Existing Home Inflation Remains “Contained”

Right, the Fed’s actions have definitely not caused any inflation.

Asset inflation is only a temporary relief/diversion from consumer price inflation. In this case (unlike with, say, equities), the investment good is also a consumption good – housing – so the pass-through is relatively straightforward. And, I would say, probably inevitable.

 

Summary of My Post-CPI Tweets

Writing from the Netherlands after visiting future clients this week; here is a summary of my post-CPI tweets (Follow me @inflation_guy) :

• very surprising core inflation, barely rounded up to 0.1% month/month. Waiting for breakdown, but Shelter was still +0.1% so something odd.
• Core CPI ex-shelter only 1.39%, not terribly far from the 2010 lows.
• …part of the answer is that core commodities decelerated further, -0.1% y/y. But core services, most of which is housing, ALSO decel.
• Major groups; Accel: Food/Bev (15.3%); Decel: Apparel, Transp, Medical Care, Educ/Comm (34.3%). Balance unch on y/y rate rounded to tenths.
• Housing actually accelerated slightly. So decline in core was apparel, Medical Care, Education, and non-fuel transportation. Hmmm.
• …If you believe core is going to keep falling, you DON’T want to bet on it being led lower by Medical Care and Education.
• We expect this to be the low print on core. Our forecast remains 2.6%-3.0% for 2013, but only 0.6% has been realized so far
• It wd probably be prudent to lower our 4cast range; we will if there is another miss lower in May. But not by much: housing still the driver

I think the sixth bullet is the key point: core inflation is drooping because of Medical Care and Education & Communication decelerating. This is terrific news, but there’s about forty years of history that should lead one to be skeptical that these are the categories that will lead inflation lower.

Our forecast for 2.6%-3.0% is based on an expected acceleration in rents, based on the recent rise in home prices. We’re not changing that forecast yet because our model didn’t expect the acceleration to happen yet. However, it should begin to happen in the next 1-3 months.

If primary and Owners’ Equivalent rents don’t begin to accelerate in the next month or two, we will lower our 2013 forecast simply because it will be difficult to see a sufficient acceleration to reach our goal with only a half year or so to go. But the reason we don’t lower our forecast much is that the primary driver here is still rents, and there is no question which way rent inflation is headed. Only if we conclude that for some strange reason there is going to be a permanent shift in the capitalization rate of owner-occupied housing (that is, if there is a permanent shift in the ratio of rents to prices from what it has historically been) would we reconsider the direction of our forecast, and then only if home prices stopped launching higher.

Meanwhile, weak growth numbers, soft inflation numbers, and the seeming success of the Abe program in Japan as growth there has abruptly surprised higher (although it cannot be attributable to the BOJ monetization, since that program hasn’t been around long enough to affect the real economy even if there is money illusion at work) ought to cause any silly talk about the “taper” of the Fed’s buying program. That was always due for enormous skepticism, but with all of the arrows pointing the wrong way there is almost no chance that the FOMC will elect to taper purchases in the next few months. Indeed, I would expect the “hints” of such action to cease in short order. The only reason to talk about it is to (a) convince the world that Fed policy is credible, but a ruling on that credibility won’t be made until the episode is over, based on results, not at this time and based on what they say; or (b) because there is little cost of doing so, since the markets won’t panic if there’s no chance of near-term implementation.

A Broken Record But It’s A Good Song

There has been a bunch of new data over the last couple of days, but I am afraid that all of the new stuff will not keep me from sounding like a broken record.

Consumer Confidence jumped yesterday, but more interesting is the fact that the “Jobs Hard to Get” subindex rose to the highest level since late last year, suggesting that weak jobs data isn’t entirely a one-off. Today, the ADP report was weaker-than-expected, at 119k (versus expectations for 150k) and a downward revision to last month. The Chicago Purchasing Managers’ Index on Tuesday was the weakest since 2009, but the ISM Manufacturing report today was on-target. Still, neither manufacturing index is generating much confidence that the economy is about to take off, and the early-year bump has been entirely reversed (see chart, source Bloomberg).

The Shiller Home Price Index, reported on Tuesday, was higher-than-expected at 9.3% year-on-year, rather than the 9.0% expected (and versus an 8.1% last!). What’s really interesting about this is that the recent surge in year-on-year growth has come because the usual seasonal pattern that sees prices sag in the springtime hasn’t been in evidence this year – accordingly, the year-on-year comparisons have gotten easier as prices have gone sideways rather than falling as they tend to do between August and March (see chart, source Bloomberg).

That’s interesting because such a phenomenon was also a condition of the bubble years prior to 2007 – prices generally rose steadily with only a hint of seasonality. Post-bubble, if you wanted to sell your house in February you had to offer a concession on price. Those concessions aren’t happening any more, which is a back-door confirmation of the overall price action.

As I have said before, ad nauseum, we are seeing slow and/or falling growth and firm and/or rising inflation in the pipeline, and that’s not at all inconsistent. Mainstream economists, and journalists of all stripes, seem to accept as a fundamental verity the linkage between growth and inflation, but the only minor problem with this firmly-held belief is that it ain’t so. Growth is bad, and inflation is still going to go up. In Q1, core CPI rose at a 2.1% pace, and I still think that for the full year core CPI will rise at 2.6%-3.0%.

I want to add a quick word here about a thesis that has been advanced recently. The thought is that if the abrupt housing demand is coming from investors rather than consumers, then rising housing prices might be consistent with pressure on rents. I think it’s important to clear up this confusion. Microeconomics tells us that when the price of a good goes up, the price of a substitute tends to rise as well. It is possible, if the overall price level is flat, that a phenomenon such as is described in this hypothetical could happen, with home prices rising and rents falling. But what is much more likely is that rents simply go up more slowly than home prices, so that they decline relative to home prices, rather than declining absolutely. This is, in fact, what we see historically: large increases in home prices tend to lead to increases in rents, but not of the same magnitude, and vice-versa. Whether the mechanism for this is a systematic institutional investor presence or just a large number of one-off instances of individuals renting out their second “investment” homes doesn’t really matter. Accordingly, I don’t expect to see a drastically different course carved out by the rental/home price relationship from what it has been historically. The main difference may be that the lags between home prices, inventories, rents, and so on might get screwed up somewhat, if institutional investors cause this to happen in a more organized way than the organic way in which it usually happens.

Another aside: there has also been a lot made recently, especially in commodity markets, about weak data from China. It is amazing how important it is to global commodity markets that China grows at 9% and not 8%. If I were a member of Chinese leadership, I would be trying to convince my data bureau to release slightly weak figures, since every time it does the hedge funds of the world offer large amounts of commodities as discount prices, which is just what a growing economy needs. It’s not like anyone believes the figures when they are reported to be high; I wonder why we believe it when they are reported to be low?

In addition to the data today, the Federal Reserve finished its meeting and announced no change in monetary policy for now. And there isn’t one coming for a while, either. There was no important change in the statement, although the Fed did take care to remind us that it “is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.” [emphasis added] That’s comforting. But the simple fact is that the economy isn’t going to be booming any time soon, and the Committee isn’t going to taper its purchases unless it does because they labor under the delusion that they’re helping. Perhaps next year.

For the rest of the week, investors will be focused on Friday’s Employment Report. I am not really worried about the report being weaker-than-expected, because from everything I read it seems that the market is already anticipating something close to Armageddon (or at least, that’s how they are explaining the continued pressure on breakevens and commodities). So far, this is a routine slowdown that might be slipping into a renewed recession. Meanwhile, expectations on Friday are for Payrolls of 145k, up from 88k but down from the pace of the last year. And the ‘whisper’ number seems to be lower than that. I suspect the more likely surprise is that there is an upward revision to the 88k and the number exceeds estimates. Somehow, that will be also perceived as a negative for breakevens!

TIPS suffered today, even as nominal bonds rallied. Our Fisher yield decomposition model currently suggests that TIPS are as cheap, relative to nominals, as they have been since early September last year (when 10-year breakevens were at the same level they are at now). I am quite bullish on breakevens from here.

Why the Fed Doesn’t Fear Inflation, But You Do

The core PCE deflator for March recorded a near-record 1.1%. Should we worry that deflation is taking hold?

Well, first of all you should recognize that the PCE, unlike the CPI, is frequently revised and by significant amounts. As the chart below shows, this is only a near-record because there was a massive revision that raised the 2010 low from 0.7% or so to 1.1%. We should be wary, in my opinion, to draw any strong conclusions from (and certainly wary of implementing policy based on) a data series that can have the rate of change revised by 60%.

But still, core PCE is near its lows while core CPI is not. Should we be concerned about deflation? Should the Fed?

There are a number of reasons for the difference. A persistent difference of about 0.25%-0.5% is consistent with differences in the type of formula used and other “normal” differences. The Fed favors the PCE because it has a broader representation of the economy – in that it doesn’t focus “just” on consumers – and because it adjusts more quickly as the composition of spending changes. However, if you are looking at how the costs to you the consumer change, the CPI is the index that you should be looking at.

The main reason that core PCE is currently so much lower than core CPI is that PCE has a much lower weight on housing. And, thanks to the Fed’s loose money policy, it is housing that is driving the CPI higher. The difference in housing weights currently adds 0.31% to CPI compared to PCE. The PCE makes up for this low weight in housing by having a much higher weight on medical care (about three times the CPI weight). Why the huge difference in the medical care weight?

The CPI and PCE metrics are meant to measure different things – the PCE is broader, but the CPI measures specifically expenditures by consumers. Consequently, the difference in medical care weights occurs because the CPI measures spending by consumers, while the PCE includes spending by Medicare, Medicaid, other government entities, the employer portion of health insurance, and other non-consumer payers. Which do you think is more relevant for consumers? And which do you think is a better representation of what a typical consumer spends: 42% on housing and 6% on medical care, or 26% on housing and 22% on medical care? In simple terms, do you spend more for your house, or do you spend about equal amounts on both? I suspect that for most Americans, especially those who are employed and those who are currently receiving Medicare, spending on housing is vastly higher than direct spending on medical care.

Isn’t it convenient for the Fed that right now, they can focus on a metric that is pointedly underweighting the category of expenditure that is most directly being affected by quantitative easing? This is one reason that I do not expect QE to stop any time this year.

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.

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[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.

Summary of My Post-CPI Tweets

Below is a summary of my post-CPI tweets. You can follow me @inflation_guy.

• Sigh.Not this month!Core #inflation +0.1%, waiting 4 data to see rounding. Big fall in apparel, & housing uptick not happening yet.
• Apparel decline most since April 2001. That will reverse.
• Core with rounding looks like 0.106%, 1.89% y/y. definitely weak. Will look at breakdown to see where.
• This is the most that y/y has been below our forecast track since January 2009!
• Core services fell from +2.6% y/y to +2.5%, but core goods fell to flat from +0.3%. Our thesis is that these will converge up, not down.
• Core goods is inherently harder to forecast. Core services is largely housing.
• Accelerating subgroups: Educ/Comm (6.8% of basket). Decel: Apparel, Transp, Food & Bev, Recreation (41.7%). Unch: Housing, Med Care, Other
• CPI drooping appears to be seasonal maladjustment. The Apparel burp itself is worth 0.04%.
• Housing – we’re still waiting for the upturn. This month primary rents rose to 2.81% from 2.74% y/y, Lodging Away from Home rose too.
• Owners’ Equivalent Rent (24% of CPI) fell to 2.083% vs 2.144%. Since Primaries are rising, probably just a lag issue. 1 or 2 more months.
• Apparel saw broad-based huge declines. Again, likely seasonal. Core decelerated 0.11%, and 0.06% of that was Apparel.
• Our forecast for full-year CPI doesn’t change as a result of this number. We’re still at 2.6%-3.0% on core for 2013.

I don’t want to overplay the Apparel card here. March is a big month for seasonal adjustment for Apparel, but it is possible that this marks the end of the two-year spike in Apparel prices. If it does, then it resolves one speculation I’ve had: that the rise in Apparel, after twenty years of flat-to-declining prices, indicated that in some areas the globalization dividend on inflation may have ended. It is far too early to say that speculation is wrong, especially with big seasonal adjustments in March. Prior to 1992, there were certainly setbacks in Apparel on a regular basis due to the difficulty in seasonal adjustment. So it’s too early to say this is wrong, but not too early to say it’s surprising. And, after all, there’s always the possibility that the screwy numbers were the last twenty-three of them, and not this one. But these are still the highest seasonally-adjusted Apparel prices we’ve had in March since 2001 (see chart, source BLS, below).

The small blip down in Housing is much less of a concern. Primary rents are still rising, and OER didn’t exactly decline aggressively. We’ve been waiting out a “flat part” in the lag structure – this just means we have to wait another month or two. The chart below is updated (multiple sources) through this morning.

None of this will help the commodities guys, nor the TIPS guys, in the short run. But it doesn’t change the big picture for inflation. It’s coming. We just have to wait another month or two for the evidence!

 

Big Trade, Little Door

In ordinary times, the terrorist attack at the finish line of the Boston Marathon (officials are being careful not to call it “terrorism,” but I’m not an official so I can operate in the reality sphere) would absolutely trump anything that happened in the markets today and, in fact, would likely have been the cause of any market movement that actually occurred. That’s because most of the time markets echo the framework of the rest of reality: most of the universe is space, and most market activity is just empty noise.

This is the reason that traders who are continuously transacting in the markets are called “noise traders.”

But on Monday, there was plenty of market action and it had nothing to do with Boston, nor with the slightly-earlier ultimatum from North Korea to South Korea, which stated that military action would “start immediately.” (N.b.: There were many losers today, but one of them surely must be reckoned as Kim Jong-un. A tin-pot dictator makes a threat, and is almost immediately knocked off the front page of the New York Times by events in Boston. That must really annoy him.)

Before the attack in Boston, however, there was already plenty of financial pain. The carnage in the precious metals pits came right on cue after the negative sell-side reports of late last week had a chance to work on the psyches of investors. Gold fell 10%, and silver nearly 14%. This represents the worst two-day fall in gold in thirty years. And, while yesterday I pointed out that the commodity “super-cycle” certainly doesn’t look like one, I can understand how the picture of gold in real terms looks like it may be completing something big (see chart of gold expressed in December 2012 dollars using CPI, source Bloomberg).

There is considerable concern tonight that these losses may provoke selling in related markets as investors raise funds to meet margin calls. This is possible, although significant thumpings in the past in precious metals (it isn’t like this is the first time we’ve seen volatility in a commodity) didn’t provoke dramatic related-market action. To be sure, the avalanche is much more loaded now than it has been in the past, with equity markets sharply overvalued and investors already reaching a level of disgust with commodities. But I don’t think it goes too far. (Those may be my famous last words!)

What happened in gold and silver is a function of the big trade/little door syndrome, more than anything else. News outlets blamed the weak data yesterday in the U.S. and the small miss in Chinese GDP (7.7% versus 8.0% expected, but keep in mind that we all know these are made-up numbers) for setting off the wave of selling, but that’s just the latest straw. The break of technical levels on Friday, combined with the suddenly-burning desire of hedgies to not be the last one through the little door, is what led to such a dramatic move today. It may well continue until everyone who wants to get through the little door has done so. Or, it may not – but I would admonish an investor who wants to buy gold here to think like a trader rather than a playground monitor: don’t try to break up the fight. If the hedgies want to eat each other in a fight to get to the door, let them.

And, incidentally, remember that the big trade/little door syndrome is not limited to gold and silver. Think about equity exposures too. If you’re long by policy, fine. But if you’re long stocks and feeling uncomfortable about it, then “sell down to the sleeping point” at least.

The irony of the timing of the gold rout is potentially juicy, with CPI tomorrow. The decline in precious metals is happening partly because so many investors are abruptly convinced that inflation has truly been defeated. It is incredible to me that this belief is so widespread, but perhaps this is the sine qua non for the next washout in financial markets and the setup for the long-awaited up-move in commodities (for, although the “super-cycle” is evidently just now ending according to some observers, commodities prices have been in general decline for the last two years).

Growth is falling short of expectations, but that doesn’t have any implications for inflation. Tomorrow’s CPI is forecast to be flat and +0.2% on core, holding core inflation constant at 2.0%. Sentiment appears to be favoring a shortfall in those figures, but it is my belief that we are on the cusp of the next sustained move higher in core inflation, to be led by housing. Remember that the last two CPI figures haven’t exactly been soothing. Two months ago, core inflation was +0.3% when the market was expecting +0.2%. Last month, all eight major subgroups of CPI accelerated on a year-on-year basis, the first time that has ever happened since the current 8 subgroups have been in existence. I am loathe to pick the month where we’re going to see Owners’ Equivalent Rent finally break higher, because econometric lags are not written in stone. But it ought to be soon.

When it happens, expect sell-side economists and pundits of all stripes, to say nothing of the Federal Reserve, to downplay the significance of it. I wouldn’t expect a sudden rally in commodities or a rebound in breakevens (10-year breakevens are at the lows of the year, mainly because rates on the whole are declining – 10y TIPS yields are also within 3bps of the year’s low), but it might help stop the bleeding.

Why Inflation Futures Matter

The Chicago Mercantile Exchange (CME) is currently having discussions with market participants and is considering launching in 2013 two new futures contracts related to inflation: a Consumer Price Index (CPI) futures contract and a deliverable TIPS futures contract. My company has been an advocate for these contracts and involved in their construction. We expect to be involved in making markets in them. Our interest is therefore no doubt obvious. But are these contracts important, in a larger sense, for the market? The answer is yes, and here is why.

It is a fact of financial life that most mature markets enjoy three legs of a liquidity ecosystem: cash markets, over-the-counter (OTC) derivatives, and exchange-traded derivatives. For example, in the nominal interest rates market Treasuries provide a deep and liquid cash market, there is a large and well-functioning market for LIBOR swaps, and there is efficient and transparent pricing in the futures markets as represented by Bond, Note, 5-year Note, 2-year Note, UltraBond, and Eurodollar contracts.

The presence of three legs, rather than only one or two, in this ecosystem is important. With two legs, there are only two directions of liquidity transmission: A to B and B to A. But with three legs, there are six ways that liquidity can be transferred: A to B, A to C, B to A, B to C, C to A and C to B. By adding the third leg, the avenues of liquidity transmission aren’t increased 50%, but threefold.

This richer liquidity ecosystem matters the most in crisis situations, such as during the credit crisis of 2008. Consider that during the crisis, credit and inflation markets became quite illiquid at times while equities, nominal rates, and commodities remained (comparatively) liquid. The main difference between these two sets is that the latter three markets all have cash, OTC, and exchange-traded instruments while the former two have only two (in both cases, cash and OTC derivatives).

Accordingly, while the inflation-linked bond market has become truly huge (see chart below, source Barclays Capital) and the inflation-linked swap market has enjoyed an almost uninterrupted rise in volumes since 2006, investors need the third component of the ecosystem: exchange-traded futures contracts on inflation and/or real rates. It is interesting to note that one analysis of the original CPI futures contract traded on the CSCE (many years ago) suggested that a prime cause of the contract’s failing was that “…the CPI futures market, unlike other futures markets, has no underlying asset which is storable or traded on an active spot market, which reduces the opportunities for arbitrageurs and speculators to participate in the market.” (Horrigan, B. R., “The CPI Futures Market: The Inflation Hedge That Won’t Grow”, Federal Reserve Bank of Philadelphia Business Review , May/June 1987, 3-14).

Adding these products will likely increase the volumes and the liquidity of all inflation products, including (perhaps especially) the liquidity of off-the-run TIPS. This liquidity will also remove the main lingering concern among those investors who have not yet made meaningful investments in the market.

Inflation-related futures are not a new idea. Since at least the 1970s, economists have anticipated that these instruments would one day be available. Several previous attempts, dating back to as early as the mid-1980s, have failed for various reasons – too early, too different, bad structure. But futures that present a different method of investing in, trading, or hedging inflation and real rate exposures are needed, not only because they create opportunities to make different sorts of trades or to trade more efficiently but also for the good of the market itself. Healthy markets in CPI futures and TIPS futures will create a better liquidity ecosystem for the entire inflation market, including for off-the-run TIPS bonds and seasoned inflation swaps.

Unfortunately, at the moment the CME appears to be afraid of launching new products that might not immediately work. It wasn’t always that way – once, a CME official told me that since it cost them virtually nothing to list a contract, they favored launching lots of them and seeing what the market took to. This has changed, and the pendulum has swung in the opposite direction. Now, although many market participants are asking for these futures and there are market-makers willing to make markets, the CME is deferring a decision on them until later in the year. I remain hopeful that they will launch, because they are sorely needed.

Bailing In

Cyprus, for now, has seen disaster averted. In a flurry of weekend maneuvers, Cypriot and troika officials decided on a plan to merge the top two banks, fully protecting the insured depositors while socking the uninsured depositors of those two banks and the non-government financial stakeholders. In short: depositors at the largest bank will lose ~40% of their deposits above the guaranteed threshold, depositors at the second-largest bank will lose ~100% of their deposits above the threshold, bondholders (both senior and subordinated) at the second-largest bank will be wiped out and bondholders (including senior bondholders) at the largest bank will be wiped out. Equity holders in both banks will be fully wiped out.

That’s not completely accurate, because there are various classes of government (Cyprus) and supranational stakeholders (e.g. the ECB) who it appears will be spared, but the rest will be fully “bailed in.”

Yes, let’s take a minute to examine this addition to the lexicon. “Bailed in” is the opposite of “bailed out.” We already had a term for that; we used to say that these people were “wiped out.” But now, the idiocracy has decided that “bailed in” is a kinder and gentler way of saying that you’ve lost everything, but thanks for your contribution to the bailout.” It’s based on the law of conservation of bailing, I think, which states that for every bailout there is an equal and opposite bail-in.

Personally, I don’t think it’s a word and Microsoft Word doesn’t think so either.

However, we should get used to the word because the head of the Eurogroup of Eurozone finance ministers said that the Cyprus solution is the “new template” for resolving future Eurozone banking problems. I would hope that somewhere here it would occur to these people that the “template” they arrived at after almost losing Cyprus was something like what a financial-sector analyst (say, three years out of school) would have come up with as the “first-pass after thinking about the problem for five minutes” solution. Unfortunately, the “after thinking about it for five more minutes” solution recognizes that this solution pushes assets into the too-big-to-fail banks, since no person (or corporation) in his right mind will hold more than the deposit insurance maximum at any given bank (even if that person believes that the idiocracy learned a lesson and won’t grab insured deposits in the future), unless it’s very unlikely that the bank would ever be allowed to fail in the first place.

To be sure, the Powers That Be are aware that this solution isn’t perfect, since banks in Cyprus are to remain closed “until further notice.” This is because the obvious side-effect to the implemented Plan B is that every uninsured deposit will flee the country’s third, fourth, fifth, and sixth-largest banks the moment the wires open. This is the classic problem with bank runs. If you ring-fence a group of banks, the weakest bank outside of that circle immediately becomes the weakest overall bank and the run commences there. Thus, unless you protect all of the banks, the run will continue until there are no more uninsured but vulnerable deposits.

Now, if the original Plan A hadn’t called for the “bailing in” of depositors even at more-stable banks, then the bank run may not have happened since “vulnerable” then would be taken to mean “deposits at a weak institution.” But now, depositors in Cyprus are on notice that “vulnerable” means “deposits in a country that has weak banks, whether or not that includes this one.” Indeed, I would expect many “insured” deposits to leave the banking system for mattresses and other alternative savings vehicles, now that we know that an “insured” deposit in Cyprus is just exactly as secure as the politicians’ spines allow it to be. This time, the spines held (and three cheers for the Cypriot legislature who declared they’d secede before allowing their insured citizens to be mugged), but what about next time? In their place, I’d be taking out enough to live on for a few months, at least.

Incredibly, despite the fact that the stock market got exactly what it wanted, market gains evaporated within minutes of the opening bell as smart money sold to the folks who did what CNBC told them to do (it’s okay…it’s just that they’re trying to bail you in. You want to help the institutions, right?). Commodities and bonds were flat, but there’s always tomorrow. Ironically, today’s weak market performance came on the heels of a couple of strong regional Fed reports from Dallas and Chicago, and ahead of what is likely to be decent Durable Goods (Consensus: +3.9%, +0.6% ex-transportation), New Home Sales (Consensus: 420k from 437k, but that would still be the 2nd highest non-tax-break number since 2008), and Consumer Confidence (Consensus: 67.5 from 69.6, but still closer to the highs than the lows of the last few years) data. Also out is the S&P Case Shiller index for January, which is expected to have risen 7.85% from year-ago levels.

All of which, and much more, is already in the price. Stocks only look good if your alternative is a bank account in Cyprus.

The Economy in the Plastic Bubble

We’re going to leave behind the topic of Cyprus for a day. It does seem as if events are coming to a head, but with banks there closed until Tuesday (and the ECB lifeline in place until Monday), there will be lots of news over the next few days but most of it will be heat without light.

So, speaking of heat and light, let’s look at today’s data. Specifically, let’s look at Existing Home Sales.

While the total sales number fell just shy of the 5mm-unit level, the 4.98mm print still represented the highest number (aside from the home-buyer-tax-credit induced surge in 2009) since 2007 (see chart, source Bloomberg).

The inventory of homes available for sale bounced off of 14-year lows, but remains at levels lower than any we’ve seen in over a decade.

And, near and dear to my heart, the median price of existing homes accelerated from last month (although, due to historical revisions, last month’s y/y was revised down to 10.67%) and stands at 11.34%. The January Home Price Index from FHA also came out; the 6.46% year-on-year rate of increase in that index is also the highest post-2007.

There are long lags between both of these indices and the appearance of price pressures in the Consumer Price Index, but at the moment all indicators of housing point the same direction: Owner’s Equivalent Rent should be in the 2.75% neighborhood by year-end, and could be as high as 3%. This is a key part of our forecast that core CPI should reach 2.6%-3.0% by year-end, and accelerate further in 2014.

The amazing recent run in home prices – which I suspect is driven in part by institutional investor interest in real estate – has caused existing home prices as a multiple of household income to move above levels that prevailed for the last quarter-century of the 20^th century. The housing industry likes to present charts of housing affordability, which takes into account the current level of interest rates, because currently those interest rates make even the relatively high home prices look more affordable.

Yes, I said “relatively high home prices.” The median sales price of existing homes averaged 3.36x median household income from 1975 to 2000, with a relatively small range of values around that average. Even including the bubble, when the multiples reached 4.8x, the average through 2011 only rose to 3.54. As of year-end 2012, the multiple was back to approximately 3.48 and if median prices rise “only” 8% this year (remember, the current pace is 11.3% and rising) the multiple will be around 3.6x by the end of the year (see chart, source U.S. Census Bureau, National Association of Realtors, Enduring Investments).

Notice that even at the depths of the crisis, home prices were only slightly cheap by pre-2000 standards. Similarly, equity prices at the lows only reached approximately fair value by pre-2000 standards. There are two interpretations of this fact set. It could mean that the pre-2000 era valuations were too low, and that modern financial markets and structures make higher valuation multiples permanently viable. Or it could mean that the Federal Reserve continues to artificially support markets at multiples that are not likely to be sustainable in the long run. I suspect the latter point is more accurate, although I am open-minded about whether the former point might have some validity.

This isn’t necessarily a bad strategy, if the idea is to let the market stair-step down to equilibrium rather than letting it crash there all at once. But I don’t see anything that suggests the Federal Reserve has the slightest idea how to value assets. I understand that they don’t want to substitute their own analysis for the market’s judgment (at least, that would be the counterargument), but that’s what they’re doing anyway – with no indication that they plan to back off anytime soon. The Fed is just more comfortable in the bubble, and afraid to leave it entirely. But don’t we have to, eventually?

The VIX returned to 14 today, which makes a bit more sense to me than the 12.7 level of yesterday. It still seems low to me, but at least there is a way for long-vol positions to actually lose.