The chart below from Google Trends shows the relative trend in the search term “rising inflation.” It has shown absolutely nothing since the early days of extraordinary central bank intervention.

risinginflationsearch

Now, I don’t really care very much when the fear of inflation broadens. It is the phenomenon of inflation, not the fear of it, which causes the most damage to society. However, there is no doubt that the fear of inflation definitely could cause damage to markets much sooner than inflation itself can. The concern has been rising in narrow pockets of the markets where inflation itself is actually traded, but because we trade headline inflation the information has been obscured. The chart below (source: Enduring Investments) shows the 1-year headline inflation swap, in black, which has risen from about 1.4% to 2.2% since November. But the green line shows the implied core inflation extracted from those swap quotes, and that line has risen from 1.2% in December to 2.6% or so now. That is far more significant – 2.6% core inflation over the next year would mean core PCE would exceed 2% by next spring. This is a very reasonable expectation, but as I said it is still only a narrow part of the market that is willing to bet that way.

coresincedec

If I was long equities – which I am not, as our four-asset-class model currently has only a 7.4% weight in stocks – then I would keep an eye on the search terms and for other anecdotal evidence that inflation fears are starting to actually rise among investors, rather than just being the probably-cynical musings of people who don’t want to be seen as having missed the signs (even if they don’t really believe it).

They Came to Play

I am generally reluctant to call anything a “game changer,” because in a complex global economy with intricately interdependent markets it takes something truly special to change everything. However, I am tempted to attach that appellation to the ECB’s historic action this morning. It probably does not “change the game” per se, but it is very significant.

Feeble money growth in the Eurozone has been a big concern of mine for a while (and I mentioned it as recently as Monday). In our Quarterly Inflation Outlook back in February, we wrote:

“The new best candidate for having a lost decade, now, becomes Europe, as it sports the lowest M2 growth among major economic blocs… It frankly is shocking to us that money supply growth has been so weak and the central bank so lethargic towards this fact even with Draghi at the controls. It was generally thought that Draghi’s election posed a great risk to price stability in Europe… but in the other direction from what the Eurozone is now confronting. There have been murmurings about the possibility of the ECB instituting negative deposit rates and other aggressive stimulations of the money supply, but in the meantime money growth is slipping to well below where it needs to be to stabilize prices. Europe, in our view, is the biggest counterweight to global inflationary dynamics, which is good for the world but bad for Europe.”

All of that changed, in one fell swoop, today. The ECB’s actions were unprecedented, and largely unexpected. First, and somewhat expected, was the body’s decision to implement a negative deposit rate for bank reserves held at the ECB.  This is akin to the Fed incorporating a negative rate for Interest on Excess Reserves (IOER). What it does is to actually penalize banks for holding excess reserves.

There are two ways for a bank to shed excess reserves. The first way is to sell the reserves to another bank in the interbank market. This doesn’t change anything about the aggregate amount of excess reserves; it just moves those reserves around. In the process, it will push market interest rates negative (since a bank should be willing to take any interest rate that is less negative than what the ECB is charging) and probably increase retail banking fees at the margin (since there is otherwise no way to charge depositors a negative rate). This will weaken banks, but doesn’t increase money growth. The second way a bank can shed excess reserves is to lend money, which increases the reserves it is required to hold and therefore changes the reserves from excess to required. A bank is incentivized to make marginally riskier loans (which lowers its margins due to increased credit losses) because there is a small advantage to using up “expensive” reserves. This also will weaken banks. But, more importantly, it will stimulate money growth and that is what the ECB is aiming for.

If that was all the ECB had done, though, it would not be terribly significant. The utilization of the ECB’s deposit facility is only about €29bln at this writing, which is already near the lowest level since the crisis began (see chart, source Bloomberg).

ECBdepo

But the ECB did not stop there. At the press conference after the formal announcement, Draghi unveiled a package of €400bln in “targeted” LTRO, which means that if banks lend the money they acquire through the LTRO then the term of the loan is four years; otherwise it must be paid back in two years.[1] Even more important, the central bank suspended the sterilization of LTRO. “Sterilization” is when the bank soaks up the reserves created by the LTRO. As long as the ECB was sterilizing its quantitative easing, it could not have any impact. It is similar, but more extreme, to what the Fed did in instituting IOER to restrain banks from actually using the reserves created by QE. It never made much sense, but in the ECB’s case there was evidently some concern that doing QE without sterilization was not permitted under the institution’s charter.

Apparently, those concerns have been resolved. But QE without sterilization is meaningful. The ECB is thus not only doing quantitative easing, but is actively taking steps to make sure that the liquidity being added to the system is flushed, rather than leaked, into the transactional money supply.

If the ECB actually follows through on these pledges, then we can expect a rapid turn-around in the region’s money growth, and before long a turn higher in the region’s inflation readings. And, perhaps, not merely for the region: the chart below (source: Bloomberg, Enduring Investments) shows the correlation between core CPI in the US and the average increase in US and Eurozone M2. Currently US M2 is growing at better than 7% over the last year, while Eurozone M2 is 1.9%. Increasing the pace of M2 growth in Europe might well help push US inflation higher – not that it needed any help, as it is already swinging higher.

europlusus

The renewed determination of the ECB to push prices higher should as a result be good not only for European inflation swaps (10-year inflation swaps were up 2-3bps today, but have a long way to go before they are back to normal levels – see chart, source Bloomberg), but also for US inflation swaps (which were up 1-2bps today).

euroinfl10

Finally, if it is true that central bank generosity is what has been underpinning global asset markets, an aggressive ECB might give a bit more life to global equities. Perhaps one more leg. But then again, perhaps not – and when the piper’s tune is over, it could be brutal. It is currently quite dangerous to be dancing to that piper. For my money, I’d rather be long breakevens.


[1] This is interesting for lots of reasons, but one of them is that the ECB will measure (if I understand correctly) the net lending of the institution, so if that contracts then the loan will be called. But there are lots of reasons for an institution to decrease lending. Some of them, such as a generally weak economic environment or a weak balance sheet of the bank, would be exacerbated by an unwelcome “call” of the loan by the ECB. In the former case it would exacerbate a weak economic situation; in the latter it could accelerate a bank collapse. I may not understand the conditions for the call, but if my understanding is correct then this is a curious wrinkle.

Worried About Not Being Worried

June 2, 2014 4 comments

I am beginning to worry about my own complacency. As a person who has been a participant in the fixed-income markets for a long time, I have become quite naturally a very cautious investor. Such caution is a quintessentially fixed-income mindset (although you might not guess that from the way bond people behaved in the run-up to the global financial crisis) – as a bond investor, you are essentially in the position of someone who is short options: taking in small amounts on a regular basis, with an occasional large loss when the credit defaults. A bond investor can greatly improve his performance in the long run relative to an index by merely avoiding the blow-ups. Miss the Enron moment, and you pick up a lot of relative performance. (The same is true of equities, but there is much more upside to being an optimist. The stock market selects for optimists, the bond market for pessimists.)

This is a lesson that many high-yield investors today, chasing near-term carry, seem to have forgotten. But my purpose here isn’t to bash those involved in the global reach for yield. I am merely pointing out that this is how I tend to think. I am always looking for the next disaster that hangs a portfolio with a big negative number. As Prince Humperdinck said in The Princess Bride, “I always think everything could be a trap – which is why I’m still alive.”

And I am starting to worry about my own complacency. I don’t get the feeling that we’re gearing up for Round 2 of the global financial crisis. Something bad, perhaps, but not catastrophic.

To be sure, there are a large number of potential pitfalls facing investors today, and I think market volatilities underestimate their probabilities substantially. We are facing an inflection in policy from the ECB this week, with analysts expecting a substantial additional easing action (and it is overdue, with money growth in Europe down to a feeble 1.9% y/y, near the worst levels of the post-crisis period – see chart, source Bloomberg). Absent a major change in policy, liquidity on the continent is going to become increasingly dear with possible ramifications for the real economy as well as the asset economy.

EUM2

The Federal Reserve is facing a more-serious policy inflection point, with no agreement amongst FOMC members (as far as I can tell) about how to transition from the end of QE to the eventual tightening. I’ve pointed out before – while many Fed officials were whistling Dixie about how easy it would be to reverse policy – that there is no proven method for raising interest rates with the vast quantity of excess reserves sitting inert on bank balance sheets. Moreover, raising interest rates isn’t the key…restraining money growth is. The key point for markets is simply that there is no plan in place that removes these reserves, which means that interest rates are not likely to respond to Fed desires to see them rise. And, if the Fed uses a brute-force method of raising the interest paid on excess reserves, then rates may rise but we don’t know what will happen to the relative quantities of required and excess reserves (and it is the level of required reserves that actually matter for inflation). It is a thorny problem, and one which the markets aren’t giving enough credit regarding the difficulty thereof.

Valuation levels are high across the board (with the exception of commodity indices). They’re doubly high in stocks, with high multiples on earnings that are themselves high with respect to revenues. And yes, this concerns me. I expect more volatility ahead, and perhaps serious volatility. But the fact that I am just saying “perhaps,” when all of my experience and models say “there is no escape without some bad stuff happening,” means that I am being infected – relative to my usual caution – by the general complacency.

In other words, I am worried that I am not worried enough.

The interesting thing is that equity bulls said during the entire march higher that “it doesn’t matter what the fundamentals are, the Fed is pushing the market higher and spreads tighter.” I still don’t believe that was an inevitable outcome to the Fed’s QE, but the fact is that people believed it and they were correct: that was enough to keep the market going higher. I can’t be comfortable going along with the crowd in that circumstance, but in retrospect it would have been better to abandon the models, throw caution to the wind, and ride along with the fun. And perhaps this regret is one reason for my developing complacency.

But that way lies madness, since the problem is not the ride but the getting out when the ride is over. The Fed is no longer providing QE (or, in any event, QE will shortly end altogether). So what’s the excuse now? It seems to me that everyone is still riding on the fun train, and just watching carefully to see if anyone jumps off. I think the market rally is on very tenuous footing, because if faith in the market’s liquidity goes away, the value anchor is very far from these levels. Yet, part of me is skeptical that a market which hasn’t corrected in more than two years can actually return to those value anchors. I should know better, because the bond-market mindset reminds me that market gains are generally linear while market losses are discontinuous, sloppy, and non-linear. Especially, I ought to be thinking, when market liquidity is so poor thanks to the government’s assault on market makers over the last few years.

I keep wondering if there is one more pulse higher in stocks coming, one more decline in commodities before they begin to catch up with money growth and inflation, one more rally in bonds before they begin to discount a higher inflation path. And this is very possible, because while I worry about my own developing complacency most investors are not concerned about their own.

Complacency or no, insurance is cheap. The low current level of implied volatilities in almost every asset class makes portfolio protection worthwhile, even if it costs a bit of performance to acquire that protection.

Deflation, Indeed!

May 15, 2014 2 comments

Today’s post-CPI update is later than usual (normally, on CPI day I ‘tweet’ my impressions as I have them). A prospect meeting got in the way – yes, isn’t it interesting that there is demand for creative inflation-linked solutions?

Probably, after today, this will be a trifle less surprising. Core inflation surprised on the high side. Consensus had been for the month-over-month figure to be +0.1%; instead it printed +0.236%. This pushed the year-on-year core inflation rate to 1.826%, the highest it has been in a year…and yet still the lowest it is likely to be for a very long time.

So, with the wonderful perfection of timing that is only possible from elite policymakers, the Fed has begun to chirp about deflation fears at just exactly the time that core inflation is turning higher. Do recall that core inflation never got below 1.6% – very far from “deflation” – and was only that low because of well-known effects stemming from the impact of the sequester last year on Medicare payments. Median inflation, which eliminates the influence of small outlier decreases (and increases) on the number, scraped as low as 2.0%, and now sits at 2.2%. It has not been higher than that since mid-2012. Median inflation hasn’t been higher than 2.3% since 2009, so it is fair to say that inflation is much closer to the highs of the last five years than to the lows. Deflation, indeed.

A closer view of the subcomponents do not give any less cause for concern. Of the eight major subcomponents, six (Food & Beverages, Apparel, Transportation, Medical Care, Recreation, and Education & Communication) accelerated on a year-over-year basis while only two (Housing and “Other”) decelerated.

At first glance, that sounds promising. Housing inflation dropped to 2.5% from 2.8%, and those people who are worried about another housing bust right now will be quick to seize on that deceleration. Housing inflation, which is 41% of the total consumption basket, has been a primary driver of core inflation’s recovery in recent months so a deceleration would be welcome. But a closer look suggests that the number for Housing overstates the ‘deceleration’ case considerably. “Fuels and utilities,” which is 5.2% of the entire consumption basket and about 1/8th of Housing, dropped from 6.8% y/y to 4.2%. That was the entire source of the deceleration in housing. The larger pieces, which are also much more persistent, were higher: Primary rents rose from 2.88% y/y to 3.05% y/y, while Owners’ Equivalent Rent was roughly flat at 2.62% compared to 2.61%. So it is perhaps too early to panic about deflation, since the rise in OER and Primary rents is right on schedule as we have been marking it for some time (see chart below, source Enduring Investments).

updatedOER

Outside of housing, core inflation accelerated as well. Core ex-Shelter rose to 1.16% from 0.90%. The inflation is still significantly in services, as core commodities are still only -0.3% year/year. But that will rise soon, probably starting as soon as next month, based on our proxy measure.

As has been well advertised, the temporary depression in Medical Care inflation growth has officially ended. Now that April 2013 is out of the year/year data, the Medical Care major group saw prices rise 2.42% over the last year compared with 2.17% y/y a month ago. Medicinal drugs are at +1.70% compared with +1.44%. Medical equipment and supplies -1.39% vs -1.53%. Hospital and related services +5.55% vs 4.69%. I don’t see the deflation, do you?

This rise in CPI was broad and deep, with nearly 80% of the lower-level indices seeing increases in the y/y rate. It is hard to find any major component about which I would have to express concern, if I was a Federal Reserve official worried about deflation. The breadth of increase is itself a signal. When some prices go up, it is a change in relative prices and will be considered inflation by some people (those who are sensitive to those prices) and not so much by others. But “inflation” is really about a general rise in prices, in which most goods and services participate. As I mentioned above, not all goods prices are participating but in general most prices are rising and, if this month is any gauge, accelerating.

We should hesitate to read too much into any one month’s inflation number. There is a lot of noise in any economic data, so that it can be hard to discern the signal. I believe that there is enough underlying strength here that this is in fact more signal than noise, though, and so I continue to expect core inflation to accelerate for the balance of the year.

I have no idea how long Fed officials will continue to fret about deflation, nor how long it will take the concern to shift to inflation. I suspect it will take a long time, although the stock market today seems less certain on that point with the S&P at this writing down -1.3%. Curiously bonds, which are clearly overvalued if inflation is not contained, rallied today (although breakevens predictably widened). But I think all markets are safe for some time from the risk that central bankers will develop a concern about inflation that is acute enough to spur them to action. (Not to mention that it isn’t at all clear to me what action they could take that would have an effect on the inflation dynamic in any reasonable time frame given that excess reserves must be drained first before any tightening has teeth). This does not mean that I am sanguine about the prospects for nominal asset classes such as stocks and nominal bonds – but at some point, they won’t need the Fed’s cudgel to persuade them to re-price. When inflation is obvious enough to all, that will be sufficient.

Patience is a Pain

If it seems that the frequency of my posts has diminished of late, it is no illusion. There are many reasons for that, many business-related, but there is at least one which is market-related: a three-month-long, 20bp range in real and nominal yields and a year-to-date S&P return that seems locked between +2% and -2% with the exception of the January dip offers precious little to remark upon. Along with those listless markets, we have had plenty of economic data that it was very evident the market preferred to ignore and blame on “severe weather.” And, to the Fed’s lasting credit (no pun intended), the decision to start the taper under Bernanke and thus give Yellen a few months of simply sitting in the captain’s chair with the plane on autopilot has short-circuited the usual rude welcome the markets offer to new Fed Chairmen.

These sedate markets irritate momentum traders (you can’t trade what doesn’t exist) and bore value traders – at least, when the markets are sedate at levels that offer no value. For individual investors, this is a boon if they are able to take advantage of the quiet to pull their attention away from CNBC and back to their real lives and jobs, but for professional investment managers it is frustrating since it is hard to add value when markets are becalmed.[1] Yes, successful investing – which is presumably what successful investment managers should be practicing – is very much about patience, and this is doubly or trebly true for value managers who eschew investing heavily into overvalued markets. I am sympathetic with the frustrations of great investors like Jeremy Grantham at GMO, but I will point out that his frustrations are more acute among less-legendary managers. It is, after all, much easier to pursue the patient style of a Hussman or Grantham…if you are Hussman or Grantham.

Again, I’m not whining too much about our own difficulty in securing good performance, because we’ve done well to be overweight commodities and with some of our other position preferences. I’m more whining about the difficulty of writing about these markets!

But let’s reset the picture, now.

The very weak Q1 GDP figure from last Wednesday (a mere +0.1%, albeit with strong consumption) is old news, to be sure, and investors are right to underweight this information since we already knew Q1 growth was weak. But at the same time, I would admonish investors who wish to patiently take the long view not to get too ebullient about Friday’s jobs figure. Payrolls of +288k, with solid upward revisions, sounds great, but it only keeps us on the 200k/month growth path that we have had since the recovery reached full throttle back in late 2011 (see chart, source Bloomberg).

unempavg

As I wrote back in August, 200k is what you can expect once the expansion is proceeding at a normal pace, and that’s exactly what you’ve gotten for a couple of years now. Similarly, if you project a simple trend on the Unemployment Rate from late 2011 (see chart, source Bloomberg) you can see that the remarkable plunge in the ‘Rate merely operated as a ‘catch-up’ from the winter bounce higher.

unemptrend

If you believe that inflation is caused when economies run out of slack (I don’t), then the low unemployment rate should concern you – not because it fell rapidly, because it is nearer to whatever threshold matters for inflation. If you rather think that inflation is caused by too much money chasing too few goods, then you’ve already been alarmed by the continued healthy rise in M2 and the fact that median inflation rose to 2.1% this month. So, either way, people (and policymakers) ought to be getting at least more concerned about inflation, no matter what their theoretical predilections. And, in fact, we see some evidence of that. Implied core inflation for the next 12 months (taking 1-year inflation swaps and hedging energy) has risen in the past month to about 2.25% from 1.75%. To some extent, this seems to be seasonal, as that measure has risen and peaked in the last three March/April periods. Investors tend to mistake the rise in gasoline prices that normally happens in the spring to be inflation, even though it ordinarily falls back later in the year. But right now, the implied acceleration in core inflation from the current level of 1.7% is the highest it’s been in three years (see chart, source Enduring Investments).

impliedvsrecentcore

The bigger spike, on the left side of that chart, corresponds with the significant fears around the time of QE2. But what’s interesting now, of course, is that the Fed is actually tightening (providing less liquidity is the definition of tightening) rather than easing. Some of this is probably attributable to base effects, as last year’s one-off price decline in medical care services due to sequestration-induced Medicare spending cuts is about to begin passing out of the data. But some of it, I suspect, reflects a true … if modest … rising concern about the near-term inflation trajectory.

 

[1] Unless, that is, you are overweight commodities…which we are. The DJ-UBS is +8.9% year-to-date.

Tempest in a Microsecond

April 1, 2014 3 comments

News flash! High-frequency trading (HFT) is happening!

The “60 Minutes” piece on HFT that aired this weekend ensured that now, finally, everyone has heard of HFT. Even “60 Minutes” has now heard of it, four years after the Flash Crash and more than a decade after it began. Apparently the FBI is now suddenly concerned over this “latest blemish.”

Again, this is hardly new. Here is the record of Google search activity of the term “high frequency trading.”

Capture

So why is it that, for years, most of the world knew about HFT and yet no one did anything about it?? According to author Michael Lewis, the stock market is rigged! There should be an uproar (at least, there should be if you are selling a book). Why has there been no uproar previously?

To put it simply: this is a crime where it isn’t clear anyone is being hurt, Lewis’s panicky declaration notwithstanding. Except, that is, other high-frequency traders, who have fought over the tiny fractions of a penny so hard that the incidence of HFT is actually in decline. Let’s be clear about what HFT is, because there seems to be some misunderstanding (one commentator I saw summarized it as “the big banks buy the stock and then the retail investor buys it 5%-10% higher.” This would be a problem, if that’s what was happening. But it isn’t. The high frequency traders are playing for fractions of a penny. And the person they are stepping in front of may be your buy order, or it may be the offer you just bought from – if you ever see fills like $20.5999 when the offer was $20.60, then you were injured to the tune of minus 1/100 of a cent per share. The whole notion of HFT is to be in and out of a position in milliseconds, which basically limits expected profits to a fraction of the bid/offer. And when there are lots of high frequency traders crossing signals? Then the bid/offer narrows. That’s not a loss to you – it’s a gain.

High frequency traders aren’t just buying and pushing markets up. They are buying and selling nearly-instantly, scalping fractions of pennies. From all that we know, they have no net effect on prices. Indeed, from all that we know, both the beneficial aspects and the negative aspects remain unproven (see “What Do We Know About High Frequency Trading?” from Charles Jones of the Columbia Business School.

So, if you’re being ripped off, it’s far more likely that you’re being ripped off by commissions than that you’re being ripped off by the robots.

But let’s suppose that the robots do push prices up 5% higher than they would otherwise be. Either that’s the right price to pay…in which case they made the market more efficient by pushing it nearer to fair value…or it’s the wrong price to pay, in which case the only way they win is by selling it to someone who pays too much. If that’s you, then the robots aren’t the problem – you are. Stop giving them a greater fool to sell to, and they will lose money.

Now, this is all good advertising for another concept, which needs to be stated often to individual investors but probably could be said in a nicer way than “you’re getting ripped off by robots”: yes, the market is full of very, very smart people. And yet, on average returns cannot be above-average! This means that if you don’t know everything there is to know about TSLA and you buy it anyway, then you can be sure you will still own it, or be still buying it, when the smart guys decide it is time to sell it to you. They don’t have to have inside information to beat you – they just have to know more than you about the company, about valuations, about how it should be valued, and so on. This is why I very rarely buy individual equities. I am an expert in some things, but I don’t know everything there is to know about TSLA. I am the sucker at that table.

Long-time readers will know that I am no apologist for Wall Street. I spent plenty of time on that side of the phone, and I have seen the warts even though I also know that there are lots of good, honest people in the business. The biggest problems with Wall Street are (a) those good, honest people aren’t always fully competent, (b) the big banks are too big, so that when you get weak competence and very weak oversight combined with occasional dishonesty, there can be serious damage done, (c) there is not a strong enough culture at many firms of “client first;” although that doesn’t mean the culture is “me first,” it means the client’s needs sometimes are forgotten, and finally (d) the Street is not particularly creative when it comes to new product development.

And I don’t really like the algo traders and the movement of the business to have more robots in charge. But look, this trend (not necessarily HFT but automated trading) is what you get when you start regulating the heck out of the humans. Which do you want? Kill the robots, and you need more of those dastardly humans. Remove the humans, and those lightning-quick robots might trade in front of you. Choose. In both cases, you will be victimized less if you (a) trade large and liquid indices, not individual equities, and (b) trade infrequently.

The far bigger problem in my mind is the opacity, still, of bond trading and the very large bid/offer spreads that retail investors pay to buy or sell ordinary Treasury bonds that trade in large size – often billions – on tiny fractions of 1% of price. Think of it: in equities, with or without HFT you will get a better price for a 100-lot than for a 1,000,000-lot. But in bonds, you will get a vastly better price for a billion than for a thousand. Now that is where a retail investor should get angry.

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