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Classic
Numerous classic cognitive errors are on display at once in these markets. We have “overconfidence,” with large bets being made on the basis of strongly-believed models and forecasts…but these are forecasts of the dynamics of a system whose configuration is distinctly unlike anything we have seen before, even remotely. What does a “taper” do to rates? How can we know, since we have never even had QE, much less a taper, before? How aggressively does it make sense to bet on the outcome of such a transition period, given rational-sized error bars on the estimates?
We also see naïve extrapolation of trends. TIPS go down every day, it seems, for no better reason than that “core inflation is low, and the Fed is no longer going to be maintaining as loose a policy.” Ten-year TIPS yields have risen 83bps since April 25th (5y TIPS, +107bps since April 4th). Ten-year breakevens have fallen from 2.59%, within 15bps of an all-time high, on March 14th to 2.03% – the lowest since January 2012 – now. What has changed? Our model identified TIPS as cheap to Treasuries (that is, breakevens too low for the level of nominal rates) and went nearly max-long when breakevens were still at 2.30%. It is some solace that this position has fared better than a long position in TIPS, but when markets simply follow recent momentum mindlessly it can be painful.
Year-ahead core inflation is priced in the market at roughly 1.50%, despite the fact that current core inflation of 1.7% is only at this level because of persistently soggy core goods prices (and core goods are much more volatile than core services prices). Meanwhile, although core services prices remain buoyant, housing rents have not even begun to respond to the sudden boom in housing prices. To realize the core inflation priced into the 1-year inflation swap, core goods prices need to remain low and rends would need to decelerate while a shortage of owner-occupied housing drives the prices of existing homes skyward. It is possible, but it would be a very unusual economic occurrence. As I have previously written, we are maintaining our forecast for core inflation in 2012 at 2.6%-3.0%; although we may tweak that lowers if next week’s CPI is disappointing, we will not be changing it dramatically. Based on both top-down and bottom-up forecasts, we think the inflation market right now is very wrong. However, in accordance with paragraph 1, above, our 80% confidence interval for that estimate would be quite wide. Still, we feel that most errors looking out at least one year are going to be in the direction of higher inflation, not lower inflation.
Now, our forecast relies significantly on the behavior of the housing market, since shelter is the largest share of the budget for most of us. There has been a lot written recently about how the rise in rates could shatter the housing recovery. But let me explain why I don’t think that will happen.
I remember reading many years ago in “The Money Game” by Adam Smith (a pseudonym) that “you make more money with good investing decisions than with good financing decisions.” At least, I think that’s where I read it. In any event, it is true: if you are creating the next Microsoft, it makes very little difference if you finance it at 2% or at 15%, because the investment performance will completely obliterate the cost of financing. And this is why higher rates, even significantly higher rates, will not derail the housing market while prices are rising at 10%+ per annum. A home buyer is clearly happier to borrow at 3% than at 5% (tax-deductible), but if the home price is appreciating at 10% per annum (tax free, for much of it, and tax-deferred in any event) then it is a home run for the buyer either way. What hurts the housing market is when the expectation of future home price changes goes from go-go to stop-stop. And, with most consumers concerned with inflation and recent price trends in the home market, this isn’t going to change soon.
Here is an illustration of the real-world response of housing to rates. This first chart is the Mortgage Banking Association’s Refinancing index, plotted against 10-year Treasury rates (inverted). You can see that the recent rise in rates is having a significant impact on refinancing activity.
And this next chart is a chart of the MBA Purchase Index, showing activity on mortgages related to new purchases of homes. Again, the 10-year Treasury rate is inverted. You can see that there is no meaningful correlation here; if anything, purchase activity has been rising over the past year while rates have also been rising.
So, rest easy: higher interest rates are not going to meaningfully impact the housing market, unless they go much higher. Indeed, homebuyers might reasonably believe here that there is a “Bernanke put” on home prices in the same way that investors (correctly) believed there was a “Greenspan put” on stock prices. The Fed (and for that matter the state and federal governments) clearly have responded and can reasonably be expected to respond robustly to a future home price bust. So why not be long real estate here, if your downside is protected…and in any case, is limited to your home equity?
And if home prices do not decline, then rents are not going to decline, and in fact need to accelerate to keep up with the previously-seen rise in home prices. That is going to cause core inflation to rise going forward.
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One final note: over the next month or two I hope to put out a few more articles like the one I wrote on June 8th about equity returns and inflation, but focusing on other asset classes such as real estate, infrastructure, commodity indices, etcetera. But in the meantime, I wanted to point out one security to keep an eye on. It is one of only two inflation-linked bonds that is traded on an exchange with a daily price and reasonable bid/offer spreads. The symbol is OSM (for Bloomberg users: you need the <CORP> key), and it is a floating-rate inflation-linked bond issued by SLM Corp with a March 2017 maturity. The problem with this security is that it is very hard to figure out what its true yield is unless you have an inflation derivatives curve, and even harder to figure out whether the issue is priced correctly given that you own SLM credit. The recent selloff has driven the real yield of this issue to (approximately) 3.40%, which is obviously much higher than is available for TIPS. The bad news is that the bond is still fairly expensive given the spread that should exist for a SLM bond, but in terms of raw real yield to maturity there are not many inflation-linked bonds out there with that yield. I am not recommending this security, but mention it as a point of information for investors who may want to check it out on their own.
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.
Telling Stories About TIPS
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.)
Droopy
For a change, fixed-income is where all of the excitement is. For more than a month (since March 5th, the S&P has closed no lower than 1540 and no higher than 1570, plus or minus a couple of nickels: a month-long range of less than 2%. What’s really amazing about that is that on seven of those twenty-three trading days, the range of the day was more than half of the month’s entire closing range. In two of the last four trading days, the intraday range was two-thirds of that for the entire month!
Meanwhile, the 10-year Treasury rate has gone from 1.90% to 2.06%, down to 1.71%, and ending today at 1.75%. The closing range in point terms of the current 10-year note was 99-16 to 102-19, or a bit more than 3% (and it was obviously more than that for the long bond). It has been a long time since bonds were more volatile than stocks over a period as long as a month.
Most of that volatility in nominal rates has been on the real interest rate side. The range in closing 10-year TIPS yields is -0.52% to -0.76%, or 24bps, compared to 35bps for the nominal yield. That’s more volatility than the real yield should be displaying at this level of rates, and it has moved TIPS from being slightly cheap a month ago to somewhat rich. Our Fisher yield decomposition model, which had been neutral on TIPS and breakevens since mid-February, is now modestly short TIPS (and still flat breakevens). Moreover, the leverage applied by our long-inflation-biased “smart beta” model is only 2/3 of the neutral leverage, so conservatism is the watchword at the moment.
The rally in TIPS and nominal yields owes much, I am sure, to the somewhat feeble data we have seen over the last week. The Employment data, in particular, were very disappointing, especially to that group of people who expected profligate monetary policy easing to create economic growth. It will surprise no regular reader of this column that I am not shocked to see a lack of growth response to aggressive monetary policy easing – as I take pains to remind readers, monetary policy is not supposed to affect growth, except in the presence of money illusion. It is therefore something less than a news flash that growth is responding more to tiny changes in government spending (albeit temporarily) than to massive changes in monetary aggregates.
To be sure, even monetary aggregates have been drooping lately…at least, the ones that matter. M2 has been lurching along in the mid-6% growth rate year-on-year, and flat over the last quarter (see chart, source Federal Reserve). That’s only slightly above the average growth rate in M2 since 1981 – although, to be fair, the average core inflation over the same time period has been about 3.1%, so core inflation is still well below where we would expect it to get to if this rate of monetary growth continues.
Growth in commercial bank credit growth, also, has retreated to only 4.1% year-over-year after spending most of the past year above 5%. It too is still right around the long-term average real growth in commercial bank credit (see chart, source Federal Reserve, Enduring Investments), but last year it had been edging towards the mid-2000s standard.
So these are positive developments from the standpoint of future inflation, but it is far too early to call victory on that front. I expect the rise in M2 to re-accelerate in fairly short order; but in any event it is important to remember that the Fed is not the only game in town and not the only central bank that is pursuing easy-money policies. Indeed, last week the biggest news was that the Bank of Japan pledged to double its monetary base, its holdings of JGBs, and its holdings of ETFs and JREITs over a period of only two years.
This policy will almost surely produce the result the Japanese policymakers have been shamelessly vocal about seeking: higher inflation, in a short period of time. At the end of the day, the inflation that Japan gets in the near-term will depend on what their domestic money velocities and multipliers do, but they will surely get higher inflation eventually just as the Fed’s policies have produced inflation even with declining multipliers and velocity. To my mind, the Japanese inflation swaps market – which according to Bloomberg is at 1.26% for 5 years and 1.01% for 10 years – seems to be cheap!
But the Japanese policy will certainly not stop at the water’s edge. Around 2/3 of our domestic inflation is sourced from global factors, and the monetary policy of a major trading partner is a significant global factor. The behavior of the Yen and industry response to changing competitive pressures from Japan will determine how much of the BOJ’s inflation remains domestic and how much is exported, but it would be surprising indeed if the result was entirely contained within the borders of Japan. The Yen has responded sharply to the policy changes at the BOJ (see chart, source Bloomberg), but in my opinion it has very much further to go. In fact, the only reason we may not get back to mid-1980s levels is that the Fed’s policy is similarly aggressive – the only difference at the moment is that the Fed is giving lip service to the notion that they intend to hold down inflation in the long run. (I don’t believe them.)
None of the above has much, if anything, to do with North Korea, or Cyprus, or Slovenia, or Portugal. All of those countries still are potential wild cards, and all of them (it needs hardly be said) constitute downside risk. The White House is seemingly satisfied to wait to see if North Korea really will launch a nuclear-tipped missile; this means that the entire distribution of potential outcomes is compressed so that there is a very high likelihood of nothing bad happening, and a very small chance of something really, really bad happening. How do you trade that? The answer is that you use options. Implied volatilities are under pressure again because the recent tight range makes it difficult to eat the time decay of long-vol positions. But as for me, I’m delighted to pay insurance premiums for insurance that turns out to be unnecessary, especially when that premium is low. I don’t have any long equity positions, but if I did then I’d be protecting them with cheap put options.
Not Growing to the Sky – Nor Ready to Fall, Yet
If only we could dwell permanently in January, looking at December 2012 economic data, the U.S. would be a warm and sunny place. Today’s Durable Goods number came in above expectations, although with revisions the ex-transportation figure was only slightly above forecasts. Again, though, this is a report for December, when incomes were higher due to the tax anticipation.
The December data is mostly finished, however, and now the January data begins to be reported. That starts with Consumer Confidence (Consensus: 64.0 from 65.1) on Tuesday. It can’t happen soon enough for the bond market. The 10-year Treasury note touched 2% today, for the first time since last April; 10-year TIPS got above -0.60% for the first time since August (although, to be fair, 11bps of that is due to the roll, since the old 10-year TIPS are still at -0.69% which wouldn’t even be the highest yield this month).
It is impressive to see the bond market selling off even though the Federal Reserve continues to buy. Partly, this may be because investors are fearful that the strong data will cause the Fed to stop buying, whereupon we all know we don’t want to be overlong. That is unlikely to happen, certainly at this week’s meeting. It is no mystery that December’s numbers were pumped up by large distributions being made in 2012 over 2013, and the Fed would want to see (a) more strength than was evident even in December and (b) that strength maintained for a little while at least! And, of course, while the fiscal cliff can has been kicked down the road a couple of months, there is also still a debt ceiling debate that must be had in the next month or two. It seems unlikely that the Fed would stop buying Treasuries while those uncertainties still loom.
Over the last 18 months, the 10-year note has come up to the 2% level a number of times. Usually, that level has been pierced by 3-4bps before the market reversed again, but on two occasions yields went as high as 2.40%.
I think the top in bonds (lows in yield) have been reached, but I don’t think the market will break to higher yields just yet. As I noted last week, I really don’t want to be short bonds headed into the next week-plus of data.
Now, looking at a long-term chart the current set-up in 10-year yields is interesting. The chart below (Source: Bloomberg) is of monthly closing levels in 10-year yields, with the y-axis drawn with logarithmic scale. For years, I’ve always drawn the channel shown on the chart, such that it contained the entire bull market until the breakout around the time of the 2008 crisis.
A more common, but I think arguably less-correct way, is to draw the y-axis with a normal linear scale. In this case, the most-recent low actually makes a rare 6-point support trendline on the monthly closes. The channel is no longer truly a channel (the lines are not quite parallel), and the channel doesn’t include the two 1980-1984 spikes, but it’s a much prettier picture.
In either case, there is nothing to suggest that the secular downtrend in rates has yet become an uptrend. Someday, it will, because trees don’t grow to the sky, and I wouldn’t want to wait until 3.50% to start re-positioning (much less, the 4% implied by the log chart). But I don’t think that day is here yet.
Now, while most people are still not afraid of inflation – which is the most-likely reason for nominal interest rates to eventually normalize – inflation swaps continue to rise. The 10-year inflation swap rate reached 2.80% today, about 10bps from the post-Lehman highs (see Chart, source Enduring Investments). Some people, evidently, are starting to be concerned.
Incidentally, some might be tempted to attribute today’s inflation market rally the rise in unleaded gasoline futures. Unleaded rallied on news that Hess Corp (HES) is closing its NJ oil refining facility and its U.S. terminal network. However, this did not seem to translate into the inflation markets, as it often does – normally, the inflation swaps curve would flatten as the gasoline move has more relevance for a shorter inflation horizon, but today the front of the curve if anything underperformed after carry is taken into consideration. The rise in inflation swap quotes is deeper than this.
Dropping the Anchor
The S&P managed to hit the seemingly-important 1,500 level today, before fading to close unchanged. The market took heart early from the print of Initial Claims at 330k. This is of course good news, although some blame may be due to the holiday-shortened week (the BLS had to estimate claims for some states, including California, which were unable to submit their figures in time) and the still-volatile seasonal pattern. Traditionally, this is the week I start paying attention to ‘Claims, but each subsequent number matters more than the last. I’d love to hear that the post-holiday layoffs weren’t as significant as they usually are, implying that more ‘seasonal’ workers are being retained. I’m skeptical of it, though, until we see a few more weeks of such evidence or confirmation in the survey numbers.
This is a good time to remember that economic data aren’t “right” or “wrong”; they are experiments, like taking the heights of five random motorists and trying to guess the average height of the people who drive on a particular freeway. We never know the true underlying state of the economy, or the true underlying trend rate of any particular economic datum. We come into an economic release with a null hypothesis, and that hypothesis may either be rejected or not rejected (economic data can never really confirm your hypothesis, but they can support your hypothesis). It is for this reason that I ignore the first few Initial Claims figures of the new year. The error bars on them are so wide that it is almost impossible to reject any halfway-rational null hypothesis. Once we have seen a couple more Claims figures in this range, or gotten support for the notion of an improving job market from Consumer Confidence figures (for example), it will be easier to reject the null hypothesis that the economy is still bumping along in a nearly-jobless recovery.
Also today, the TIPS auction produced strong results despite the fact that the market never priced in a ‘concession’ for the size. At 1:00ET, the bid in the market was -0.62%, but the U.S. Treasury sold $15bln at a lower yield (higher price) of -0.63%. Moving $15bln in size without hitting the bid is a fair sign of hunger in the inflation market.
And why shouldn’t there be hunger? If you think the economy is heating up, you can’t really short bonds unless you want to sell them and hope the Fed is just about done buying. But the Fisher equation says:
(1+n)=(1+r)(1+i)(1+p), which we usually simplify to say
Nominal rates = real rates + expected inflation
If the Fed is holding nominal rates constant, and investors are expecting inflation to rise as growth heats up (note: I am not changing my view that these are unrelated…I’m merely observing how investors behave in the market), then TIPS ought to stay comparatively well-bid because investors will buy breakevens as the bearish trade, rather than selling Treasuries in a Quixotic attempt to outlast the Fed. I think breakevens and inflation swaps, which remain near the highest levels since 2006 (in the 10-year sector) and near the highest levels since there have been TIPS, are going to remain pretty well bid.
The last data of the week are the New Home Sales (Consensus: 385k from 377k) from December. The forecast is for the highest level of sales in several years, and the biggest hurdle seems to be that inventories of homes remain very low.
One quick observation about home prices and “inflation expectations” that is interesting. Pollster Rasmussen reported today that 29% of Americans expect their home’s value to rise over the next year. While this is close to the highest levels the survey has recorded (it was only started in April 2010), it is strikingly low considering that both new and existing home sales prices are up at a double-digit pace over the last year, and even the slower-moving Case-Shiller index has home prices up at over twice the rate of core inflation (4.31% as of October, the last available data, with next week’s release expected to be 5.6%). The point simply being this: the Federal Reserve relies mightily on the assumption that inflation cannot really get started when inflation expectations are well-anchored. But nowhere are inflation expectations better anchored, probably, than in home prices – and yet, home prices are rising at something not far away from the peak rates of a couple of years ago.
That’s something to think about. Maybe it’s time that the Fed dropped the whole notion of anchored inflation expectations, which no one has ever demonstrated since there are no good measures of consumer inflation expectations. The idea of an inflation-expectations anchor was developed to explain why inflation did not accelerate in the 1990s even while the economy did, causing previously-estimated models to breakdown. There are other explanations that don’t require positing an anchor that cannot be measured (for example, the private/public debt ratio plays an important role in my company’s models), but the imaginations of the academic community became…well…anchored to the idea. It’s time to drop that anchor…at least until we develop a way to measure those expectations, and then to test the idea.
Today’s Icarus
It is hard to be the top dog.
Today, despite another low-volume session (incredibly, NYSE Composite volume is already 1.5 billion shares behind 2012’s volume-to-date), investors were looking forward to a slew of earnings announcements. By and large, companies hit or exceeded the hurdles set for them, as they typically do.
Apple (AAPL), which released fiscal Q1 earnings after the close, was among those that exceeded expectations. Sales rose 18%, although falling marginally short of expectations, and the company posted a $13.81/share profit compared with expectations for $13.53/share. Apple guided Q2 revenue estimates downward, and the stock was pummeled more than 6% after the close.
What’s amazing to me is that investors were not satisfied. Bloomberg gaped that “Apple Inc. posted no profit growth and the slowest increase in sales in 14 quarters…” This is a very large company. How long did people think that the firm could grow at “only” 18%? The same story also suggested the reason for the disappointing reaction: “The results reinforce concern that Apple’s growth is being hurt by higher production costs…”
No, its growth is being hurt because it’s a very large company. (Review the beginning of my January 15th post, where I link the research on the performance of the stock market’s “top dog”.)
Now, Apple is a wonderful, wonderful company. I want to be like Apple. I want my daughter to marry someone like Apple. It only has an 11.7 trailing P/E, and a yield of 2.06%. There’s much to like. But it’s huge. Like Microsoft before it, it is going to transition to a period of large-industrial-concern growth (MSFT has a 10.7 multiple and a 3.33% yield). The difference between MSFT and AAPL is that the former has an almost unassailable position in some of its markets. The latter, while a very cool company, has unassailable positions in … perhaps the iPod, to the extent that market isn’t cannibalized by the smartphone market. On the other hand, MSFT is a ruthless, uncreative company that has historically put out buggy products (although version 275 of Excel seems to crash less). AAPL is an ultra-cool, creative company that is in ‘what have you done for me lately’ product markets. I am not saying that I would do a long-short on MSFT-AAPL, and I’m not even saying that AAPL needs to trade lower from these levels. I’m merely pointing out that the dividend growth model contemplates a transition to lower long-run growth, and AAPL is going to have lower long-term growth eventually. That shouldn’t be surprising. Its main problem as an investment was that it was far too expensive for a company in transition, and moreover that transition was almost assured once it became such a huge company. Gravity isn’t just a good idea, Icarus: it’s the law.
The good news is that if AAPL is on its way to becoming IBM (without the gray-costumed drones of the 1984 advertisements, of course), it may have fallen far enough. IBM trades at a 13.4 P/E and a 1.66% dividend yield. Even Icarus bounced once he’d fallen for a while.
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Thursday’s main economic data will be Initial Claims (Consensus: 355k from 335k). It is getting late enough in January that it is starting to make sense to pay attention to Claims again; however, as always with a weekly figure it will take a few weeks to let the average settle out.
More important, to me, is the auction of the new 10-year TIPS. This is not a re-opening, but rather a January-2023 maturity. The Treasury will be auctioning $15bln of the security, and I believe the auction will go well. The WI is pricing at roughly a 10-11bp pick-up from the current 10-year. That looks like too much, and I would expect that investors who own the current 10-year TIPS would be eager to add 11bps for six months of maturity (and pick up a slightly closer-to-the-money deflation floor in the process). Add to this the fact that the 10-year sector is fairly cheap on the curve generally, and you have the ingredients for a pretty good auction even if the absolute levels of yield are heinous and the breakevens are relatively wide by recent standards.
A Relatively Good Deal Doesn’t Mean It’s A Good Deal
I suspect that everyone has ‘default activities’ that they automatically turn to when nothing else is working. For example, when I can’t sleep and I’ve tried everything, I go downstairs and have a bowl of cereal. Some folks hit the gym when they’re frustrated. Others go shopping when they’re depressed.
And apparently, some people buy stocks when they’re not turned on by anything else.
There wasn’t any outrageously positive news today that sent the S&P +0.8% on the day. Initial Claims (371k) was slightly higher than expected (but I advocate ignoring that release in late December and most of January). The dollar dropped sharply against the Euro. I initially thought that this was because the President nominated as Treasury Secretary someone with no financial markets experience at all but a solid resumé of hard-nosed negotiations with Congress, but the Euro gained against all major currencies so it was perhaps due more to the fact that ECB President Draghi didn’t ease further at the policy meeting held today (though they were not expected to). Bloomberg blamed a better-than-expected rise in Chinese exports, but the miss was well within the usual variance for a volatile number so that seems unlikely to me.
I am not entirely kidding about the frustration that “there’s nothing else to invest in.” I was just working today on a chart for a keynote presentation I have been asked to give at the Inside Indexing conference in Boston in April (See the link here, although most of the information on the site is still the 2012 data). I have previously run this chart, showing Enduring Investments’ projected 10-year annualized real returns and risks (this is as of year-end 2012).
The slope of that line indicates that the current tradeoff of risk for return is 2.7:1. That is, for a 1% higher expected annualized real return, you will have to accept a 2.7% increase in the annualized standard deviation of annuitized real returns (the “right” measure of risk, as it measures the variance in the long-term real purchasing power of the investment). Now, here’s the chart as of April 23, 2003, using all the same methodology:
The slope of the line back then was 9.1:1. That is, in 2003 you needed to take more than three times as much risk to add 1% in expected real return to your portfolio.
But notice something else also that is very important. The change in the slope of the line didn’t come because expected equity or commodity index returns got better. Indeed, those two asset classes have roughly the same forward expected returns as they did back then, although slightly different risks the way we figure it. What happened is that the expected real returns to Treasuries, TIPS, and Corporate Bonds all fell precipitously.
Of course, this comes as no surprise to anyone, because we’ve all watched the Fed push interest rates down so far that we need extra decimal places. But I think comparing these charts you can understand a fundamental verity: people are not buying stocks because they expect awesome returns going forward (hopefully, anyway, because they’re not going to get them). They’re buying stocks because there’s less reward to buying less-risky asset classes. Which is, after all, what the Fed was trying to do (this is called the “portfolio balance channel” in monetary policymaker parlance: force people to take more risk than they want, because it’s a relatively good deal even if it’s not a good deal in an absolute sense).
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A few other notes about today’s news:
Inflation markets were abuzz today, with inflation-linked bonds outpacing their nominal counterparts in many countries, because the UK’s ONS announced that it has decided not to change the RPI that applies to Gilt linkers (inflation-linked bonds, like TIPS). The ONS (similar to our BLS) has been studying how to make certain important technical corrections to the way the RPI is calculated to make it more accurate; these changes would have had the effect of lowering the RPI significantly. As a consequence, these bonds have been trading at higher real yields, reflecting the fact that if the ONS chose to change the RPI formulation, the yield on the bond would have to be higher to compensate investors for that change if the same value was to be delivered. That is, instead of a yield of (for example) 1% added to expected inflation of 2.5%, the yield would rise to 1.5% to reflect the expectation that measured inflation would be at 2.0%. Many investors thought it was very likely that the ONS would choose one of several options for restating RPI that would have had such a deleterious effect on the bonds.
In the event, the ONS made the wise decision that it would be unfair to change the terms of the bonds retroactively by making a significant change to the RPI, so they will release a second index called the RPIJ, which will now be the benchmark index and featured in ONS releases. But they will also continue to calculate the RPI and the existing bonds will continue to track RPI.
This is a great relief to inflation-linked bondholders the world over, because it sets a very important precedent. The U.S. Treasury has long said that if the BLS made a material change to the way CPI was calculated, it would plan to continue paying on the basis of the old-formulation CPI (if it was still available) or a suitable alternative, but many investors from time to time have worried about whether they would do that in practice. It will be harder to do so with the ONS precedent.
Because investors had thought the ONS was leaning the other way, Gilt linkers rallied a bunch. For example, the UKTI 1.25%-11/2055 rallied 10 points on the day (the yield fell by about 20bps), which is an enormous move at the long end. The 5-year linker (Nov 2017) yield fell 35bps. This is likely to have a spillover effect in US TIPS, since the latter now look much better on a relative value basis than they did previously. Anyone who was long UK linkers yesterday is probably considering 30 year TIPS at a pickup of 42bps.
Finally, in Fed news Esther George, the President of the Kansas City Fed (replacing Thomas Hoenig) was on the tape today. “Fed’s George Says Low Rates Risk Stoking Inflation Surge,” said Bloomberg. No kidding? (See here for Market News’ coverage of the same speech). At the very least, said George, the asset purchases will “almost certainly increase the risk of complicating the FOMC’s exit strategy.” Neither of those statements ought to be the least bit surprising or controversial, but it’s unusual to hear a Fed official state these things so bluntly. But she may have crossed the line with this one, which might get her ostracized at the next FOMC meeting:
Like others, I am concerned about the high rate of unemployment, but I recognize that monetary policy, by contributing to financial imbalances and instability, can just as easily aggravate unemployment as heal it.
Keep speaking truth to power, Ms. George!
The Stocking Is Mostly Full
With the exception of a resolution to the budget crisis, Tuesday probably saw the best combination of possible news and expectations that we could have for the remainder of 2012. The stocking is mostly filled with all of the gifts we are likely to get this year.
It started with the announcement that Greece managed to meet its goal for the bond buyback, as it attracted some €31bln in tenders. As it turns out, they had to pay more than the absolute highest price they were supposed to pay (the closing price on November 23rd), but as I noted at the time there was little to no chance of Greece completing the buyback without paying above-market prices, unless the sellers were coerced in some way, so that wasn’t really news.
Now, according to the Bloomberg story, the Euro finance ministers get to meet on December 13th to decide whether to release the €34.4bln tranche of the rescue which was contingent on a successful buyback. But the deal is almost done. Given the interest holidays and the lengthened maturity of Greece’s debt, it is looking increasingly likely that they’ve managed to delay the day of reckoning substantially. Sure, they did that by moving all of the debt to official institutions, who will carry it at par although it will eventually be defaulted on. Sure, this creates the risk of me-too-ism from other PIIGS who would like a lengthy payment holiday and hundreds of billions of Euros in support. But the risk that Greece will need to default in the near-term is passing. Of course, so is the need for Greece to continue austerity, once they’ve gotten everything they need from the Eurozone finance ministers. Maybe they were more clever than I gave them credit for…
So Greece was good news, and we’re also cheerfully waiting for tomorrow’s FOMC meeting. The results are so widely expected as to lead one to expect the intentions of the Fed had been carefully vetted beforehand. The overwhelming consensus is that the Fed will announce that they will cease half of Operation Twist: the half that has them selling short-dated Treasuries, of which the Fed now has almost none. The consequence is that the Fed will now be outright buying about $45bln in long-dated Treasuries, over and above what they were already purchasing in QE3, per month, without end.
Obviously, equities liked this idea because we all know that the script says stocks are supposed to ramp up into QE. More surprisingly, long-dated Treasuries actually slipped a bit lower. The 10-year yield is at 1.65% and 10-year real yields at -0.89%.
Now, here’s the problem as we roll into Wednesday. There’s really no chance that the Fed is going to do more than $45bln per month in Treasuries purchases, especially with the inconvenient (albeit cosmetic) downtick in the Unemployment Rate this month. Therefore, what is priced into the stock market is pretty much the best-case for QE.
Is there any chance that the Fed might actually do less, or even defer until the next meeting the decision about whether to pursue an acceleration of QE? The chart below (Source: Bloomberg) shows the 5-year inflation breakeven, 5-years forward, taken from TIPS and Treasuries.
Clearly, while inflation expectations are “contained” in the Fed’s view, they are plainly becoming steadily less-contained. The 5y, 5y forward BEI has been rising in a trend for fourteen months now, and it is above 3%. In inflation swaps, which don’t have embedded the financing advantage of nominal Treasuries over TIPS, the 5y, 5y forward is 3.17%. In short, the market is currently pricing expectations that the Fed will fail in its mission to keep core CPI inflation around 2.25%, and that there will be a long-lasting deviation from that target.
(As an aside: we can’t tell just from the point estimate taken off the yield curve whether market expectations are for a steady miss, or whether the expectation is for something fairly close to target, but with considerably “option value” because the upward tails are a lot longer than the downward tails. It appears that both are currently contributing to the high forward breakevens because implied inflation volatilities have been rising.)
Now, like everyone else I expect that the Fed will stay on the course that has been laid out for them by the market, and endorse a QE4 plan tomorrow. And I don’t think we’ll get Evans Rule parameters tomorrow. But, as I said, all likely surprises from that expectation are negative for equity markets, and even if the Fed delivers what has been writ then I’m not sure where we get a further rally unless the fiscal cliff is averted.
Fiscal Baby Steps Aren’t Worth the Angst
Unless today’s unseasonably-warm temperatures in the New York area (through some metaphysical conservation-of-energy mechanism) means that Hell is freezing over, we are a long way from resolution on the fiscal cliff discussions.
The Republicans countered President Obama’s proposal for a $1.6 trillion tax hike with their own plan that would cut the cumulative deficit (according to static scoring, as all of these proposals are) by $2.2 trillion through a combination of closing special interest loopholes, introducing deduction caps on high earners, increasing the Medicare eligibility age, cutting some discretionary spending, and using chained CPI as the Social Security escalator in order to slow the growth of benefits. After having previously lambasted the Republicans for not offering specifics, the White House today labeled the proposal “nothing new,” apparently without irony.
To be fair, the Republicans had called the President’s proposal a “la-la land offer.” So you can see, we are obviously very close to a deal and a smiling, hand-shaking, giddy signing ceremony in the Rose Garden.
All of this is sheer madness. These hikes and cuts are measured over the projection horizon, so we’re arguing about cutting perhaps 20% per year from the current trillion-dollar deficits. Good heavens, it’s a good thing we’re not trying to do something radical, like balance the budget. The combination of the national debt and the Social Security and Medicare liabilities add up to over $1.1million per taxpayer (Source: www.usdebtclock.org), and the debate is over cutting around $20,000 per taxpayer over the next decade. Don’t strain yourselves, fellows.
It’s incredible that some of these things are even subject to argument. The Medicare eligibility age will eventually be effectively infinity, because the program is not viable on this planet with health care such as we have come to expect, and since the liability is in real terms (units of healthcare, not of dollars) we can’t inflate our way out of it. So gradually moving the eligibility age a whole lot higher is something that we simply will have to do. Why not now?
People who say that cutting the deficit by $2.2 trillion over 7-10 years is hard to do have not actually tried it. It is actually pretty easy to get the budget back to some semblance of balance, as long as you don’t have to run for re-election or if you consider the future of the country to be more important than winning another term (and you know, there’s even a chance your constituents may reward that bold sacrifice!). All that you have to do is to reverse most of the things we’ve done to the budget over the last decade and you’re close – of course, the interest costs now are a lot higher, and will only climb in the future. But if you put entitlement reform on the table, it gets downright easy…again, if you don’t have to run for re-election.
Now, that interest portion of the deficit is somewhat scary. The chart below comes from Bloomberg, and it’s one of my favorite Bloomberg functions (DDIS). It shows the debt maturity distribution of U.S. Treasuries, and shows the interest and principal amounts currently scheduled.
It appears as if the interest costs (right column) max out at $196bln in 2013 and then decline, but keep in mind that these numbers ignore the fact that debt will be rolled when it matures. The $196bln is something closer to the baseline expectation, in the event that the Fed keeps interest rates anchored pretty near zero. It may be disturbing to note that the Treasury next year needs to roll $1.26 trillion in maturing securities, in addition to the $1 trillion of new money they need to raise due to the deficit; in 2014 the problem will start to grow even scarier as all of the 5-year issuance from 2009 starts to come due, along with all of the debt that has been rolled in the last couple of years. If you want to point to a come-to-Jesus moment in the bond market, it is likely to be in 2014 when this fact intersects with the expectation of the end of QE. It’s one thing to sell $2.26 trillion in Treasury securities if the Fed is committed to buying $1 trillion of them. It’s a little harder when they’re not, or if they are (as they claim they can) actually trying to sell some Treasuries from their own vaults. Good luck.
That’s why I don’t think we ought to be arguing over $200bln per year in the fiscal cliff. The problem is already much larger than that.
Now, that presumes that QE actually ends sometime in 2013. Some Fed officials have recently made noises to suggest that there is no reason that QE needs to end any time soon, and that the Fed is “nowhere near” the limit of what it can do. The problem is that 2014 will force a very serious choice on the Fed, because I think inflation is going to continue to rise throughout next year (our point forecast for core inflation is about 2.8% for 2013, but with all the tails to the upside), while I seriously doubt that Unemployment will get below 7%. And, as just noted, the market reality is that without Fed buying, the Treasury is going to have a devil of a time placing its debt in 2014 without higher yields (as an aside, I also suspect all dollar swap spreads will be negative in the next few years).
I’m not the only one who thinks that inflation is likely to be rising. While the nominal interest rate debacle is, in my opinion, not likely to hit us until 2014, rising inflation is happening today and the expectation of a continuation of that trend is being reflected in inflation swap rates. The chart below (Source: Bloomberg) shows that 10-year inflation swap rates are again up around 2.75%.
Now, if inflation expectations are rising but the Fed is going to fix nominal 10-year rates at 1.60%-1.80% where they are now, then the scary result is that TIPS yields, already ridiculously low, could go further. I am not bullish on TIPS, because as a rule I won’t buy something that is rich on the expectation that it might get richer. That way lies madness, since when the thing you bought goes down you have no plausible excuse. Moreover, speaking for myself, I know that I would be unable to maintain a position that I knew to be fundamentally mispriced the wrong way. But if 10-year inflation expectations went to, say, 3.6% and 10-year nominal yields were fixed at 1.6%, real yields would be forced to -2.00%. This is the reason I won’t short TIPS in the current environment, although I view them as overvalued.
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What article would be complete without news from Europe? Today Greece offered to pay up to €10bln to buy back their own bonds, with bids due Friday. Completion of this buyback is a precondition to Greece’s receiving the next tranche of the bailout, but it will be challenging if they refuse to pay market prices (as the Euro finance minister communiqué released last week suggested, since it limited the prices paid to those prevailing on November 23rd). It still is a philosophical step forward, since at least it serves to recognize the unrealized gains that Greece effectively has when its liabilities are priced where they are now. This is, after all, essentially the same thing that happens in a default: in that case, Greece would offer to pay 35 cents on the dollar for all of its debt. In this case, they’re trying to “default” on just enough of the private debt so that the public debt can be carried at par for a while and maybe, someday, be paid off at par.
I just wonder if they can make it to “someday.”
