Today’s article will be brief (some might say blessedly so). The topic is the publication of an article on the NY Fed’s blog entitled “Convexity Event Risks in a Rising Interest Rate Environment.”
Long-time readers may recall that I wrote an article last year, with 10-year notes at 2.12%, called “Bonds and the ‘Convexity Trade’,” in which I commented that “the bond market is very vulnerable to a convexity trade to higher yields…the recent move to new high yields for the last 12 months could trigger such a phenomenon. If it does, then we will see 10-year note rates above 3% in fairly short order.” Within a few weeks, 10-year note yields hit 2.60% and eventually topped out at 3%.
Now, the Fed tells me that this selloff was “more gradual and therefore inconsistent with a sell-off driven primarily by convexity hedging.” I suppose in a way I can agree. The sell-off was primarily driven by the fact that the Fed had abused the hell out of the bond market and pushed it to unsustainable levels. But I don’t think that’s what they’re saying.
Indeed, the Fed is actually claiming credit for the fact that the selloff was only 140bps. You see, the reason that we didn’t get a convexity-based selloff – or at least, we only got the one, and not the one I was really concerned about, on a push over 3% – is because the Fed had bought so many mortgage-backed securities that there weren’t enough current-coupon MBS left to cause a debacle!
How wonderfully serendipitous it is that even the most egregious failures of the Federal Reserve turn out to benefit society in heretofore unexpected ways. You will recall that one of the main reasons given by the Federal Reserve to purchase mortgages in the first place was to help unfreeze the mortgage market, and to provoke additional mortgage origination. In that, it evidently failed, for if it had succeeded then the total amount of negative convexity in public hands would not have changed very dramatically. In fact, it would have been worse since the new origination would have been current coupons and replacing higher coupons.
The real reason that the convexity-spurred selloff wasn’t worse isn’t because the Fed had taken all of the current coupon MBS out of the market, but because the Fed continued to buy even in the move to higher yields. A negative-convexity selloff has two parts: the increased demand for hedging, and the decreased supply of counterparties to take the other side as the ball gets rolling. In this case, one big buyer remained, which emboldened dealers who knew they wouldn’t be stuck “holding the bag.” That is the reason that the selloff was “only” 140bps and not worse.
However, the observation that the Fed’s policy was a failure, as it did not stimulate vast amounts of new mortgage activity, remains. It is true that there is less negative convexity in the mortgage market than there would otherwise have been in the absence of Fed buying. But that’s an indictment, not exoneration.
On this site I almost never cross-reference posts that have been put up on the Enduring Investments blog, because access to that blog is only available to investors that we pre-screen while this blog is available to pretty much anyone. So, if I post something at the Enduring Investments site, it’s generally intended for a different audience than are the articles put here.
However, in this case I am making an exception because I think the article just posted on that blog, “Inflation and Insurers: How Inflation Resembles a Reinsurance Problem,” contains really important thoughts applicable to anyone in the insurance industry – and we’ve gotten feedback from a number of insurance companies that our presentation on this topic is timely and insightful. So, if you represent an insurance company or know of someone who ought to hear these thoughts, send them to the link above!
On CNBC today, analyst Meredith Whitney commented that “everybody loses” from the Detroit declaration of bankruptcy.
If that is the case, then why in the world are they seeking bankruptcy? If everybody loses, then it means nobody wins from declaring bankruptcy, and if that’s the case then it would be truly idiotic to seek it.
But of course, this is nonsense. There is no wealth being either created or destroyed in a bankruptcy proceeding; it is merely being forcibly reallocated. In this case, the winners are the taxpayers of Detroit. More to the point, it is the future taxpayers of Detroit, who were on the hook for a bunch of liabilities that they were going to have to figure out how to pay someday, but are not now going to have to pay. Those folks win big. And it’s a good thing, too, because Detroit needs more of these future taxpayers to move to Detroit.
The losers are many in number. Bondholders will lose a lot. Pensioners will, unfortunately, lose a lot. Many of the public service unions will lose a lot as their contracts are rolled back. But their losses are equal in magnitude to the gains of the future taxpayers.
Another prediction that Whitney made is on firmer ground. She said that this bankruptcy would touch off a wave of other municipal bankruptcies. I think there is a very good chance of that. I am not saying that because I have analyzed the balance sheets of many municipalities in great detail, as Whitney have (although I have seen enough, in trying to persuade some of them to hedge their post-employment medical liabilities, to be concerned). I say it because we have seen such phenomena before in industries which were overburdened. Consider telecommunications in the early 2000s. Once one big telecom company declared bankruptcy, it suddenly had a big cost advantage over its rivals, and could underprice them until its rivals followed the same path. We’ve also seen this in airlines. It seems to me that it is entirely possible that, if Detroit is able to lower taxes and reinvigorate the economy once it no longer needs to service these overwhelming liabilities, and begins to attract migrants from high-tax neighboring cities and states, then it makes the finances of places like, say, Chicago that much worse as their taxpayers leave.
- upward surprise + upward revision in #Payrolls – not too shocking, as I pointed out in last article. Weak hours though…
- Here is part of what’s happening in #payrolls: more jobs, fewer hours = employers cutting back hours to avoid Obamacare coverage
- Question is, which is better for confidence? More jobs, lower earnings & wages, or fewer, but better, jobs? Probably the former.
- average weekly hours have stagnated since 2011, even as Unemployment has fallen.
Today’s Employment report was pretty straightforward: an upward surprise to payrolls and upward revisions; a decline in the Unemployment Rate, and declines in hours worked. The upward revisions to Payrolls is not really a surprise, although seeing the Unemployment Rate continue to decline when Consumer Confidence “Jobs Hard to Get” is increasing is unusual.
Two years ago, the “Average Hours Worked” was 34.4 hours and the Unemployment Rate was 9.0%. Today, average hours worked is still 34.4 hours and the Unemployment Rate is 7.5%.
What I said about Obamacare coverage should be expanded a bit. There have been anecdotal reports (see, e.g., here and here) that many employers are cutting back hours for some employees, because they are required to offer health insurance (at steep premium increases) to part-time employees working at least 30 hours per week. The incentives are large, especially for employers who are near the 50 employee cutoff, to cut back employee hours. The way this would show up in the data, if the behavior was widespread, would be (a) a decline in average hours, as more people work shorter shifts, and (b) potentially (but not automatically) an increase in the number employed, since an employer who cuts 100 hours of work from existing employees is now 10 hours short of the labor input needed. I suspect this is only partly the case – if you cut 100 hours, maybe you add three 25-hour part-timers (it still costs money to hire, after all) – but it may help explain why the payrolls number keeps rising and the jobless number keeps falling although the average hours worked is pretty stagnant.
It would also help resolve the conundrum between the “Jobs Hard to Get” survey result and the Unemployment Rate, although it is a small divergence at present. If respondents are answering the survey as if the question is whether good or full-time jobs are hard to get, it may well be the case that those jobs are getting more difficult to find while there are more part-time positions being offered.
This is mere speculation, and storytelling, but I think it’s plausible that this is happening and may be affecting the data.
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.
It always bugs me a bit when a market event that happens for one cause is attributed to another cause merely to advance an easy narrative. The awful 5y TIPS auction yesterday and subsequent flush of TIPS breakevens is being attributed to a “fading of inflation concerns.” There may be some fading of inflation concerns, although as I demonstrated in my last article expectations for core inflation haven’t been fading.
But the main reasons the auction failed were far simpler. Prime among these is that the 5-year TIPS have always had more problems being sold, because people who want inflation protection tend to primarily want long inflation protection. In the last couple of years, I’ve had discussions with many institutional investors who expressed interest when I discussed a 50-year inflation-linked bond. But the 5y TIPS are mainly of interest to (a) indexers and (b) foreign central banks. As such, they are prone to occasional disasters when the central banks don’t show up, dealer risk-taking appetite is low, and market momentum is such that dealers don’t feel like warehousing the auction risk until the indexes are rebalanced at month-end and the indexers come for the paper. This isn’t to say that I expected this to be a bad auction, because the last few auctions of all kinds have been pretty normal (that is, more like normal Treasury auctions than like TIPS auctions of old). But it’s not surprising to me that it happened. And it has nothing to do with inflation fears fading, except that some buyers perhaps figured they could buy at better levels later because of the market narrative about inflation fears fading.
And today, we’re seeing a big bounce-back in breakevens so far. What does that do to the narrative?
(As an aside, and for disclosure, our Fisher model identified TIPS as exceptionally cheap compared with nominal bonds after the auction and went fully long breakevens on the close.)
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.
A slow Monday, and the S&P could barely manage a +0.3% rally. That’s tantamount to a selloff, these days, as the all-time nominal highs are a mere 20 points away. I’m not joking: with stocks up 9.1% on the year, the S&P is averaging +0.19% per day, which means the all-time highs ought to be reached by next Wednesday.
Meanwhile, our measure of valuation for equities has reached levels not seen since July of 2011. The expected compounded after-inflation return for the S&P 500, inclusive of dividends, is just 2.00% (it got to 1.81% in July 2011 – and, for the record, it stood at 0.83% at the end of 2006).
The VIX tumbled today to the lowest level since April of 2007 (see chart, source Bloomberg), two weeks after Fed Chairman Bernanke told Congress that the “subprime crisis” was likely to stay “contained” (which it did, in roughly the same sense that the universe itself has a boundary).
Now, I don’t want to follow the usual course and list all of the things we could be worrying about (Italy, Cyprus, France, Iran, North Korea…) to somehow argue that prices are too high. After all, there’s always something to worry about. No, that’s not my argument at all. My argument is that prices are too high regardless of what the news is.
Over the next ten years, compounded real returns after inflation will likely be in the neighborhood of 2% per annum. They could reach 5% per annum, but they could be -3% per annum with equal probability. Note that these are real returns I am speaking of, so there is no reason stocks can’t continue to reach new nominal highs especially if consumer prices continue to accelerate.
(And here’s an odd fact: while equity market volumes over the last few years have been shrinking persistently, the gap between 2012 and 2013 has been narrowing over the last month and a half. That is, volumes are still running about 78mm shares/day below the year-to-date pace in 2012, but at the end of January that figure was 113mm shares/day. So volume is still shrinking, but no longer monotonically.)
So I’m not sure when we are going to get a significant correction on the order of late 2011 (~20%), but we are overdue. Frankly, if I thought the correction was likely to be no more than 20%, I probably wouldn’t even be particularly concerned, because 10% and 20% corrections happen in healthy markets. But I can’t discount the possibility of a 2000-2002 or 2007-2008 sort of decline. The conditions are “right” for just such an occurrence, unfortunately.
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.
I suppose I need to say something quickly about the FOMC minutes which were released yesterday, because the markets are seemingly gyrating on a “surprisingly hawkish” reading of them. The dollar is rising strongly, and part of the reason that equities slid in the afternoon yesterday was that it was perceived the Fed wouldn’t be endlessly doing QE.
The “surprisingly hawkish” part allegedly comes from this quote:
In considering the outlook for the labor market and the broader economy, a few members expressed the view that ongoing asset purchases would likely be warranted until about the end of 2013, while a few others emphasized the need for considerable policy accommodation but did not state a specific time frame or total for purchases. Several others thought that it would probably be appropriate to slow or to stop purchases well before the end of 2013, citing concerns about financial stability or the size of the balance sheet. One member viewed any additional purchases as unwarranted.
Various reports today focused entirely on this phrase. Bloomberg, for example, said “Fed board members said they will probably end their $85 billion monthly bond purchases, known as quantitative easing, in 2013, according to minutes of their Dec. 11-12 meeting released yesterday.” Of course, they said nothing of the kind. This paragraph followed an extensive discussion about “several persistent headwinds” including the likelihood of tighter fiscal policy, and “[t]he staff viewed…the risks as skewed to the downside.” There is far more negative in these minutes than there is positive. This illustrates the danger of taking a single quote out of context.
But what is even more important is this: the Evans Rule is now parameterized. The statement about when officials think that QE will end is simply a statement about when they think the parameters will be realized. But who cares? Private forecasters are no worse than Fed forecasters! Personally, I thought that we’d breach those parameters fairly quickly, and my note on the subject was called “Objects In Mirror May Be Closer Than They Appear.” The error here seems to be that people expected QE-infinity really meant that the Fed would be easing forever, and that was incorrect a couple of weeks ago…not yesterday.
In any event, it doesn’t matter because the real question isn’t how much more water they add to the vat (that is, sterile reserves) but how (and if) they are able to remove the water that is already in the vat – which is trying very hard to get through the valve into M2. Again, I urge readers who took the end of the year off to look at my piece on this topic, “What Will the Fed Do When It’s Finally Time To Tighten?” Money supply is accelerating again, +8.25% over the last year. And European M2 in November (numbers just out recently) accelerated to the fastest y/y pace since 2009.
If this makes investors concerned about the sketchy valuations of fixed income and stocks, then good – those markets are frothy and I will welcome prices where long equity investing holds more long-term promise than it currently does. But the reaction to the minutes, in my view, is mostly a case of people failing to understand Fedspeak.