Employment (Tweets and Further Detail)

Here are my post-Employment tweets, summarized and expanded on:

• Employment Report: Unemp Rate up to 7.923% from 7.849% – the consumer confidence report was the hint that’d happen.
• Always hard to look at the January Payrolls report especially. In addition to rockin seasonals, you get prior yr revisions.
• Avg Hourly Earnings +2.1% y/y, faster than any time in 2012. Wages lag inflation so this will be higher than this at year-end.
• …the bad news is that aggregate inflation will be higher as well.
• So after the benchmark revisions, avg 2011 payrolls gain was 153k. For 2012: 156k. Today: 157k. Nice stimulus.
• Nearly 5 years after the recession started, “Not in Labor Force, Want a Job Now” still near the highs.

Here is the BLS chart on the “Not in Labor Force, Want a Job Now” series.

And here is a chart (Source: BLS, Bloomberg) showing the trailing 12-months deficit (represented positive) versus Payrolls. You can see why there’s some reason to think the massive spending (blue line) curtailed further job losses in the recession, although it’s important to remember that we don’t know the counterfactual…that is, what would have happened in the absence of spending.

The graph does not imply that if the government had not run a huge deficit that we would have had continuing job losses, even though that is the tale our elected representatives would like you to believe. Indeed, look at the next chart, which shows the level of the deficit versus the 12-month acceleration/deceleration in job growth, lagged 12 months.

If there seems to be a correlation between big deficits and job market acceleration, it comes mainly from the big swings associated with the teeth of the crisis when the causality may have been going either direction. Take out that big “S” and you have similar jobs growth with huge government and with small government (and you can see that same fact on the prior chart).

Unemployment and Initial Claims – A Quick Chart

It was a pretty quiet day today, so instead of writing about the fairly boring market action (although AAPL broke below $500 for a few minutes and TIPS continued their recent bounce) I wrote a book report about the book How the Trading Floor Really Works. However, because people have requested that I separate obviously unrelated posts, you can find that review here.

There is one chart I would like to share – sort of a holdover from last week that I never got around to. It shows the unemployment rate (white line) against Initial Unemployment Claims (yellow line) for the last couple of cycles. (Source: Bloomberg)

So, do you think the job market is improving? You’re right! Does the job market still suck? You betcha!

There is also something different going on here, beyond the usual year-end seasonal adjustment tomfoolery. The decline in Initial Claims typically happens when the economy has stopped getting worse, and the current level is consistent with an economy that is turning jobs over at roughly the normal pace. We’re not creating lots more unemployed. But the slow decline in the Unemployment Rate is a sign that we’re not absorbing the existing unemployed through new growth of existing enterprises, or creation of new enterprises, as is typical in recoveries. I don’t think it should come as an absolute shock that in this business-unfriendly climate, businesses are reticent to expand, even if production as a whole is expanding.

Off With A Bang

After 2012 ended with more than the usual amount of whimpering (although not from investors, who saw gains in equity as well as bond markets), 2013 has begun with a bang.

The fiscal cliff has become more of a fiscal slope, with tax increases on high-earners in the form of higher marginal rates, and on all other earners in the form of the expiration of withholding tax cuts. (Hence, the ‘middle class’ that was supposedly protected in this deal is apparently defined as the jobless.) The spending cuts were delayed for two months, so that the impact of these tax increases – as well as tax increases associated with the implementation of Obamacare – is the only part of the “fiscal cliff” that will be immediately felt.

However, in two months there will be another showdown over spending and the debt ceiling, with more uncertainty for investors and consumers.

Now, it may be that this works out to be clever. If the economy continues to gain strength, then it will be easier to cut spending in two months than it is now. And, if the economy is really booming as much as some say, the budget cutting should be aggressive (since, after all, if we can’t balance the budget during boom times, when can it be balanced?). Color me skeptical on this point, although as I said in my wrap-up comment last year I think 2013 will be a better year in terms of growth than 2012 was.

It is certainly beginning that way; or, rather, I suppose 2012 ended with some momentum. The December ADP figures showed a 215k increase in payroll jobs, and an upward revision to November’s data. The 215k number was above expectations, and the highest figure since the spring. Be a bit cautious in extrapolating that surprise to tomorrow, however, as the data suggest there has been insufficient seasonal adjustment in December for the last few years. (December usually sees lots of hiring, and January lots of firing; by adjusting for this tendency we should eliminate this tendency from the data. However, the absolute scale of the hirings/firings at this time of year is so large that seasonal adjustment is very difficult. The BLS tends to be more successful at it than ADP, so all else being equal I would be wary of the possibility that tomorrow’s Payrolls data (Consensus: 153k) falls short of the newly-raised expectations…the consensus of the 15 economists on Bloomberg who updated their forecasts today after ADP is 180k, rather than 153k.

Nevertheless, the economy is indeed expanding. I would even say that it is expanding faster than I would have hoped a couple of months ago. (That isn’t to say that the current pace is torrid, but rather that I am a congenital sourpuss, a consequence of being a bond guy who wants my money back rather than an equity guy who dreams of sugarplums).

The rotten part, from investors’ perspective, is that the stock market and the corporate bond market have already priced in great growth results, and bond markets haven’t yet. That’s how you get both bonds and stocks doing well in 2012, after all.

The question for buyers of the equity market is, how much better can companies do? The chart below (Source: Federal Reserve Z.1) shows that as of Q3, after-tax corporate profits stood at a post-war record of 12.6%. This was actually an increase over levels that were already lofty.

To be sure, this ratio can fall without corporate profits themselves declining – if, going forward, national income expands at a rate faster than profits, then this ratio will decline. Question: do you think that the market would react well to earnings growth of 1% when the economy is growing at, say, 3%? Me either.

On the fixed-income side of the ledger, interest rates have done some important technical work recently. Ten-year nominal bond yields have risen 30bps in the last month, and the 1.91% rate on 10-year Treasuries is the highest since May. Even more interesting is the fact that this movement in nominal rates has come completely from a rise in real yields (recall that nominal yields equal, approximately, the sum of real yields and a priori inflation expectations), which have also risen 30bps over the last month. Ten-year real yields (TIPS) are now the highest they have been since August, at -0.61%. Moreover, this is the first time that 10-year real yields have risen at least 30bps from a prior yield low since October 2011 (see chart, source Bloomberg).

The fact that inflation breakeven expectations, while near the highs of the last few years, have not risen further in this fixed-income selloff suggests that the selloff is being driven more by growth expectations (which most directly impact real yields) than by inflation fears. That seems consistent with the anecdotal chatter. It seems that investors, for now, are comfortable with long-term breakeven inflation around 2.5% and inflation swaps (a purer measure of inflation expectations) around 2.75% at the 10-year point. There are sellers there, for now. The discontinuity will likely be abrupt, when it happens, but at the current rates TIPS have plenty of room to weaken further and provide the majority of the nominal-yield increase.

I still think there will be an abrupt discontinuity, although the Fed continues to be very confident (as the FOMC minutes released today showed)  that inflation expectations are “well-anchored.” They are until they aren’t, I guess. For their sake, I hope the anchor drags along, rather than simply snapping off.

Summary Of My Post-Payrolls Tweets

The following are my post-Payrolls tweets (@inflation_guy), along with some charts and added thoughts.

• Payrolls number close, expected 85k was actually 146k but 49k of downward revisions. Amazingly good guesses given Sandy.
• Unemployment Rate drops to 7.746% from 7.876% (so really 0.1 drop not 0.2 drop), due to sharp particip drop to 63.6 from 63.8
• Not a particularly good report; haven’t had >200k jobs since March, after these revisions. But chatterverse will say it’s bullish stocks
• Goods producing jobs -22k; service-providing +169k. Retail trade +53, allaying some fears that weak Xmas season could hurt #s.
• Here’s some good news: Aggregate weekly hours rose to a new post-2008 high of 104.1, which is higher than it was in 2000. [Note: chart below]
• “Not in labor force” rose again: second highest total ever. Not in labor force, want a job now also rose. This is “shadow unemployment.” [Note: charts below]
• The chatterverse will say it’s a good report, but in my view it isn’t good enough, and we’ll quickly turn to fiscal cliff again.

As noted, this isn’t a great report. It continues the theme of tepid recovery, but without the people leaving the labor force the unemployment rate would be much higher. The chart below (source: BLS via Bloomberg) shows the “not in labor force” numbers going back decades.

Now, the thing is that I’m not sure this is a temporary phenomenon – some of these people are leaving the labor force because they’re giving up, but some of them are leaving the labor force because they’re retiring, or retiring early. We would be expecting some rise in this number anyway, due to the fact that Baby Boomers are starting to retire. So I think the chart below (same source) is a better view of the part of this rise that’s truly disturbing. It shows the category “not in labor force, but want a job now.” These are people who are not counted in the labor force because they’re not looking for a job, but if someone called and offered them a job they’d take it. Presumably, when the job market starts visibly recovering, these people will start to look again.

Finally, let’s not lose sight of the fact that the economy is still stumbling, but at least it’s stumbling forward. The chart below (same source) shows the aggregate weekly hours worked by production or nonsupervisory employees (2002=100).

As I say above, this isn’t a great report, and it isn’t a bad report – in my view, it’s good enough so that the CNBC talking heads can tell everyone to buy but not so good that it will re-direct the narrative from the fiscal cliff. And it certainly isn’t good enough to claim that there’s any evidence the economy is “ready to explode” once the fiscal cliff is resolved.

‘Scary’ Analysis

On Wednesday, I was trapped listening to CNBC because I was at one of our major consulting clients’ offices and it was on. I was struck by, and thought I would share, their insightful advice about what to do if the market has a ‘scary October.’ Their advice, phrased a number of different ways at a number of different times during the day, was to “average in,” and “take the opportunity to buy low.” So: respond to weakness in stocks by buying.

It would reasonable to consider whether that is solid advice – after all, it is much better to buy lower prices and multiples than higher prices and multiples – except for the fact that it’s the same advice they give when the market is rallying: buy. In fact, if one were to buy every time CNBC said to buy, and sell every time CNBC said to sell, over the last 15 years, I am pretty sure you’d be about 2500% long.

In this case, I don’t fault the advice itself, just the track record of the advisor. If the market actually declines an appreciable amount (2.5% off the highs does not, I think, qualify), then it makes sense to buy. Stocks are, after all, real assets. They don’t tend to perform well in inflationary periods, because of the initial shift in valuation multiples as inflation moves from low and stable to higher levels, but once valuations have adjusted, they do just fine. So far, valuations have not in fact adjusted, and remain high; so also do gross margins and corporate earnings as a percentage of GDP (which is currently near the highest levels of the last 60 years). I would buy equities after a ‘scary October,’ but not unless it’s a lot scarier than it is right now.

Stocks are doing poorly despite the suddenly whiz-bang employment picture. Today’s 339,000 print on Initial Unemployment Claims (versus a consensus of 370k) was the best since January 2008 (see chart, source Bloomberg).

Now, unfortunately, this number can’t be taken at face value. Unlike with the Employment report, all that you need to massage a weekly Claims number is for the government workers in a state to work a bit slower processing unemployment claims that week. As it happened, the BLS noted in the report that one state was responsible for most of the drop, which is not what you’d expect to see if the ranks of the jobless were suddenly thinning due to economic growth. It looks like one state (the BLS won’t say which one, but it must have been a big one; I’m guessing California, where some gas stations were closed last week and gasoline prices shot to near $6/gallon in some places, but I am not sure why the BLS wouldn’t tell which state since they typically do).

But, again, I must admonish readers to remember that the reported numbers are not as important as whatever is actually happening in the economy. If the numbers are not a good reflection of that, the man on the street will know it. They certainly know it in this case.

Now, there is certainly a possibility that employment has suddenly accelerated. But I don’t consider that a very likely possibility, since employment (as we are incessantly reminded near turns in the economy) tends to lag the business cycle rather than lead it. We haven’t seen a sudden surge in Durable Goods or purchasing managers’ reports, and seasonally-adjusted gasoline demand is the lowest it has been since 2008 (see the busy chart below, source Bloomberg, that plots the DOE Motor Gasoline Implied Demand by calendar date for the last five years. The white line represents 2012).

Total trucking miles are also at the lowest level, not the highest, since 2009 (see chart, source ATA and Bloomberg).

And, in case that’s partly a response to high gasoline prices, here are US Freight Carloads from the Association of American Railroads (with the 52-week moving average, in red. Source: AAR and Bloomberg).

That, and not the weekly Claims numbers, are what Americans feel. While consumer confidence may improve simply if things don’t get worse, that’s not the same as the way confidence will improve if ever activity – not just stock prices – starts to actually improve.

Europe continues to be the biggest threat to the global growth dynamic, but last night’s S&P downgrade of Spain two notches (from BBB+ to BBB-) was ignored by the market. Spanish yields actually declined. This is the way it should be, because we all know ratings are fairly useless generally but especially for sovereigns. As I have written previously, the only circumstance in which sovereign ratings make any sense is in fact in countries like Spain that may be unable to pay their debt because they cannot print their own currency. In any country that can print, it is impossible for there to be a forced bankruptcy; ergo, the rating of such sovereigns (such as the US) must be trying to measure not the ability to pay (which is absolute) but the willingness to pay rather than to default – even if to do so requires inflating, that isn’t a default. But if ratings have to measure willingness, they’re completely messed up. We have no way to evaluate willingness to pay. All of which is a long-winded way of saying that ratings only matter these days I think because of the risk of ratings triggers, such as when investors can only hold ‘investment grade’ paper and so need to sell bonds if they’re downgraded below that level. And I suspect this isn’t a big problem with Spain, as most conscious investors probably concluded months ago that this is not an ‘investment grade’ credit.

The election and earnings season remain the foci for the month of October. (And inflation traders also look forward to the 30-year TIPS auction, next week, which has started to put mild downward pressure on BEI already). There are plenty of other global issues still in play, but I’d expect stocks to continue to drift lower under the growing pressure of end-of-year selling to lock in lower tax rates, a weak earnings season, and increasing signs that the global slowdown is real. Will it get ‘scary’? I doubt it will get scary enough to buy.

A Summary of My Post-Employment Tweets

Here is a summary of my post-Employment tweets (@inflation_guy on Twitter):

• Before any comments about unemployment, a note: it isn’t the NUMBERS that affect the political race, it’s the reality of unemployment.
• Unemployment rate 7.796% from 8.111% and vs expectations of 8.2%. 114k new jobs, tho weak in private payrolls, +86k net revisions though.
• According to household survey, 873k more people are employed this month. Uh huh. can you say ‘seasonal adjustment problem?’
• I doubt there is manipulation in these numbers, but they’re the kind of numbers that make people suspect manipulation.
• avg hourly earnings and avg weekly hours both a tick higher than expected.
• In sum, this isn’t a robust report by any stretch (114k new jobs), but it’s better than expected. I expect the unemp drop will retrace.
• Series I like, “Not in Labor Force, Want a Job Now,” fell to 6.727mm people: still 2nd highest since series started in 1994.
• As a reminder: people don’t vote the numbers they see on TV. They vote the numbers they see and feel.

 

The Employment report was good, but not terrific. Any way you slice it, 114k new jobs isn’t going to get anyone dancing in the streets, even with revisions. A quick word to the conspiracy theorists out there: if I was going to manipulate this number, I would do a better job. By monkeying with seasonal adjustments and secondary assumptions, you could produce a much better “new jobs” number. It would require a whole lot of people to be “in on it,” so you might as well get some value out of it, if you’re that kind of sleazebag. So I don’t think there’s any manipulation here, just bad seasonal adjustment.

But more importantly, it isn’t the number that affects the election. People think that because the unemployment rate and the re-election success of the incumbent are related, the former causes the latter. It’s not so. It’s that both are related to a third factor, the actual condition of the labor market. Remember that these are experiments, imperfect estimates of real world conditions. As it turns out, individuals are really good at assessing the state of the job market without any help from the statisticians – they just look at how many of their pals are out of work. So even if this was a completely made up number (or, more likely, just a fortuitous wiggle in the Obama direction), it wouldn’t affect the polls. Thought experiment: if the BLS today had reported 4% unemployment, what would the effect on the election be? The correct answer is zero, because everyone would know that’s not the real unemployment rate.

It’s the same thing here. If the unemployment rate really dropped 0.3% in one month, then it will affect the polls. If it didn’t, it won’t.

Judging from the total of the various employment and activity series we have, I think we have an economy that is still growing slowly, but decelerating and risking a relapse into recession. But we’re not there yet.

Slow Motion

Everything is moving in slow motion. To some degree, this is normal on 9/11, when many Americans, and especially those in the financial markets, have trouble concentrating fully; however, this goes beyond the anniversary of the attacks. Market volumes, which I expected to begin to pick up last week, remain anemic by any recent standard. Volumes last Friday, on the day of the Employment report that could well be the deciding factor in provoking QE (although I was already on record before the data as saying I thought the Fed would ease in September), were actually lighter than on Thursday. Only 641mm shares changed hands on the NYSE.

That was similar to the volumes on the two previous Employment Fridays: in July 561mm shares traded at the end of July 4^th week, and August 3^rd‘s 712mm shares was the second-lowest total that week. But I thought those were summer numbers – it is beginning to appear I was wrong.

The decline in volumes is either bad news or worse news, depending on the cause. If the cause is that market-makers and high-frequency traders have pulled back from trading, then it is bad news because that implies less liquidity. Of course, one can argue that having slightly wider and slightly less-deep markets is a reasonable price to pay for having markets that don’t advantage fast-twitch trading over longer-term investing; I don’t agree with that point but it’s a normative assessment and I won’t quibble with it. If that’s the only reason volumes have declined, then it’s bad news for investors (and especially large investors), but a solvable problem.

What concerns me is that if that is the issue, we still should be seeing volumes rise now as there is more news to trade – Employment, the Fed, ECB, the German high court, and so on. I pointed out in early August that when markets are less-liquid, as they often are in August, it can lead to lower volumes because the larger cost of initiating any move implies that it takes more certainty of the result before it makes sense to re-allocate any meaningful amount of a portfolio. True enough, but surely the Employment report, which caused a number of economists to change their call from “QE possible but not likely” to “QE is virtually guaranteed”, is important enough to cause some re-allocation of portfolios?

Well, perhaps not. If there is other uncertainty, beyond just the liquidity itself, then the hurdle for re-allocation (and thus, more volumes) goes still higher. We have all had moments like that, when the stock we want to sell has an earnings report out tomorrow, and even though we want to add or subtract from our position we often will choose to wait until that information is released – even if the expectation for the information itself ought to already be impounded in the price.

The uncertainty I worry about it the continued political uncertainty. I don’t just mean at the levels of the Presidency, although Obama in his convention acceptance speech mentioned FDR and applauded “the kind of bold, persistent experimentation that [he] pursued during the only crisis worse than this one.” It was, many people (myself included) now believe, the experimentation that helped extend the Depression by many years – for an excellent exposition of this argument, see The Forgotten Man: A New History of the Great Depression, by Amity Shlaes. But while the President is clearly the experimenter-in-chief, the dramatically (and frequently) changing landscape for financial services firms is causing a tremendous amount of certainty among market-makers of all kinds.

If investors get the feeling “why bother? The market is completely manipulated/screwed up anyway,” then we’re probably pretty close to the next bear market, with the good news being that it could be the one that truly wipes out the ‘cult of equity’ and allows the basing of a real bull market thereafter. I’m not about to try to call the timing of the next downswing of magnitude. I’ve been somewhat more (tactically) positive recently although stocks remain overvalued and analysts optimistic that the extremely wide current margins can be maintained. But for a bull market, you need people to buy because they think businesses have great prospects, not because stocks don’t look too bad if your alternative is nominal bonds. While certain businesses have good prospects (that’s always true), business as a whole doesn’t feel very good or look very good. Whatever the timing, I still think that valuations will have to retreat a fair amount before we can have a strong upswing again.

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There are other unsettling signs, involving inflation. The teacher strike in Chicago; the NFL referee strike: unemployment is at 8.1% (and practically speaking, the reality is worse than that), and yet unions are striking. This is why the data tends to show that wages follow inflation, and it’s also why I’m skeptical that the current high margins for businesses are sustainable. Now, teachers and referees don’t exactly work in free markets, but it’s still strange to see in this kind of environment. Or is it? The chart below (Source: BLS, and Devine, Janice M., “Cost-of-living Clauses: Trends and Current Characteristics”, Compensation and Working Conditions, December 1996.) shows the percentage of all employees under collective bargaining agreements covered (in the CBA) by a cost of living adjustment.

Incidentally, I should give a hat-tip to ING Capital Markets; I originally developed that chart for a presentation I was giving on their behalf.

The chart shows that in the weak, inflationary economic environment that prevailed in the 1970s, one of the things that happened is that even while the overall proportion of unionized workers was declining (as it has done more or less consistently since 1954), the unions were gaining strength relative to management and able to force into CBAs clauses that tended to institutionalize inflation. The key point here being that this happened even while the economy was in a growth malaise. When the economy is weak, the protections offered by unions seem more attractive, and businesses are less able to resist union pressures.

Surprise! A weak economy is actually bad for business, as well as employees. What is perhaps surprising to some is that workers don’t simply sit around and take what businesses dole out to them because they ‘re afraid of losing their jobs – they do in fact fight back. This is contrary to conventional wisdom, which occasionally defends the association of slow growth with disinflation by pointing to the fact that slack in the labor market implies workers cannot press for higher wages. As I’ve pointed out before, it is true that real wages can be slack when unemployment is high, but that is not the same as nominal wages being slack. This illustrates one mechanism by which employees can keep up, somewhat, in nominal terms when prices rise even if they lose on real wage growth.

Summary Of My Post-Employment Tweets

Here is a summary of my post-Employment tweets at @inflation_guy, for those not on Twitter and those who just want to see them all together. I also include a chart and some commentary:

• Ouch. #Canada added 1/3 as many jobs as the US did last month, and that nation has 1/9 of the population.
• Awful payroll data – 34k lower than expected with an additional -41k revision.
• Unemp rate fell from 8.254% to 8.111%, looks like a 0.2% fall but only b/c rounding. And it was all labor force shrinkage.
• Saw comment that the unemp # matters politically. No it doesn’t. These are numbers. What matters is what people feel is happening. And
• ..and with employment, the man on the street doesn’t need the government to tell him if the employment situation sucks.
• Weekly hours back to where we started the year. And Participation Rate now at the lowest level since 1979.
• One thing this ought to do is quiet the conspiracy theories about how Obama is cooking the numbers! Couldn’t have cooked up worse.
• Internals even worse: I follow “Not in Labor Force, Want a Job Now”. Highest since they strted asking that qn: [Note: I include this chart below]
• 7 million people aren’t even looking for work, but want a job and would take one if offered. 7 million!
• Don’t worry too much about hourly wages meaning deflation is coming. Wages follow #inflation, they don’t lead.

Here’s the chart referred to in the second-to-last tweet (Source: BLS):

Republicans, don’t cheer because we got a weak number. It isn’t the number that causes trouble to the Obama campaign; it’s the perception of the job market and that’s not necessarily correlated to the number itself. Perceptions were already bad, and it’s more likely this number is slightly understated.

Democrats, don’t cheer because of the decline in the Unemployment Rate. You might think it makes a nice talking point, but if you crow about the improving labor market people will think you’re an idiot. The labor market isn’t improving. It’s stagnating, at best; at worst, the crisis in Europe and the weakening of growth in Asia is dragging our increasingly export-sensitive economy down.

In fact, both sides of the aisle should be crying. But watch stocks jump! It’s a little disappointing to me, actually, since more pundits will now get the QE3 call right. However, this number didn’t “seal the deal” – it was already sealed, and the Fed was going to be easing next week no matter what today’s number was.

Not Good Enough To Warrant That Reaction

Stocks surged today, although still on fairly light volume, in a striking response to the ECB’s proposal of a plan we already knew most of the details of. The S&P rallied 2%, and Treasury yields rose 7bps at the 10-year point (1.67%), with 10y TIPS yields +5bps (-0.65%) and breakevens therefore 2bps wider. Commodities were relatively strong, outside of the livestock group.

The ECB’s plan is essentially as described in leaks previously, although apparently there are some minor asterisks that prevent the central bank from just going in to buy lots of bonds right away. The ECB didn’t cut rates, or make the deposit rate negative, as some 40% of economists expected according to Bloomberg. That cut wasn’t in the cards, for the nonce anyway. As I pointed out yesterday, if the ECB wants to sterilize bond purchases, they certainly can’t cut deposit rates and probably have to raise them (if they were serious about sterilizing). In theory, they could cut deposit rates and then offer short-term bank bills as a way to absorb the extra money in circulation, but that’s the same thing in the end: we hold your money and pay you interest. The fact that it isn’t reserves, but bills, is not relevant to the sterilization discussion, and that approach is actually somewhat more flexible since the ECB can more easily raise the rate it pays on bills to be sure of soaking up enough money than it can adjust the deposit rate to accomplish the same thing. The problem, though, is that bill sales occur in the open, and it will be really obvious if they aren’t able to sterilize the purchases.

It continues to be striking how resistant central bankers are to the notion that markets, and not central bankers, ought to set market rates. Bloomberg and other media sources wrote of the ECB’s “fight to wrest back control of rates…after nearly three years of turmoil.”  When, exactly, were rates in control of central bankers to begin with? Other than the trivial case of the overnight rate, that is. That’s just crazy talk.

There is, however, still the issue that sovereign governments need to formally request aid, and agree to conditions, before the unlimited buying can begin. It occurs to me that the unlimited buying might be tied to the conditions, and so not be unlimited after all. But the bigger problem is that governments (especially now that their rates have rallied a bit and the wolf has temporarily retreated from the door) insist on having the temerity to negotiate conditions, rather than to simply accept the gruel the EU says they’re entitled to. For example, according to the Spanish news outlet El Pais, Spain’s opening bid is for a full bailout without any extra conditions (hat tip to Andy F). At least that gives them plenty of room for concessions.

Now, perhaps the rally in equities wasn’t due to the ECB’s offer to buy bonds after all. Maybe it was because the economic data was slightly stronger than expected, although I’m skeptical of that. ADP showed a gain of 201,000 jobs, the highest gain since March, plus an upward revision to 173,000 last month. Initial Claims were a bit lower than expected, at 365,000. These are both on the better side of expectations, but negligibly so given the size of the error bars involved. The ADP report may have encouraged some shorts to cover in front of the Employment Report tomorrow, but the short-term correlation between changes in ADP and changes in the Employment Report is quite poor, as the chart below shows. The R-squared of the relationship is 0.165. That is, if you know that ADP accelerated 28k this month compared with last month, it tells you almost nothing about whether Non-Farm Payrolls will accelerate or decelerate from last month’s figure.

The correlation of the levels of the changes themselves is of course much better, with an R-squared of 0.857 over the same period, but the standard error is 93k. So, today’s 201k from ADP would produce a point estimate, based on the regression (not shown here), of 210k for Payrolls. But the error bar would make the expected range 117k on the low side to 303k on the high side. Ergo, it’s still a bit early to get over-excited about the Payrolls report tomorrow.

There’s a secondary concern here that is silly, but needs to be considered. If the number is strong tomorrow, there will be some investors (and perhaps quite many) who will be skeptical that the numbers just happened to improve right in the middle of the Democratic National Convention, hours after President Obama accepts the nomination. I am not one of those who will be skeptical, not because I think any particular Administration is above the idea of manipulating the data, but because I think it would be almost impossible to do so without the conspiracy coming to light. There are simply too many people involved in the generating of this government statistic (and, of course, the ADP figure is not remotely influenced by the government). But the same people who believe the government manipulates CPI will believe they manipulate the jobs report, and this has market implications: if the figure is weak, investors will have a higher level of confidence in the data (since it goes without saying that no one would manipulate the number to be worse) than if it is strong, which further implies – especially after today’s rally – that the price response in the equity market is likely to be skewed negatively. I don’t like taking positions ahead of major numbers, but in this case I’d be inclined to shade a bit short. But just a bit.

ADP was a bit stronger-than-expected, and Payrolls may be higher or lower. But either way, these figures do have the usual error bars, and it seems unlikely that this augurs an unexpected and durable improvement in the employment situation when the man on the street is still reporting that jobs are harder to get. Nevertheless, the economy seems not to be getting worse at the moment, either, and with traditional monetary policy there would be no cause whatsoever to ease. I suppose it goes without saying that those traditions are no longer being observed, however, and I continue to think we’ll see the Fed ease next week – almost regardless of what the data does.

Deserving It

Does Chad “Ochocinco” Johnson deserve another chance?

That’s a question I saw several times bandied about today on the NFL Network. (It is, after all, kickoff night of the NFL and so you will perhaps forgive the digression.) But no one seemed to ask the question that I find much more interesting, and more relevant in other familiar contexts as well:

Does any other team deserve to be saddled with Ochocinco for another season?

Because really, it isn’t just a question of whether he deserves another chance. That would imply there is some objective standard by which his ‘deservedness’ should be measured. It seems to me that this begs the question. Shouldn’t the arbiters of whether he deserves another chance be the people who actually have to be saddled with the consequences of giving him another chance?

I’m just saying…

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There is a very interesting development in inflation land: Deutsche Bank, which along with Credit Suisse distanced themselves from less-innovative firms earlier this year when they issued ETN/ETF structures that allow an investor to invest in a long-breakeven position, has created a tradeable index that proxies core inflation.

Now, it isn’t any mystery that you can create core inflation by taking headline inflation and stripping out energy (and, if you feel like torturing yourself with tiny futures positions, food) – for example, I presented a chart of ‘implied core inflation’ in the article linked here -  so the DB product doesn’t break any new theoretical ground. But it is a huge leap forward in that it allows more market participants to trade in a direct way something that acts like core inflation.

Why would an investor care about core inflation? Is it because he “doesn’t care about buying gasoline and food”? No, an investor may wish to buy a core-inflation-linked bond for the same reason that a Fed governor wants to focus on core even though all prices matter: core inflation moves around less in the short run, but in the long run core and headline inflation move together. The chart below (Source: Bloomberg) shows the core CPI price index, and the headline CPI price index, normalized so that they were both 100 on December 31, 1979. Since then, prices have tripled, whether you are looking at headline or core. The difference in the compounded inflation rate? Core inflation has risen at a 3.471% inflation rate, while headline inflation has grown at 3.415%.

This is why central bankers want to focus on core – headline provides lots of noise but almost no signal. And it’s the same reason that investors should prefer bonds linked to core inflation: you get virtually all of the long-term protection against inflation that you do with headline-inflation-linked bonds (like TIPS), but with much lower short-term volatility.

Now, Deutsche’s index isn’t truly core inflation, but a proxy thereof. It appears to be a decent proxy, but it is still a proxy (and we have some more theoretical/quantitative critiques that are beyond the scope of this column). And their product is a swap, not a bond (although it would not surprise me to see bonds linked to this index in the very near future). So it isn’t perfect – but it is a huge step forward, and Deutsche Bank (and Allan Levin, the guy there who has the vision) deserves praise for actually innovating. Innovation tends to happen on the buy side, and with smaller firms, not with big sell-side institutions, and we should cheer it when we see it.

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Now, back to actual markets: tomorrow, the ECB is expected to announce a new program of buying periphery bonds when necessary. Actually, it is a bit more than expectation, since the plan was leaked today. Supposedly, the ECB will announce that they are going to do “unlimited, sterilized bond buying” of securities three years and less in maturity.

The Euro was somewhat buoyed by this news. The idea is that big bond purchases will bring down sovereign yields, but sterilization of the purchases will mean that it isn’t truly monetization and therefore not inflationary.

This seems ridiculous to me. I am not surprised at the idea that the ECB would conduct large purchases of bonds that no one else seems to want; they did quite a bit of that with Greece, after all. But I’ve lost track – are they still sterilizing the billions in bonds that they’ve already bought, as well as the two LTRO operations which they claimed to sterilize, but never explicitly did except through the expedient of paying interest on reserves to sop up the liquidity?

How are they going to sterilize more purchases? There are basically three straightforward ways for a central bank to remove liquidity from the market. We used to think that there were only two, because the only ways the central bank ever did it was to (a) conduct large reverse-repurchase operations in which the central bank lent bonds and borrowed cash, taking the cash temporarily out of the economy and (b) to sell bonds outright, to make a permanent reduction in reserves. Now we recognize a third option, although we’re not sure how efficacious it is: (c) raising the interest rate on deposits of excess reserves at the central bank, so as to discourage the multiplication of those reserves.

But for the ECB’s purchases to be effective in terms of their size, they will be far too large to use reverse-repos as a sterilization method; and it doesn’t seem to make much sense to be selling bonds when they’re buying other bonds, unless they want to try and push up the yields of countries like the Netherlands and Germany (which might not be politically too astute) at the same time that they’re lowering the yields of Spain and Portugal. And they just cut the deposit rate to zero in July…are they going to raise it again?

I can understand the political cleverness of such an announcement, if the ECB makes it: make the bond buys “unlimited” to suggest that they can’t be outmuscled, but also sterilized so it’s not printing. But these can’t both be true – because there is not unlimited capacity for sterilization.

That plan can only work if, in fact, the ECB doesn’t actually buy many bonds. In the past, they’ve tried to trick the market into rallying with “bazooka-like” comments so that they didn’t actually have to do anything. To date, it has never worked. I doubt this will, either.

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Back in the U.S., the wave of Employment data is about to hit. Tomorrow morning, Initial Claims (Consensus: 370k) will be released; about Claims the only thing I want to note is that while it is down considerably from the peak of the most-recent recession, it is only slightly below where it was at the peak of the last recession. Over the last 52 weeks, Claims have averaged 381k; in May of 2002 that average reached 419k. Also due out tomorrow is the ADP report (Consensus: 140k), which is expected to weaken slightly from last month’s figure. On Friday, of course, the Payrolls report is expected to show a rise of 127k new jobs with the Unemployment Rate steady at 8.3%.

Some observers have made a lot of the fact that the Citigroup Economic Surprise index has risen from -65 or so in July to nearly flat now. But this is not a sign of improving economic conditions; it is a sign of improving economic forecasts. Remember that this index doesn’t capture absolute levels, but the degree to which economists are missing. The current level is near flat because economists adapted their forecasts to the weak data, not because the data improved to catch up with the over-optimistic forecasts. I wouldn’t draw much relief from that indicator.

Now, with the ECB and the Fed on the calendar over the next week, markets may well get some relief. But the economy, not so much, even if we do deserve it.