Archive
Chutzpah
It has been a busy couple of weeks on the business side, which is why I haven’t been writing many articles. However, I wanted to be sure and pen a quick one today.
The main economic data is due out later this week: Existing Home Sales on Wednesday, New Home Sales on Thursday (both of these more interesting for the home price indications than for the volume figures), and Durable Goods on Friday. (Some of us also get excited about the 10-year TIPS re-opening on Thursday, with real yields at a 1-year high after a 35bp selloff over the last three weeks). But Monday and Tuesday have been relatively bereft of news, except for the occasional Fed speaker.
It is that “occasional Fed speaker” that I want to mention today.
St. Louis Fed President James Bullard today gave a speech in Europe, about the need for the ECB to pursue “aggressive” QE in order to prevent a long period of low inflation and deflation such as that experienced by Japan over the last few decades.
What word am I searching for here…would it be “chutzpah?”
I realize that Chairman Bernanke has already been featured on a magazine cover as a Hero. It bears remembering that Greenspan was also called the Maestro at one point, although we are now all aware that his management of the Fed helped to precipitate a massive crisis. History isn’t written in real time by bloggers. It’s written by historians, years later.
But hasn’t the Fed, after all, been really successful? Isn’t a victory lap deserved? Haven’t they earned the right to lecture to other central banks about the proper execution of monetary policy? After all, the Fed brought down the unemployment rate while inflation remains tame. Case closed.
Perhaps that would be a good argument if Earth was hit by a comet tomorrow and all life ceased. But in the event life continues, we will need to wait until the cycle is complete. Celebrating now is like pumping one’s fist in celebration in the middle of a motorcycle jump over 25 buses. Nice trick, but we’ll hold our applause until you stick the landing if you don’t mind.
There seems to be great faith in the Federal Reserve that the tough part is over. All that they need to do now, it seems they believe, is to just start tightening before inflation gets going; they can do it very gradually, supposedly, because of the great credibility the Fed has and because they understand how inflation responds to rates.
But in fact, inflation doesn’t respond to rates but to money. And not to reserves, but to transactional money. Transactional money responds not to total reserves, but to banking activity and the resulting level of required reserves…which the Fed is unable to directly affect. When the Fed begins to taper, and then to somehow drain reserves, I predict it will have almost zero impact on the inflation process until the excess reserves have been drained.
Indeed, if interest rates rise when the Fed begins to do this, it will perversely tend to increase the velocity of money, which tends to vary inversely with the opportunity cost of holding cash balances (that is, velocity goes up when interest rates go up, all else equal). It’s not the only thing that matters, but it’s pretty important, as the chart below suggests (I think I have run something like this chart previously).
Now, ordinarily when the Fed is raising rates, they’re also draining reserves – so the increase in money velocity is balanced by the decline in money to some degree. That won’t happen this time. When rates go up, velocity will go up, but the quantity of (M2) money will not change because it is driven by a multiplier that acts on required reserves. That means inflation may well rise as interest rates increase, at least for a while.
I might be wrong, but I am willing to wait and see how it plays out. If I am wrong, then you don’t have to put me on the cover of a magazine.
To conclude that inflation is fully tamed at this point, anyway, is remarkably optimistic. Home prices are skyrocketing at rates only rarely seen, and it would be incredible if that did not lead to higher rents and higher core inflation…literally within a couple of months from now, judging from the historical lag patterns.
But, again, I should return to my main point: it isn’t that the Fed is wrong, it’s just that they are so completely certain that they are right even though the difficult part of the trick – unwinding the extraordinary policy without any adverse effects – lies ahead.
Sit down, James Bullard. Let the ECB manage its own affairs. I am sure they can mess it up on their own, without your help. And certainly, without your condescending advice!
Not So Fast on the Deflation Talk
I wonder how quickly all of the calls of “deflation!” will turn into calls of “hyperinflation!”
After gold was pummeled $200 in two days on April 12th and 15th, there was a proliferation of commentators who suddenly declared that inflation fears were in full flight. Although the decline in inflation swaps to that point was mainly attributable to the decline in energy prices (subsequently, some air has indeed come out of implied core inflation, but still there is no deceleration in inflation, much less deflation, priced in), the chorus of “I told you so’s” was deafening and many were encouraging Chairman Bernanke and other central bankers to take a victory lap. After the disastrous 5-year TIPS auction on April 18th I could almost hear Darth Vader saying “strike down the 5-year breakeven and the journey to a deflationary mindset will be complete.”
Well, not so fast. Since that point, gold has recovered about $100 in rallying six out of the last eight sessions. The 5-year breakeven has recovered from 1.94% to 2.15% (although to be fair about half of that was due to the roll). The 10-year breakeven also bounced 14bps, and is back above 2.40%. Today, every commodity in the DJ-UBS index, with the exception of Coffee, rallied.
Why? What has changed over the last week and a half? Nothing important; if anything, the data has been weaker than the data preceding the washout. And that fact, I continue to think, is a fact the salience of which remains ungrasped by central bankers. Unless it’s by sheer coincidence, global growth simply isn’t going to explode upward while incentive structures are so bad and governments consume such a large part of the economy. And as long as growth doesn’t explode higher, central banks will keep easing, because – despite almost five years of contrary evidence – they think it helps growth. I believe the only way that global QE stops is if central banks come to understand that they aren’t doing any good on growth, and are doing much harm on inflation, though with a lag.
I am not terribly optimistic that such a eureka moment is nigh, especially when the economics community is so subject to confirmation bias that a technical washout in gold can provoke hosannas.
An April 12 article in the Washington Post highlighted recent research that indicates a one-percentage point increase in unemployment makes us feel four times as bad as a one-percentage point increase in inflation. This is not particularly surprising, at some level, although I greatly suspect that the results are non-linear – but I am not shocked that it feels worse to see people lose their jobs (or to lose one’s own job) than to absorb slightly higher price increases.
But the article goes on to argue that “Such findings could have significant implications for monetary policy, which until the most recent recession has primarily been concerned with controlling inflation. But now some central banks are speaking of allowing inflation to rise or stay slightly above their usual targets in hopes of bringing down unemployment.” The idea the article is proposing is that it is incorrect to balance evenly the (inherently conflicting) mandates the Fed is tasked with to seek lower inflation and lower unemployment; they should favor, according to this argument, lower unemployment.
There are several flaws in this argument, but I believe it is likely that the Fed more or less agrees with the sentiment.
One flaw is that the damage to inflation comes in the compounding. If unemployment is 6% now and 6% next year, there has been no change. But if inflation is 6% this year and 6% next year, then prices are up 12.4%. And if it’s for three years, it’s 19.1%. How many years of that 1% compounding inflation do you trade for 1% incremental change in unemployment?
A bigger flaw, in my view, is that central banks don’t have any important control over the unemployment rate, while they have important control over inflation. It may also be the case that a 1% rise in background radiation levels makes people feel even worse than a 1% rise in unemployment, but that doesn’t mean the Fed should target radiation levels!
Moreover, even if you think the Fed can affect growth, it is still true that for big moves in these numbers (because we really don’t care so much about 1% inflation change or 1% unemployment change, after all) the central bank’s power to cause harm is clearly much larger in inflation. It is possible to get 101% inflation, and in fact many central banks have done so. No central bank has ever managed to produce 101% unemployment.
I doubt that commodities and breakevens will go higher in a straight line from here. And every time there is a break lower, the deflationists will call for the surrender of the monetarists. But I do wonder if this latest break is the worst we will see until there is at least some sign that QE is going to end.
Rage Against the Machines
The explosion today wasn’t at the White House. That was a false report, put out when the Twitter account of the Associated Press was hacked. But that report immediately led to immolation at some high-frequency trading (HFT) fund, somewhere, almost certainly. The S&P immediately dropped 16 points as some news algorithm (or algorithms) scraped the tweet and immediately converted it into sell orders. As they say in the circus, “whoops!” And, as in the circus, that utterance is almost immediately followed by the sound of ambulances. In an otherwise very quiet market, there was a five minute period of very active trading, punctuated by swearing so loud you could almost hear it.
Somewhere, there is a fund that was founded on the basis of its smart algos that can “react faster than humans can react,” which took losses faster than a human could have taken losses. Ouch, I say. Ouch. But my sympathy for HAL is tempered by the fact that HAL has no sympathy for me.
I am pretty sure that the rapid movement in housing prices has nothing to do with HFT algorithms, although the violence of the move is starting to be vaguely reminiscent. Fortunately, home sales documentation is still not effected in microseconds, so we all still have a chance to beat the machines. Over the last few days, we have seen Existing and New Home Sales data, and the FHA’s Home Price Index; the more stable two of these confirmed that home prices continue to accelerate. In fact, as the chart below shows, the year-on-year rise in Existing Home median prices is more than 10% faster than core inflation for only the second time since the data has been kept. The first time that happened was in the midst of the housing bubble.
Housing is nowhere near bubble territory yet, and as the chart also shows the rise in home prices can persist at better than 10% over CPI for at least a little while. However, it can’t last too long because of the reflexivity of it: eventually, no matter what happens to home prices, the increases will pass into core inflation and the spread will be eaten away from the bottom.
This isn’t even necessarily a negative sign of a re-inflating bubble. In principle, if home prices had gotten overextended on the downside in a “negative bubble,” this could simply be a snap-back and just healthy. However, that doesn’t appear to be the case. I showed here that median existing home prices as a multiple of median household income are right on the average for the last 36 years or so – certainly not cheap. The chart below shows a similar relationship for New Homes. Note that with new homes, one would expect an uptrend since the average new home has grown in size over the years and loan qualifications have also allowed lower-income borrowers to dedicate larger shares of their incomes to buying new homes.[1]
The simple implication of the fact that home prices continue to accelerate higher is that core inflation is absolutely going to head higher. I think that Owners’ Equivalent Rent will turn higher in the next couple of months; Pimco recently wrote a piece saying they think the upturn takes until late this year; but it will happen. And it will happen regardless of whether the “shadow inventory” of homes hits the market or not, although if there really is a large unsold shadow inventory of homes, that will moderate the advance. My question is: where is this shadow inventory? Existing home prices are 10-20% off the lows depending on what series you use. Are sellers waiting for a return to the peak?
Some observers have noted that homes are now suddenly appearing on the market, and they divine a supply response. This is possible, but what is more likely is that this is the normal seasonal pattern: people put their homes on the market in the spring, not in the winter. This is why the sales data are seasonally-adjusted, so don’t trust your anecdotal evidence! The chart below shows the nonseasonally-adjusted single family Existing Home Sales (source: NAR) for the last few years. You can see that the data mavens fully expect home sales to be picking up now, which is why there are many more homes on the market suddenly. There are every year at this time.
So I think we are still left with the conundrum. Where are all of those shadow homes? We know where the new homes are – they were never built, because the market was awful. That inventory will respond as builders build new homes. But as for the shadow inventory of existing homes…maybe they don’t exist?
From the standpoint of inflation, the question of shadow inventory only matters to the trajectory of future inflation, not to the question of how much CPI will rise in 2013 and 2014. Those OER increases are virtually baked in the cake, unless something very strange is happening. While an important lesson of the last few years is that very strange things happen all the time, we’re talking about a specific very strange thing: the possibility that the price of a good (a home) rises, and the price of a close substitute (a rental) does not. While those can diverge from time to time, I have great confidence in the economic verity that the prices of substitutes tend to move together.
The only way there might be a big divergence is if home prices are rising because the investment value of the home, and not its value as housing, is what is increasing (although in the bubble years, rents eventually rose as well). But if that is the case, wouldn’t that in itself be a sign that there is concern about inflation, so that people are seeking real assets wherever they can find them? Concern about inflation need not lead to inflation, but it may be a contemporaneous indication that inflation is rising and it merely hasn’t shown up in the data yet.
The rise in home prices is the biggest single alarm being sounded about inflation at the moment, and it seems to me that it pays to listen to it, and check that the doors and windows are locked…just to be sure.
[1] This is a much smaller effect with existing homes, since the average square footage of the homes existing in the entire nation changes much more slowly; also, many existing homes are move-up homes so the marginal-borrower effect, which I suspect is pretty small anyway except for the bubble years, is less pronounced.
Necessary Finger Crossing
Housekeeping note: in case you missed it, here is a link to Tuesday’s article, which was not picked up through all of the “usual” syndication channels. Note that, in addition to doggerel, it contains an announcement regarding the free ‘office hours’ I am making available to readers who wish to sign up. (On the basis of the first “round,” I’ve decided to lengthen the sessions to 20 minutes but only offer three of them per week, but this may evolve further as I learn more.)
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When we look back on this period of financial history, I wonder if it will not be called the “era of unintended consequences.” I can think of lots more names for the era, some of them unprintable, but this one certainly applies.
I tend to think of unregulated markets as chaotic, but fundamentally structured. They tend to be efficient, although research has demonstrated that even completely free markets can produce bubbles and negative bubbles. But I really do believe in something like Adam Smith’s ‘invisible hand,’ that leads the baker to make just enough bread without being told how many loaves to make. A farmer’s market or third-world bazaar, although seemingly chaotic, still often manages to arrange itself so that most purveyors of similar goods end up in one general area. However, when someone intervenes to organize the chaos, there is often an unintended consequence. A recent example is the Fed’s low-rate policy in the mid-2000s, which was meant to respond to the equity bubble burst and the recession of the early 2000s; it also helped produce the housing bubble. Certainly, the housing bubble was not intended by the Fed, but it clearly followed partly from the easy money policies. As another example, Cyprus needed a bailout partly because their banks had been involved in helping Greece by buying Greek debt. Surely countless other examples suggest themselves.
Another example came to my attention today. As part of a presentation I am giving in a week and a half, I will be talking about the “portfolio balance channel” and how it is pushing investors to take more risk than they should, based on the absolute return expectations, because of the configuration of relative return expectations. (I wrote about this in “A Relatively Good Deal Doesn’t Mean It’s A Good Deal”, back in January). But a friend pointed out that it isn’t merely retail and professional investors who are being forced to take risky assets at bad prices because the safe assets have even worse prices: central banks are as well, according to this article in the Financial Times, entitled “Central banks move into riskier assets.” Who knew?
Central bankers are not supposed to really care about portfolio returns. They’re supposed to care mainly about return of capital rather than return on capital. That’s theory, but the reality is that central bankers want to be heroes just like anyone else, and their jobs are definitely made politically easier if they are revenue generators and not cost-centers. And that in turn made me think of the article in this month’s Financial Analysts Journal by Robert C. Merton et. al., in which they argue that “monetary and fiscal policies designed to deal with things like stimulus or consumption demand can actually have unintended consequences of some magnitude for financial stability and markets.” More interestingly, they graphically illustrate how much more connected financial institutions are now than they were prior to 2008.
And one important unintended consequence of the Fed’s efforts on the portfolio balance channel is that the connectedness is increasing, and the nonlinear exposures of central banks are increasing as well. That, in turn, suggests that rather than being meaningfully safer than we were five years ago, we may well be less safe. You could already make such an argument by pointing out that sovereign states have less room to fiscally ease in response to crisis, but add to that the fact that central banks themselves could be caught up in a crisis and be losing capital at just the moment when it is most needed. Of course, at some level a central bank that has control over its own currency – unlike those in, say, Portugal or Italy – can always print a solution. The increasing risk posture of central banks, I believe, increases the possibility of a blatant printing outcome (as opposed to the circumspect printing currently being pursued) in response to a renewed crisis.
Never before have so many fingers been crossed for the global economy. And never before has it been so necessary to cross our fingers!
A Bright Golden Haze
There’s a bright golden haze on the meadow,
There’s a bright golden haze on the meadow.
The Dow is as high as an elephant’s eye,
An’ it looks like it’s climbin’ clear up to the sky.
Oh what a beautiful morning!
Oh what a beautiful day.
It’s far too pretty for trading,
So why don’t we play golf today.
With apologies to Rodgers and Hammerstein, it appeared as if the lovely spring day in the Northeast took its toll on market activity today. It has always been the case that good weather tended to cause trading to slow, but as trader bonuses have gradually disconnected from performance over the last few years it seems as if the pattern has been accentuated. True, there wasn’t much to trade on today…but in the past that didn’t seem to matter quite so much.
That said, I won’t stop at merely butchering show tunes as there are one or two recent stories I’d like to address from yesterday that I didn’t broach in that somewhat-lengthy article. The first is the news that President Obama’s latest tax plan includes a provision to cap IRAs at $3 million. To most of us, that’s a lot of money, although the article points out rightly that if you are a business owner who has contributed to a retirement plan as long as it has been available, it is fairly easy to get numbers above that level without needing extraordinary returns. Thrift, and compound returns, are two of the only three investing miracles that can produce great wealth with little effort (the third is rebalancing – look for my book “Only Three Miracles,” due out in roughly 2023).
But more disturbing is the fact that the White House has not said whether this $3mm level would be indexed for inflation (or, for that matter, whether it would affect defined benefit plans or Roth IRAs on which you’ve already paid taxes). If it is not indexed for inflation, then any readers of this column could be ‘capped out’ of tax-advantaged structures with sufficient inflation. And, since there is no reason that inflation could not reach scary levels, given the right circumstances, this is something that every investor should be aware of.
It is also disturbing to me, personally, that according to the story:
“The White House said in an April 5 statement that under current law ‘some wealthy individuals’ can accumulate ‘substantially more than is needed to fund reasonable levels of retirement saving.’”
Maybe I am the only person who is concerned about the use of the word “reasonable” here, as if my decision for what amount of savings I want to accumulate, rather than spend, is open to someone else’s validation of whether my savings is “reasonable.” But I suspect not. This statement isn’t part of the law, but it is part of the context under which laws are being proposed, and I think this means that we investors (including unreasonable ones, who should be spending much more and saving less, darn it) ought to be paying attention.
The other topic I want to include concerns the remarks of Chairman Bernanke yesterday at a conference in Georgia. I’ve previously pointed out in this space that selling assets from SOMA or letting those bonds run off are not feasible approaches for the Fed to take when it comes time to tighten. Apparently, the Fed now agrees, after having previously discussed (publicly) these options. Bernanke remarked in his response to audience questions that “asset sales are late in the process and not meant to be the principal tool of policy normalization” and that rather the Fed prefers to adjust the interest rate paid on excess reserves (IOER) as its main policy tool.
My main complaint about the IOER tool is that we have no idea how it is calibrated, and whether a small adjustment can cause important amounts of liquidity to be pulled back from the market. Moreover, I think this is a defensive tool – the Fed needs to keep the Excess Reserves from becoming Required Reserves by having banks expand lending too quickly. But consider the difficulty: if a bank has $1bln in excess reserves and $50mm in required reserves (for example), and increases lending by 50% so that required reserves rise to $75mm and excess reserves fall to $975mm, then by how much does the Fed need to raise IOER, currently at 25bps, to induce the bank to hold $1bln rather than $975mm in excess reserves? This is the problem – the Fed isn’t operating on the variable that they actually want to control.
The picture below is a slide from the presentation I will be delivering this month at the Inside Indexing event in Boston. Notice the relative sizes of the excess and required reserves slices. The Fed needs to take big swipes at the excess reserves piece without damaging the required reserves piece too much. This strikes me as being somewhat more challenging than the Federal Reserve currently seems to believe.
I continue to think that the best solution for the Fed, and also the one least likely to be deployed, is to raise reserve requirements to make official the unofficial policy of de-leveraging banks. By doing that, they will with one wave of the magic monetary wand cause excess reserves to vanish and they can operate again on required reserves.
Do you want to discuss any of this with me directly? Long-time readers know that I value the interaction with readers, as that feedback is the main compensation I get for writing this column. Well, I am introducing today a new way to interact with me, (and more importantly, for me to interact with you). I am offering (free) “office hours” to anyone who wants to sign up, to talk about pretty much anything in a free-form give-and-take. I’m starting with four 15-minute sessions per week, and we’ll see how it goes (of course, anyone who wants a deeper dive on an inflation topic is welcome to contact me about consulting through Enduring Investments). To sign up for my free office hours, click here and pick a date and time.
Droopy
For a change, fixed-income is where all of the excitement is. For more than a month (since March 5th, the S&P has closed no lower than 1540 and no higher than 1570, plus or minus a couple of nickels: a month-long range of less than 2%. What’s really amazing about that is that on seven of those twenty-three trading days, the range of the day was more than half of the month’s entire closing range. In two of the last four trading days, the intraday range was two-thirds of that for the entire month!
Meanwhile, the 10-year Treasury rate has gone from 1.90% to 2.06%, down to 1.71%, and ending today at 1.75%. The closing range in point terms of the current 10-year note was 99-16 to 102-19, or a bit more than 3% (and it was obviously more than that for the long bond). It has been a long time since bonds were more volatile than stocks over a period as long as a month.
Most of that volatility in nominal rates has been on the real interest rate side. The range in closing 10-year TIPS yields is -0.52% to -0.76%, or 24bps, compared to 35bps for the nominal yield. That’s more volatility than the real yield should be displaying at this level of rates, and it has moved TIPS from being slightly cheap a month ago to somewhat rich. Our Fisher yield decomposition model, which had been neutral on TIPS and breakevens since mid-February, is now modestly short TIPS (and still flat breakevens). Moreover, the leverage applied by our long-inflation-biased “smart beta” model is only 2/3 of the neutral leverage, so conservatism is the watchword at the moment.
The rally in TIPS and nominal yields owes much, I am sure, to the somewhat feeble data we have seen over the last week. The Employment data, in particular, were very disappointing, especially to that group of people who expected profligate monetary policy easing to create economic growth. It will surprise no regular reader of this column that I am not shocked to see a lack of growth response to aggressive monetary policy easing – as I take pains to remind readers, monetary policy is not supposed to affect growth, except in the presence of money illusion. It is therefore something less than a news flash that growth is responding more to tiny changes in government spending (albeit temporarily) than to massive changes in monetary aggregates.
To be sure, even monetary aggregates have been drooping lately…at least, the ones that matter. M2 has been lurching along in the mid-6% growth rate year-on-year, and flat over the last quarter (see chart, source Federal Reserve). That’s only slightly above the average growth rate in M2 since 1981 – although, to be fair, the average core inflation over the same time period has been about 3.1%, so core inflation is still well below where we would expect it to get to if this rate of monetary growth continues.
Growth in commercial bank credit growth, also, has retreated to only 4.1% year-over-year after spending most of the past year above 5%. It too is still right around the long-term average real growth in commercial bank credit (see chart, source Federal Reserve, Enduring Investments), but last year it had been edging towards the mid-2000s standard.
So these are positive developments from the standpoint of future inflation, but it is far too early to call victory on that front. I expect the rise in M2 to re-accelerate in fairly short order; but in any event it is important to remember that the Fed is not the only game in town and not the only central bank that is pursuing easy-money policies. Indeed, last week the biggest news was that the Bank of Japan pledged to double its monetary base, its holdings of JGBs, and its holdings of ETFs and JREITs over a period of only two years.
This policy will almost surely produce the result the Japanese policymakers have been shamelessly vocal about seeking: higher inflation, in a short period of time. At the end of the day, the inflation that Japan gets in the near-term will depend on what their domestic money velocities and multipliers do, but they will surely get higher inflation eventually just as the Fed’s policies have produced inflation even with declining multipliers and velocity. To my mind, the Japanese inflation swaps market – which according to Bloomberg is at 1.26% for 5 years and 1.01% for 10 years – seems to be cheap!
But the Japanese policy will certainly not stop at the water’s edge. Around 2/3 of our domestic inflation is sourced from global factors, and the monetary policy of a major trading partner is a significant global factor. The behavior of the Yen and industry response to changing competitive pressures from Japan will determine how much of the BOJ’s inflation remains domestic and how much is exported, but it would be surprising indeed if the result was entirely contained within the borders of Japan. The Yen has responded sharply to the policy changes at the BOJ (see chart, source Bloomberg), but in my opinion it has very much further to go. In fact, the only reason we may not get back to mid-1980s levels is that the Fed’s policy is similarly aggressive – the only difference at the moment is that the Fed is giving lip service to the notion that they intend to hold down inflation in the long run. (I don’t believe them.)
None of the above has much, if anything, to do with North Korea, or Cyprus, or Slovenia, or Portugal. All of those countries still are potential wild cards, and all of them (it needs hardly be said) constitute downside risk. The White House is seemingly satisfied to wait to see if North Korea really will launch a nuclear-tipped missile; this means that the entire distribution of potential outcomes is compressed so that there is a very high likelihood of nothing bad happening, and a very small chance of something really, really bad happening. How do you trade that? The answer is that you use options. Implied volatilities are under pressure again because the recent tight range makes it difficult to eat the time decay of long-vol positions. But as for me, I’m delighted to pay insurance premiums for insurance that turns out to be unnecessary, especially when that premium is low. I don’t have any long equity positions, but if I did then I’d be protecting them with cheap put options.
All Men Are Mortal
Hugo Chavez, dictator of Venezuela and socialist extraordinaire, passed away on Monday in Caracas. The world will little note nor long remember what Chavez did for/to his country, and yet we care about his passing – not because of what he was, but because of what Venezuela could be and could have been.
I visited Venezuela in 1997 or so – pre-Chavez – when I was the main US fixed-income strategist for Bankers Trust. I had dinner with several members of the central bank, who said quite frankly that if they chose, they could easily pay off Venezuela’s external debt with their oil revenues. And that, mind you, was with oil prices around $20/bbl. It was also approximately the high point of Venezuelan production, which has fallen from 3mbpd to 2.4mpbd since then. Venezuela provides about 3% of the world’s supply of crude, despite the fact that it has among the biggest, if not the biggest, reserves of oil in the world. And yet, according to Capital Economics as cited by the Wall Street Journal, oil prices below $100/bbl could trigger a balance of payments crisis. The dictator milked his nation’s natural resources for billions upon billions – some of it went to “the people” in ways that were wasted by the typical inefficiencies of a socialist economy, and much of it to secure his own power.
It’s not quite as easy as saying that the next Presidente should develop Venezuela’s oil resources. Venezuela isn’t just a member of OPEC; it is a founding member of OPEC along with Iran, Iraq, Kuwait, and Saudi Arabia. So it isn’t as if the country can just start pumping wildly and change its fortunes through improved revenues. For the good of the country, most of what will need to happen under Presidentes in the future will be structural and expenditure-side. (Where have we heard that before?)
Accordingly, oil prices are likely to remain relatively undisturbed by this development, unless it appears that the next Presidente is a pure capitalist who plans to exit OPEC. Don’t hold your breath for that. In fact, to the extent that there is any unrest or confusion in the country because of a power vacuum, it might increase oil prices in the near-term. For now, Chavez’s vice president (Nicolas Maduro) will become president and a new president theoretically elected in thirty days. However, the history of Chavez, Maduro, and their party does not make most observers comfortable that this will necessarily happen in the way it is written in the Venezuelan constitution.
Meanwhile, Venezuela’s inflation is a hardly-worth-noticing 21.6%. They must have a really positive output gap, right? Of course, such inflation might have something to do with the fact that the money supply is up 600% since the end of 2007…nah, couldn’t be. The chart below (source Bloomberg, with my annotations) shows M2, GDP, and CPI for Venezuela, normalized to January 31, 2008 (just after a redenomination of old Bolivars into Bolivar Fuerte at 1000:1, which would have made the chart look screwy).
Notice a couple of things. First, notice that the huge money-printing has done nothing whatsoever to Venezuelan growth. Second, note that the huge money-printing has, however, drastically increased prices in Venezuela. Third, notice that the increase in prices has been similar in magnitude to the increase in money (technically, the increase in money divided by GDP, but as I said GDP didn’t move much) – which is just exactly what theory predicts, and what has been seen time and time again in hundreds of countries spanning scores of years.
This isn’t an instance of “hyperinflation;” rather there has been consistent inflation in the 20-35% per annum range since 2008. That’s high, but not so high that it’s completely divorced from our experience of the reaction of prices to monetary policy. It is, or should be, a precautionary lesson. As bad as Chavez’s mismanagement of the Venezuelan economy was, which helped produce the stinky growth, it was the mismanagement of the money supply that caused the inflation.
It is interesting, too, that since inflation tends to increase wealth inequality if the wealthy can own assets other than money, the inflation itself tended to keep the poor – the main constituency of a populist – in a position of greater need and greater reliance on the State. Increasing inequality and plausible deniability as to whether it is the leader’s policies that are creating that inequality: that’s a delicious cocktail if the leader has a desire to hold and increase his power.
So we take notice of Chavez’s passing, for its potential impact on oil markets but even more for the opportunity it gives us to reflect on the lessons we could have, and should have, learned from the operation of his regime.
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.
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.
