What Will the Fed Do When It’s Finally Time to Tighten?

Housekeeping note: if you missed my comment on CPI from Friday, you can find it here.  And if you missed my Bloomberg Radio interview with Carol Massar on Monday, don’t worry! I will post it when Bloomberg makes it available on their site.

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One of the busier sessions in recent memory (although still well short of 1bln shares traded on the NYSE, which was the standard not that long ago) resulted in a sharp rally in the equity market with the S&P +1.2% on the day.

The trigger for this holiday treat was the “progress” in the budget talks and what investors see as the increasing likelihood that the ‘fiscal cliff’ is averted. Be careful, however; whatever progress there was is fairly speculative, and I suspect we will see a bad news wiggle before all is resolved.

It is ironic, perhaps, that what is moving the process closer to resolution is the Republicans’ sudden refusal to be steamrolled, and to instead try and play the game rather than try to negotiate as if both parties were trying to reach a fair resolution. I refer to the fact that Speaker Boehner has begun plans to start a separate legislative track in the House of Representatives by passing a bill that would keep the Bush tax cuts in place for most Americans; the bill would not avert the spending cuts that would take effect as part of the “fiscal cliff,” but would keep the government from reaching more deeply into citizens’ pockets on January 1^st. It is, therefore, just exactly what the Republicans would want in these circumstances: spending cuts without tax increases (although fewer spending cuts than they would like).

The fact that this is a good play from the standpoint of the Republicans was immediately apparent from the fact that Democrats wasted no time in accusing Boehner of not negotiating in good faith with the President, and the President himself abruptly began to try and compromise slightly from his heretofore rigid position.

Of course, the Boener plan won’t pass the Senate because it will produce exactly zero Democrat votes, and if it somehow passed by luck it would be vetoed by the President, so it has no chance to become law. However, by putting the Democrats in the position of having to vote against tax cuts, it greatly increases the chances that both parties might negotiate to something that all parties hate, and therefore passes with flying colors.

In the US system, by Constitutional writ all revenue bills have to start in the House of Representatives, so by the very nature of this process the Republicans, who dominate the House, hold the serve in this negotiation. Incredibly, this is the first time they’ve shown any desire to use that advantage to produce a bill that represents something closer to their views.

As noted above, equities reacted very well to the Republicans’ show of spine. I’d noted several weeks back that I thought the Republicans had little incentive to negotiate, since going over the fiscal cliff represents smaller government and this may be the only opportunity that party has to get smaller government in the next few years. If this move persuades the Democrats of this fact, and the President moves to address the spending problem rather than just trying to soak the rich, then the fiscal cliff may be averted. It’s really important in a negotiation, especially if a true compromise is to be reached, that your counterparty knows that you may walk away.

Personally, I think the odds are still against this happening before year-end, but some resolution fairly early in the new year is probably odds-on. However, with the debt ceiling also approaching, 2013 may well see more of these cliffhanger negotiations.

Bonds, interestingly, sold off. You would think that the prospect for a smaller deficit, even marginally, would help the Treasury market but in this case I think investors are reacting to the fact that if the fiscal cliff is averted, it lessens the chance of near-term recession and brings forward the day of reckoning for the Fed. Today, 10-year Treasury yields rose to 1.82%, which is near the highest level since early May, and 10-year real yields rose to -0.73%. Over the last five days, nominal yields have risen 16bps, and all of that has come from real yields. That is, inflation expectations have barely moved and 10-year breakevens remain at 2.50%. Ten-year inflation swaps are at 2.77%, and the important 1-year inflation, 1 year forward has risen to 2.23%.

So, whether the ‘day of reckoning’ for the Fed is near, or far…what do they do, when they’ve hit that point? And, more importantly, what does it do to the market?

Let’s assume that we are at some point in the future and either the Unemployment Rate has dipped below 6.5%, the forward PCE inflation rate has risen above 2.5%, or inflation expectations have become “unanchored.”[1] The first thing that the Fed will do is to stop unlimited QE: the statement does not imply that they will immediately start trying to get out of the hole they are in, only that they will stop digging the hole. But suppose that inflation continues to tick up – since the evidence is that inflation is a process with momentum. What does the Fed do next? This is the real question. How quickly can the Fed react to adverse inflation outcomes?

The traditional option is that the Fed raises the overnight rate. The Fed announces this move, but the important part is what happens next: the Open Market Desk (aka ‘the Desk’) conducts reverse repos to decrease the supply of reserves, or sells securities outright if it wishes to make a more-permanent adjustment. This causes the price of reserves (also known as the overnight rate) to rise, and the Desk adjusts its activity so that the overnight rate floats near the target rate.

The problem is that this won’t work right now. There are far too many reserves in circulation for the overnight interest rate to be increased by reverse repos or small securities sales. In fact, if it wasn’t for the interest being paid on excess reserves, the overnight rate would certainly be zero, and might even be negative because the supply of reserves greatly outweighs the demand for reserves. They are called “excess” reserves for a reason – the bank doesn’t need them, and will lend them overnight for pretty much any available rate.

So in order for the Fed to push the overnight rate higher, it must first soak up all of the excess reserves in the system – about $1.5 trillion at the moment – by selling bonds. Obviously, this is not something that can be done in the short-term.

But this misses the point a little bit anyway, because it isn’t the rate that matters to monetary policy but the amount of transactional money (such as M2). The Fed can set the overnight rate at 1% by simply agreeing to pay 1% as interest on excess reserves (IOER). But that won’t do anything at all to M2, because it won’t change the amount of reserves in the system and doesn’t change the money multiplier that relates the quantity of those reserves to M2.

So the short rate is dead. It isn’t going to move for a very long time, unless the FOMC decides to help the banks out by paying a higher IOER. And if they do that, it’s not going to affect inflation so it would just be a sweet present to the banks.

Okay, so perhaps the Fed can sell those long-dated securities and push long-term interest rates higher, slowing the housing market and the economy and squelching inflation, right? That’s partly right: the Fed can sell those securities, and it can push long rates higher (although the Fed has oddly claimed that if it sold those bonds, interest rates wouldn’t rise very much, which makes one wonder why they did it in the first place since presumably the opposite would also be true and buying them wouldn’t push rates down), and that would slow growth. However, it wouldn’t affect inflation, because inflation is not meaningfully affected by growth (I’ve discussed this ad nauseum in these articles; see partial arguments here, here, here, and here). But you don’t have to believe all of the evidence on that point; just play it in reverse: if driving long rates down didn’t cause a sudden jump in inflation, why would driving long rates up cause a sudden dampening in inflation?

Fama, in that article I quoted last week, had a very good point which I thought it was worth developing in more detail. The Fed has its hands off the wheel with respect to inflation…which isn’t a problem, except that they’re sitting in the back seat. The back seat of a very, very long bus.

In any event the issue isn’t when the Fed starts its tightening, but when inflation stops going up. These are not the same things. If core inflation were to start ticking higher today, at a mere 1% per year, I think it would take 6-9 months for the Fed to stop QE (core PCE is at 1.6%), probably another 3 months at a minimum before they started to tighten, and then at least 1-2 years before they could have any meaningful impact on the money supply and cause inflation to slow. Maybe I’m being pessimistic, or maybe I’m being a bit generous by assuming that after a year the FOMC would start doing something very dramatic to sop up reserves, like issuing a trillion dollars in Fed Bills, but even assuming that everything works out just about as well as it conceivably can, if inflation started heading higher in that way then you’re looking at a core CPI figure of 4-5% before it stops rising. Like I said, it’s quite a long bus, and that translates to long “tails” of inflation outcomes.

How would markets react to this? Obviously, bond rates would be much higher, but would this be good or bad for equities? The conventional wisdom holds that equities are good hedges for inflation, because over a long period of time corporate earnings should broadly keep pace with inflation. While that is true, it is also the case that earnings tend to be translated into prices at lower multiples when inflation is high (a fact that has been known for a long time; in 1979 Franco Modigliani and Richard Cohn described this as an error but there isn’t consensus on that issue) so that stocks tend to do relatively poorly when inflation is rising and better when inflation is falling from a high level. Moreover, stocks do especially poorly in the early stages of inflation when short-term inflation is surprising to the upside, as the chart below (Source: Enduring Investments) illustrates.

This chart highlights headline inflation, rather than core, but the point should be clear: nominal bonds and equities produce good real returns when inflation is surprising to the low side (even if that means that inflation is just going up slower than expected), and very poorly when inflation surprises to the high side (even when the overall level is low).

In my mind, this means that every investor needs to have some inflation protection, but especially now when the chances for an ugly inflation surprise are significant. For the record, the best asset class when inflation is surprising to the high side as measured here? Even inflation-linked bonds have produced negative real returns in such circumstances, because the real yield increase outweighs the higher inflation accruals in the short run. But commodities indices historically produced a 4% real return over that time period when inflation surprised at least 2.5% to the upside.

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[1] It isn’t clear to me why you would want to wait until they were unanchored, if anchoring matters, since presumably it isn’t easy to anchor them again. After all, the whole reason the Fed wants anchored inflation expectations is because a regime change is thought to be hard – so if they are unanchored, you’ve just made it really hard to get inflation back down. In any event there’s not much evidence that “anchored” inflation expectations matter to actual inflation outcomes, but it’s just weird to me that the Fed would imply that they’d wait until expectations get loose from the anchor.

A Summary Of My Post-CPI Tweets

This is a summary of my Post-CPI tweets today. You can follow me @inflation_guy.

• Core CPI +0.146%, just barely missing the soft +0.2% people were looking for. But y/y still rose to 2.0%.
• that dip in core is over – next several months have easy year-ago comps.
• Services inflation +0.3%, as is Housing. It’s only core commodities that’s a drag now (+0.0% after -0.1% last month).
• Rents (both primary and OER) rose +0.2% and the y/y rise matches core inflation at 2.1%. The inflation-sapping bust is over.
• unrounded y/y core CPI: 1.988%.
• Y/Y core services inflation is 2.5%. Y/Y core goods is +0.7%. It was services that dragged core down in 2009-10. That’s over. [Note: see Chart, source BLS, below]
• accelerating subgroups: Housing, Apparel, Transport, Recreation (66.2%). Decelerating: Food&Bev, Other (20.2%). Med Care & Educ/Comm unch.
• Both primary rents (+2.7% y/y) and OER (+2.1% y/y) are accelerating – by which I mean they are inflating at a faster y/y pace.
• Median CPI from the Cleveland Fed was +0.2%, and the y/y rate steady at 2.3%. The recent disinflation is an illusion.

The first supplementary chart is for core goods and core services. The sum of these two (weighted, of course) is core CPI. As you can see, it was the decline in the core services component (notably housing) that drove the decline in core CPI in the late ‘Aughts; the overall core number was temporarily kept afloat by the rise in core goods, but the crisis caused that to collapse as well.

Over the last couple of years, core services have returned to 2.5%, and core inflation is only as low as 2% now because core goods prices have begun to decline again. However, taking a broader view, it appears to me that the disinflation in goods from the early 90s to the early 00s is over and that goods prices are gradually taking a higher track. I’ve written previously about the possibility that the “globalization dividend” in terms of disinflationary pressures has shown some signs of ebbing. Obviously, should core goods inflation return to the levels it achieved a year ago (2.2% in November and December), overall core inflation would be comfortably above 2% even if core services inflation did not continue to accelerate.

In a non-CPI related note, New York Fed President Bill Dudley said today that the Fed won’t be “hasty” to pull back easy money: “If we were to see some good news on growth I would not expect us to respond in a hasty manner.” This confirms what we already knew – the Fed is willing to risk letting the inflation genie out of the bottle. Now, faster growth is not actually causal of inflation, as I frequently point out, so not responding to growth is ironically the right strategy, but it’s important to consider the reasons he gives for this policy. He is not saying that the Fed will not respond to growth because growth is not something they can affect; what he’s actually saying is that (since the Fed believes they can affect growth meaningfully) there is a very high hurdle to tightening even if prices accelerate somewhat further as long as growth remains slow.

So in what I think is the most likely case, continued slow growth with rising inflation, the Fed wouldn’t likely start to tighten the screws until core inflation was near 3% (and more importantly, until the economists who are modeling inflation as a function of growth decide they’re wrong, and stop forecasting a decline from whatever level we are at today). Since there is a significant delay of at least 6 months from Fed action to any effect on prices, this means that core inflation could easily get comfortably above 3% before any Fed action took effect – and, with the amount of money they’d need to withdraw, and the likelihood that they would start timidly, I have no idea how long it would take for them to stop an inflationary process which, at that point, would have considerable momentum.

So, in summary, this will not be the last uptick we see in core inflation.

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.

Is Inflation Flowering?

To know that you’re standing before a cherry tree, you needn’t have cherries; cherry blossoms suffice. The seasons are long, so if you want to be able to harvest the fruit you need to look early for the signs.

So it is with inflation, and some would say it is with markets in general. We look for the early hints (a less-poetic scribe might call them ‘green shoots’) that signal when the season has turned. With inflation, indeed, the season has turned long ago, when core inflation bottomed in Europe, the U.S., and Japan in 2010 (and in the UK even earlier). But as we have seen, markets have not yet internalized this turning, or in some cases (as with nominal yields) have begun the recognition and then reversed it.

Consider now the humble 7.5% gain this month in the DJ-UBS commodity index (and comparably large moves in many other indices). It isn’t the size of the move, or its consistency, that is interesting to me; rather, it is that the movement has come partnered with a break of commodities’ relationship to the dollar.

Since commodities for the most part are priced in dollars, it is natural that they tend to move in the opposite direction from the greenback. When the dollar strengthens, then commodities are more expensive to non-dollar consumers, and they demand less. Yes, of course there are other factors, but when there are no stronger underlying currents then commodity indices tend to move inversely to the dollar. The chart below (Source: Bloomberg) illustrates the strong coupling of the dollar index (here inverted) and the DJ-UBS Commodity Index in yellow, both normalized to August 1^st, 2011.

But note that this recent movement in commodities has come not in conjunction with a weakening in the dollar, but in spite of a strengthening (albeit a modest one) of the unit. This, I think, may be the first blossoms of spring in commodity-land.

Some may object that the rise in commodity prices is primarily driven by grains, but this is not the source of this divergence. The chart below (Source: Bloomberg) shows the dollar index again (and again inverted) against the DJ-UBS ex-Agriculture Commodity Index.

I am not a disinterested observer of the Commodity Spring, as readers well know; our models have for some time now indicated that commodities were the only outright-cheap major asset class and our main strategy has been heavily overweight them for quite a while. So perhaps I will be accused of seeing blossoms where none have yet bloomed. But as commodity indices approach their highs of the year, they are still only 14-15% off their lows, and far below their highs of a few years back. They remain the cheap asset class.

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Moving to inflation more-broadly, it seems the market is growing comfortable with the notion that core inflation may have topped since it hasn’t risen appreciably in a few months. It is certainly useful for those expecting QE3 – as am I – if that perception gains currency (no irony intended) since de-fanging the hawks on the Federal Reserve Board would seem to be a sine qua non for loosening policy appreciably. But I believe that comfort is ill-placed.

I had been expecting, based on the lagged effect of the large inventory of unsold homes last year, for the housing portion of core inflation to ebb from its recent pace. It has merely flattened out, and while inventories are coming down those declines shouldn’t begin to push shelter CPI up for another quarter or two. But long-lag relationships are inherently difficult since the lags can shift over time. So let’s look at a shorter-lag relationship.

The housing component of CPI is driven by rents, both for consumers who rent their residence (“Primary Rents”) and for the consumption value of owner-occupied housing (“Owners’ Equivalent Rent” or OER). The chart below shows the relationship between OER and the CBRE index of rents on multifamily property, lagged 2 quarters (the red dot marks the last OER point). The goodness of fit of this relationship, shown for the period 2001-present in the Chart below (Source: Bloomberg and BLS), is quite reasonable[1] but interestingly, the recent rises in rents suggests that OER is significantly understated.

The number for the rental series ending in Q1 suggests that OER, which was last at 2.03% year-on-year in June, should be more like 3.4%. Since OER has a 23.5% weight in CPI and a 30.7% weight in core CPI, if OER were to converge it would be worth 0.4% on core inflation. And rental increases do not yet show much sign of ebbing. In short, the flattening out of core inflation over the last few months may represent the extent of what we can get out of housing at this point.

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The last piece of evidence is really more corroboration of a speculation I’ve previously mentioned here.  The sudden revival in apparel pricing this year has caught many analysts by surprise, and most have been expecting for the series to relapse soon (the price of cotton is often blamed, as if cotton hasn’t had any previous spikes in the last twenty years). My speculation was that the flattening and declining of apparel prices beginning in the early 1990s could plausibly be related to the opening of the U.S. textile industry to global competition, but if that is true then there must eventually come a time when the globalization has run its course and there are no more gains to be had from the declining domestic labor content in apparel. Thereafter, the rise in prices going forward should reflect rising wages in the source economies, without the dilution of changing composition.

Now Morgan Stanley has published a piece, by Joachim Fels et. al., called “Margin Call” (July 25, 2012). The authors illustrate that the U.S. margins of Chinese exporters have shrunk by 20-30% between 2004 and 2010, and argue among other things that “Price increases for Chinese imports and the spillover effects these are likely to generate may contribute to meaningful upward pressure on inflation.” This is not inconsistent with my speculation above, but adds a separate potential cause for the rise in apparel prices and other China-sourced prices (significant among them, incidentally, resin prices).

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All in all, these pieces of evidence contribute to my belief that as consumers we ought to take time to smell the flowers, because the harvest of cherries is likely to follow in train. And in this case, that would be the pits.

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[1] The R² should be taken with a grain of salt, however, since these are overlapping observations.

A Soft Evans Rule In Place

So in the end, we got about what I expected from the Fed.  Operation Twist was extended, and actually a bit more than I thought they would be able to extend it as the program will continue through year-end.

I said that I would “look for signs that an Evans-type rule is being implemented,” and we got a hint of that as well. Remember, the “Evans Rule” is a conditional policy directive modeled after Chicago Fed President Evans’ suggestion that the FOMC should provide easy money until unemployment falls below 7% or core inflation rises above 3%. Obviously, the parameters “7%” and “3%” are where the rubber meets the road – without parameterization, the policy reduces to roughly what the Fed said in its statement:

 “The Committee is prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”

Put “an unemployment rate below seven percent” in place of “sustained improvement in labor market conditions” and “core price inflation at or below three percent” in place of “price stability,” and you have exactly the Evans Rule. I doubt most of the Committee would accept 3% as an acceptable level for core inflation, but by backing into the Rule in this way the FOMC can argue later about what those parameters actually are.

Bernanke reinforced the point in his after-meeting presser, when he made clear that this didn’t mean that stability at 8.2% unemployment would be okay. He said “If we don’t see continued improvement in the labor market, we’ll be prepared to take additional steps if appropriate.” Moreover, the Fed is willing to consider further asset purchases and “still has ammunition.” (So you see – they’re relevant!)

Since I think the Unemployment Rate is fairly likely to rise, or at least not to fall, from this level, I believe the QE3 crowd got about the best that they could reasonably hope for. There was no sign leading into the meeting that policymakers were thinking seriously about another large-scale asset-purchase (LSAP) program, so it would have been a true shock if one had been delivered. If Greece had already exited the Euro, we probably would have seen it, but otherwise they will take their time to “communicate the strategy clearly” over the next month and a half. That communication will probably not take the form of outright speculation that some more LSAP is needed; with the ball teed up, all speakers need to do is lament the failure of the labor market to do better and the implications are already writ clearly.

It makes sense to go slow here. The economy is weakening, but not plunging. The crisis in Europe is less urgent, for today. The Twist has been extended, so they’re not standing idly by, and they’ve satisfied the importance of appearing relevant and concerned with their statement and promise of great things to come in the future. The ECB two weeks ago didn’t ease, and the MPC of the Bank of England narrowly voted against Chairman Mervyn King (in a true democracy, the Chairman sometimes loses), who was seeking to expand the BOE’s bond purchase program. The MPC said there was “merit in waiting” to see how things play out in the next few weeks in Europe.

To me, it sounds like July and August will see the next round of QE commence, probably from all major central banks, unless somehow the situation in Europe really does seem to be moving towards an extended period of calm and/or U.S. growth springs forward abruptly. I don’t see either of those things happening, but the benefit from waiting is that they might. In the meantime, the only thing the Fed loses is an extra couple of weeks goosing the stock market, but they can get that anyway once the communication strategy commences in earnest.

The data mill churns tomorrow after a couple of days off, with Initial Claims (Consensus: 383k from 386k) tomorrow along with Philly Fed (Consensus: 0.0 from -5.8) and Existing Home Sales (Consensus: 4.57mm from 4.62mm). The Philly Fed number is the most interesting one, as economists are expecting a significant rebound from last month’s 14-point decline. I’m not sure why I’d look for a bounce; the NY Purchasing Managers’ Index also dropped sharply in May and the Empire Manufacturing figure fell sharply in June. I wouldn’t be expecting a big jump from Philly Fed.

Leftovers

Friday was a lethargic day, with gorgeous weather producing in many market participants a justification for leisure running something like this: Europe is having a conference call over the weekend about Spain and Spanish banks, and Spain is supposed to be formally requesting aid.  As of the announcement on Saturday afternoon, we might have an entirely new set of rules. So why take any risk on Friday?

You have to admit, they have a point.

Not being as predisposed to such leisure, since I am an entrepreneur, I am writing an article today. Actually calling it an ‘article’ may be strong; actually, it’s a compilation of some random thoughts that didn’t make it into my articles this week.

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1. One commenter asked what the chart of the “hypothetical S&P price history” that I showed in yesterday’s article would look like in real space. He hypothesized that we are probably a long way away from a real high. Well, DougM, you’re right. The chart is below. Note that this is just the price index, so that your real total return would be essentially the price change on this chart, plus dividends…which works out, you can see, to basically dividends although if we ignore the first little dip to get us from the red line to the blue line, it works out to be something like 0.75% per annum real return (plus dividends). And yes, it will be a very long time until we party like it’s 1999.

2. Earlier this week, I wrote that the “Inflation Risks [Are] More Balanced, But Not By Much.”  But I wasn’t clear about what I see as the central tendency, which is to say what I think will happen to inflation “probably.” Core inflation is rising in the U.S., U.K., Europe, and Japan, and in my view there is every reason to expect that trend to continue. The driver of that inflation, which is to say hearty money growth, remains in place. It wasn’t growth that was pushing inflation higher – so the ebbing of that growth is not important to my view. I still expect core inflation to continue rising this year from the current 2.3% in the U.S.
3. What should the Fed do, if it can’t reduce rates any more and is reluctant to expand the balance sheet further? Well, if I was at the Fed and I wanted to stimulate the economy, the first thing I would do before going out and buying more powder would be to ignite the powder I’ve already bought. The FOMC should simply remove the Interest on Excess Reserves (IOER), which has contributed to the huge scale of excess reserves. In fact, ideally they would penalize excess reserves. If the Fed set IOER at -3%, you would see aggressive lending from the banking sector. Yes, many of them would be non-economic loans (if the bank can lock in only a 2% loss after the inevitable defaults, it is worth doing), but you would get loans. The Fed doesn’t want to do that because they think it will crush the money market industry. Well, exactly how well is the money-market industry doing at the moment anyway? Sure, you have to choose which bad effect you want, but don’t whine about running out of tools just because you think the money market industry is more important than the proper conduct of monetary policy.
4. This is an old story, but it just goes to show you that when real interest rates are below zero, any commodity becomes a good store of value. Apparently the Procter & Gamble brand of detergent Tide is being used in some neighborhoods as a medium of exchange and store of value - that is, as money. The articles pooh-pooh the stories of Tide heists, but to me that’s not the interesting question. If real interest rates were, say, 3%, or nominal interest rates were 5% or 6%, then the use of bottles of Tide as currency would make much less sense since they will always have a 0% real return over time (just like a bar of gold or a roll of copper wire) and you would lose real purchasing power by putting Tide, lumpily, under your mattress. But when real interest rates are -1%, Tide actually outperforms – as should all commodities. This is one reason why commodities normally do very well when real interest rates are low.
5. Corporate bond issuance is a long-inflation bet. If corporate treasurers believed there would be deflation, they’d issue inflation-linked bonds. The complete lack of inflation-linked bonds despite incredibly low real rates represents a bet that company CFOs are making that inflation will be higher in the future than it is expected to be now, based on the difference in fixed yields compared to inflation-linked yields. Or, it might represent ignorance, since if the market-clearing price for inflation is fair then we should see a much more balanced pattern of issuance with some issuers favoring ILBs and some favoring nominal bonds. But either way, it is certainly not a strong endorsement for the deflationary view – in a deflation, the last thing you want to do is issue fixed rate bonds.
6. If you own XYZ company, and the firm suddenly doubles its share count, each share of XYZ should roughly halve in price (and therefore buy half as much in exchange). We say in that case that you have been diluted. Now consider that the dollar itself is like a share of America, in that it entitles you to a certain amount of output of other people’s goods and services. What do you think should happen when your shares are “diluted” because the Fed has increased the “share count” by 27% over the last four years? Shouldn’t those shares buy less in exchange? That’s called inflation. If you don’t have 27% more dollars now than you did in June of 2008, then you have been diluted. And deluded.

Have a nice weekend.

Spooky Action At A Temporal Distance

The parallels of the current equity market rally to the August 2010-February 2011 rally following Chairman Bernanke’s hints about QE2 (a parallel I mentioned first about a month ago here) continue to mount. I can’t call today’s rally (a mere 0.1% on the close) a ‘cheerful’ rally except in the context of what might have been. Over the weekend, the G20 met in Mexico City, partly to discuss whether to increase the global commitment to a European solution (via funding for the IMF, which would then pitch in more than it has pledged to do so), and in very clear terms said no. That anything “in clear terms” would come out of a G20 communiqué is in fact unusual, but there seemed little doubt that further aid will not be forthcoming unless the Eurozone members themselves increase their commitment further.

Stocks were mildly irritated about this surprise in the overnight session, but only mildly, and that negativity was erased when the German parliament approved the Greek rescue package this morning. There was no doubt that it would do so, and yet there was a relief trade anyway.

Again, this reminds one of the mood in Q3 2010, when there were plenty of reasons for stocks to stay down (if not to fall further) and yet the market climbed; not only that, but it climbed inexorably. (It should be noted that core inflation bottomed in the month immediately preceding the month that QE2 was formally announced, although the precise timing is surely spurious.)

Another parallel is worth exploring here. The August 2010-February 2011 rally was actually in two parts. The first part ran from late August, when Chairman Bernanke delivered the Jackson Hole speech in which he all but promised QE2, until the week of the November FOMC meeting and the announcement of QE2. It covered 70 days and around 175 S&P points. Through the end of November 2010, while QE2 actually began, equities nevertheless declined about 50 S&P points; beginning in December and continuing through February 2011, the next leg tacked on another 175 S&P points over 79 days.

So far, this equity rally has covered 69 days and 167 S&P points. The similarity so far in pace and scope has been striking, with the main difference being the extremely weak volume on the advance. Now, there is no FOMC meeting tomorrow, and so the parallel is surely going to break down. Moreover, there seems not much chance that the Fed will announce a QE3 at the March 13^th meeting. If there is a parallel, are we going to rally until the Fed actually announces QE3, or are 70 days and 175 points the measure to compare?

I suspect that the market has extended itself enough that, QEx or not, it is due for some turbulence. And, frankly, a 50-point setback wouldn’t exactly crush the bull swing any more than the 50-point correction in November 2010 did. Leveling off and correcting into the end of the quarter, or at least into late March when we will find out for sure if Greece navigated one more payment bulge, seems reasonable to me especially with the cyclically-adjusted P/E up above 22 and the S&P dividend yield down below 2% (now 1.99%) again.

The parallel in bonds is somewhat more interesting. Bonds had rallied into the 2010 Jackson Hole speech, with 10-year yields falling from 4% in April to around 2.5% when the speech took place. So the rally in fixed-income had already taken place, and little else happened in nominal yields over next couple of months (see chart, source Bloomberg). But inflation breakevens rose sharply and real yields (not shown) fell, so that while nominal yields were not moving in the aggregate, inflation swaps actually rose about 50bps and real yields fell about 50bps between August 27^th and the Fed meeting in November. I first wrote about this divergence here and here.‎

While nominal yields were not registering anything in particular between Bernanke’s loud hints about QE2 and the formal announcement thereof, there was considerable action below the surface. With that back story, consider the history of yields and breakevens since last summer, illustrated in the chart below.

The divergence is more subtle, to be sure, but at least since the beginning of the year breakevens have been moving steadily higher while real yields steadily fell. The tale of the tape: 10-year inflation swaps since year-end, +37bps (was as much as +44); 10-year real yields -32bps (was as much as -35bps).[1]

Coincidence? I don’t think so. This rally has all the hallmarks of being money-induced, whether it’s the perceived promise of QE3 or the actual LTRO from the ECB and other monetary actions from other benevolent central banks. (Oh, how interesting. LTRO2 is the day after tomorrow, about 71 days after the beginning of the first leg.) Had this been an actual rally on strong economic fundamentals, we should have seen real yields rise.

There have been a couple of other developments worth noting in inflation-land recently. One is that the short end of the curve has risen appreciably, so that the 1-year inflation swap rate is above the 2-year swap rate – something which hasn’t happened since March and April of last year when oil prices were also on the rise (and 10-year nominal yields were about 150bps higher than they are now). Actually, the whole shape of the swap curve is different than it has been for a while (see Chart, source Enduring Investments).

Although you can’t see it from the chart, 5y inflation 5 years forward (aka 5×10 inflation) is above 2.90% and is threatening 3%. That hasn’t happened since last August (when 10-year nominal yields were 50bps higher than they are now).

Oh, and what happened to 10-year nominal yields after the first leg of the QE2 trade, and their long period of quiescence? Between November 4, 2010 and December 15, 2010, they rose by 100bps.

Incidentally, in 22 of the last 31 years, 10-year yields have risen in the 30 days following February 27^th. While 10-year note yields have fallen some 1200bps over those 31 years, they have risen, on average, about 20bps between now and early May (see Chart, source Enduring Investments).

It is, in short, an inopportune time to be long fixed-income. And, frankly, I’m not too sanguine about stocks, as I have said. Our model continues to allocate quite heavily to commodities in this environment, as do I in my personal accounts. Among ETFs, I am long USCI, GSG; long INFL and RINF as long-inflation expectations plays, and long TBF to be short nominal bonds. I also own SPY puts and FXY puts (which is unrelated to what I discuss above) in small amounts.

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[1] Note that I’m correcting the 10-year real yield for the substantial roll to the new TIPS issue, as otherwise it looks like real yields have fallen less than they actually have.

Model vs. Reality: Reality Wins

The bond market ended Thursday nearly unchanged, although short TIPS did very well because energy markets continued to trend higher. Gasoline rose 0.8% to $3.1136/gallon and NYMEX Crude added 1.5% to $107.83. Precious Metals were also higher. Stocks gained 0.4%. It is hard to believe this can merely be enthusiasm over growth and a “risk on” trade associated with the purported resolution of Greece’s troubles. In fact, I will say that with the almost unanimous acceptance of the notion that “the crisis is over” among the mainstream media makes me very nervous. Apple has recovered its losses from last Thursday, although on a fraction of the volume it had on the selloff, but I am accumulating equity hedges. Implied vols are at a 7-month low, but I don’t think risk is.

That is all I am going to say about market action today, because I want to mention a research publication that crossed my desk today and discuss what it means to a trader who is also an econometrician.

Goldman Sachs Global Economics, Commodities and Strategy Research today produced a piece called “The Top-Down Logic for Our Inflation Forecast.” In it, the economics team explains why they are calling for core inflation to fall to 1.5% in 2012, and 1.3% next year. Their reasoning is the “the combination of labor market slack and anchored inflation expectations should reassert itself in lower core price inflation over time.”

Frequent readers of this column will know that I have rebut the labor market slack hypothesis a number of times, and while I haven’t explicitly rebut the ‘anchored inflation expectations’ argument (mainly because modeling this requires complicated regime-shifting models that make it hard to refute null hypotheses) I am highly critical of them since the evidence in support of the notion that inflation expectations matter is based on measures of inflation expectations that demonstrably fail to measure inflation expectations.

So, you would think that these few paragraphs would be criticizing the forecast of Goldman Sachs. But that’s not really my point. Really, I want to point out the really hysterical part of the note, and observe why sell-side economic analysis is so useless (although some economists at Goldman, to be fair, are quite good). Goldman says “Although the model failed to capture the sharp pick-up in inflation in 2011, our bottom-up analysis suggests that this deviation was chiefly driven by special factors outside of the scope of the model, including pass-through from surging commodity prices and a spike in auto prices.”

Yes, that’s right: if there’s a discrepancy between reality and the model, then obviously it is reality at fault and not the model!

To make the hilarity of this point clear I reproduce below the chart from their piece:

So all the model failed to do is to pick up the most-dramatic rise in core inflation in the last 35 years or so.

To make this fair, here’s my own model (now Enduring Investments’ model) covering the same period. Note that the model forecasts are actually finalized about 12 months ahead.

As I’ve said frequently, the current surge in inflation has not been fully captured by our model (although if we distributed the lags, rather than doing a simple lag, it would probably have done better, as the strange spike in late 2011 suggests). But at least it got the direction right, and began to rise at the right time, and for the right reasons. And, unlike Goldman, I think the reason for the difference is that our model isn’t quite right and is missing or underestimating some effect – so I expect our model will catch up with reality, rather than the other way around as Goldman does.

If an economist is highly confident in the model, then it can be reasonable to expect minor deviations to be mean-reverting. But it’s the model that’s mean-reverting, not reality (it is a model, after all – it isn’t supposed to capture all the nuance of reality). And if there is a significant deviation in reality from the model, then it can make sense for an economist to hew to the model if he’s 100% confident in the model. But then, if he’s 100% confident in a model, he’s an idiot. Which reminds me of this:

Bernanke: Well, this fear of inflation, I think is way overstated. We’ve looked at it very, very carefully. We’ve analyzed it every which way…We’ve been very, very clear that we will not allow inflation to rise above 2% or less…We could raise interest rates in 15 minutes if we have to. So, there really is no problem with raising rates, tightening monetary policy, slowing the economy, reducing inflation, at the appropriate time…

Pelley: You have what degree of confidence in your ability to control this?

Bernanke: One hundred percent.

Aside from the irony that we’re already above 2% (although not in core PCE, which he will claim should be understood), the other commonality (besides utter confidence in the model) between Goldman’s economists and this Princeton economist is that they’re absolutely confident that they have the right model: labor slack and inflation expectations. So far, we have seen from neither one of these sets of economists any deep introspection about whether maybe, perhaps, labor slack and inflation expectations don’t really matter, but things like money supply do.

Incidentally, while our model’s forecast for year-end is 2.10%, if we’re right on the trend but wrong on the starting level (that is, if the effect we missed was around the bottom and isn’t something persistent) then the more-relevant figure is the 0.8% acceleration in y/y core CPI our model expects in 2012. That would put core inflation at a cool 3%. Interestingly, if we remove the dampening effect the high level of private debt has in our model – that is, if we simply hypothesize that the ratio of private/public debt has a discontinuous effect so it either dampens (at high private/public ratios) or does not dampen (at moderate or low private/public ratios), then we also get 3%. That hypothesis, obviously, is difficult to test, which is why it’s important to not be 100% confident or reliant on your model, and to always be skeptical that you may be missing a key dynamic. Life is not linear. The reason that these economists don’t know that is that they’ve never tried to trade a model! If you are an investor who relies on models, a healthy – and continuous – skepticism is your best defense against reality diverging from your model.

I suspect something in between our model’s forecast (2.1%) and our model’s forecast for acceleration (implying 0.8% acceleration) is right, and so 2.7%-2.8% is our official forecast. By the way…not that it matters, if labor slack and inflation expectations are all that matters…but M2 rose $27.9 billion in the latest week and continues to grow at a better-than-10% pace year/year. It first hit that pace exactly half a year ago.

On Friday, New Home Sales for January (Consensus: 315k from 307k) is due out at 10:00ET. More interesting is that a number of regional Fed Presidents are in NY to speak at a conference on monetary policy. The conference begins at 9:00ET, so be prepared for tape bombs all day from San Francisco Fed Williams, St. Louis Fed President Bullard, Philly Fed President Plosser, and NY Fed President Dudley – a former Goldman Sachs economist, by the way. It will be interesting to hear if any of them is interesting in examining his model, or if they all expect reality to conform to the model.

It being Friday, we are supposed to have some rumors about a Greek deal over the weekend, but I am not sure how to play that since we supposedly have a Greek deal already. Perhaps this means that there won’t be such great expectations, and we can all enjoy the weekend for a change.

Inflation: As ‘Contained’ As An Arrow From A Bow

Is 15 months in a row of rising core inflation ‘contained?’

Year-on-year core CPI has now risen for 15 consecutive months. At some point, it will seem reasonable to let it have a month off, but until now it hasn’t needed it. Fifteen months in a row. That’s impressive. It’s so impressive, in fact, that it hasn’t happened since 1973-1974, when prices were catching up from the failed experiment of price controls imposed by President Nixon in 1971-73. Core inflation has never, in the history of the data (which exists since 1957), accelerated for 16 consecutive months. So, next month we have a chance for a record!

Headline inflation was softer-than-expected by 0.1%, even as the NSA CPI index itself came in higher-than-expected. As I pointed out yesterday,  that was a semi-predictable consequence of the change to new seasonal adjustment factors. Core inflation was 0.218% month-on-month, however, which actually generated a rise in the rounded year-on-year index to 2.3% (2.277% to three decimal places). The table below shows the evolution of the year-on-year changes for the eight major subgroups from 6 months ago to 3 months ago to last month, to now.

	Weights	y/y change	prev y/y change	3m y/y chg	6m y/y chg
All items	100.0%	2.925%	2.962%	3.525%	3.629%
Food and beverages	15.0%	4.212%	4.452%	4.470%	4.001%
Housing	40.2%	1.876%	1.874%	1.869%	1.453%
Apparel	3.5%	4.664%	4.573%	4.194%	3.056%
Transportation	16.5%	4.961%	5.197%	9.185%	11.980%
Medical care	6.9%	3.605%	3.491%	3.116%	3.199%
Recreation	5.9%	1.372%	1.027%	0.253%	-0.173%
Education and communication	6.7%	1.838%	1.670%	1.371%	0.982%
Other goods and services	5.3%	1.740%	1.701%	1.660%	0.847%

Compared to last month, Apparel, Medical Care, Recreation, and Education/Communication accelerated, groups which total 23% of the consumption basket. Transportation and Food & Beverages both decelerated, and they total 31.5% of the basket. Now, notice that Transportation and Food & Beverages are the two groups that are most affected by direct commodity costs – energy and food, respectively. So…don’t get too excited by the deceleration there, although new and used motor vehicles and other components of Transportation also decelerated and that doesn’t have much to do with energy prices. In Food & Beverages, “Food at home” is decelerating (about 57% of the Food & beverages category) while “Food away from home” and “Alcoholic beverages” (the balance of the category) are accelerating.

Yes, you can get eyestrain looking too closely at these figures, but doing so does help.

For example, one theme I think the Fed is counting on is that the “Housing” component of CPI is expected to decelerate due to the still-high inventory of unsold homes and the fact that foreclosure sales can now proceed. It has been a conundrum why rents have been rising while home prices stagnate (actually, not much of a conundrum: there is an underlying inflation dynamic that in the case of the housing-asset market is being overwhelmed by a decline in multiples. But this is a conundrum to the Fed, and to be fair I also expected Housing inflation to be lower than it has been recently). And in this month’s data, you can see that the year-on-year increase in Housing CPI flattened out. But, as the table below shows, the Shelter component wasn’t what flattened out. Housing only went sideways because the “Fuels and Utilities” component declined – again, a commodity effect.

	Weights	y/y change	prev y/y change	3m y/y chg	6m y/y chg
Housing	40.2%	1.876%	1.874%	1.869%	1.453%
Shelter	30.92%	1.983%	1.905%	1.792%	1.399%
Fuels and utilities	5.27%	1.941%	2.432%	3.483%	3.201%
Household furnishings and operations	4.03%	1.035%	1.000%	0.561%	-0.224%

I still expect Housing inflation to level out and probably to decline, but so far those expectations have been dashed. It will be uncomfortable for the Fed if it remains this way; a significant part of their expectations for a visually-contained core inflation number is (mathematically) due to the expectation that housing inflation isn’t going to keep rising. As you can see in the chart below (Source: Enduring Investments http://www.enduringinvestments.com), the rest of core inflation outside of Shelter is continuing to rise. Inflation is not ‘contained’, except maybe for housing. Maybe.

I am fairly confident, though, that if Housing inflation does not decelerate as expected, then the Fed will find some other reason to ignore the very clear acceleration in inflation. The economists at the FRB are for the most part true believers in the notion that the output gap constrains any possible acceleration in inflation, despite ample evidence that output gaps don’t matter (or, anyway, matter far less than monetary variables). For another view of this proposition, see the Chart below, taken from this article by economist John Cochrane.

Fed economists also feel strongly that “well-anchored inflation expectations” means that they can ignore 15-month trends in core inflation, despite the fact that by Chairman Bernanke’s own admission we aren’t really very good at measuring inflation expectations (to be kind).

They have time. The Fed has recently begun to treat 2% (on core PCE, not core CPI) as more of a floor than a target, so it will be some months, even if core inflation doesn’t pause for a month or two pretty soon, before the Committee starts getting at all warm under the collar about inflation. Even then, they are extremely unlikely to take steps to reduce liquidity while Unemployment remains high. The Fed is in a political bind, and the only easy path for them is to “see no evil” on inflation while hoping that Unemployment drops swiftly enough for them to act before prices really get out of hand. We will see.

The Weak Ahead?

All in all, January wasn’t too bad. The S&P gained 4.4%. The DJ-UBS and SP-GSCI commodity indices rose 2.5% (USCI rose 4.9%). The 10y Treasury note yield fell 8bps. The yield of the July-21 TIPS fell 30bps to -0.43% – although, thanks to the roll, the current 10-year yield fell “only” 15bps.

The 10-year inflation swap rate rose 26bps to 2.53%.

So, basically, if you were long just about anything in the U.S., you made money in January. So then why was everyone so depressed? Consumer Confidence, which had been expected to rise to 68.0, instead dropped to 61.1. The “Jobs Hard to Get” subcomponent, which tends to move coincident with the Unemployment Rate, rose to 43.5 (see Chart, source Bloomberg). While that’s a 3-month high, it’s still well below the worst levels of the last few years although it should also be said that it doesn’t help the argument that Employment is on a steadily-improving trend.

Commodities prices being up is a good thing if you own commodity indices, it isn’t such a good thing if you don’t. Gasoline futures were up 7.5% over the month, and prices at the pump were up 15 cents (see Chart, source Bloomberg). Precious metals rallied 12.7%, but Industrial Metals jumped 10.9%. And I’m not saying these things are related, but M2 is up 1.3% (22.9% annualized) in the first three weeks of 2012, while European M2 rose 1.3% in December (15.2% annualized), the last data we have available.

Alas, this rising tide isn’t yet lifting all boats. The Case-Shiller Home Price Index fell -0.70%, more than expected. This takes the index perilously close to the lows from last spring, which optimists had believed were left behind us for good by summer. (The good news is that this will help restrain the inexorable rise in core inflation, so that central bankers bent on looking for an excuse to ease will probably get one if they don’t look too hard for what’s happening besides housing).

I should point out that the 61.1 reading in consumer confidence, and the weaker-than-expected Chicago Purchasing Managers’ report (60.2 vs 63.0 expected and my expectation of slightly better than that), while not cause for celebration, are also not disastrous. Taken together, they may shake the faith of economists predicting a smooth acceleration in the economy, but are not cause to reject a null hypothesis of a choppy, gradual, improvement in the economy.

That hypothesis will also not take much water if tomorrow’s ADP figure is 182k, which prior to last month’s best-ever print of 325k would have been regarded as quite respectable. Unfortunately, I suspect that there is some payback coming, and the figure will look weak. Prior to last month’s number, the prior six months had only averaged 136k. A modest improving trend to, say, 175k would suggest 150k needs still to be ‘paid back’ through revision or a shockingly low print tomorrow. I don’t expect that, but with the preponderance of the evidence on the labor market (including the Jobs Hard to Get number) indicating stability but not strength, I would be surprised if ADP exceeds expectations counting revisions.

Also out tomorrow is the ISM survey. The consensus of Bloomberg-surveyed economists is 54.5, but there’s a caveat here. The median estimate of economists who updated their estimate today after Chicago PM and after the ISM released new seasonal factors is 54.0. And frankly, that seems high. Last month’s number, which was originally reported at 53.9, has been revised downward to 53.1 and Chicago PM showed weakness. Be careful here, because a print of, say, 53.5 would look like a weak print to those who mechanically compare it to the consensus that includes stale data, but would still represent a slight strengthening trend.

I am anything but a bull on the economy at the moment, but that’s mainly because of the impending implosion of Greece and/or Portugal and/or who knows what other country. It is fair, though, to observe that the economy in the last few months is doing passably. It’s not strong enough to shrug off bad news from the Continent or meaningfully higher gasoline prices, but it’s also not collapsing. At the moment, anyway. Unfortunately, I think stocks are priced for much better than “an economy that’s not collapsing,” and are counting on the QE3 wind in their sales. Valuation is dicey here but I am reluctant to fight the Fed until the inflation numbers tick up a few more times.

After all, it doesn’t take as much hope to move the stock market as it once did. Today’s equity volume was the heaviest of the month at almost a billion shares traded on the NYSE. Note the word “almost”: the last month during which there were no pan-billion-share days was last April, but January’s volume is weak even compared to that (15.2bln shares versus 16.9bln last April). Prior to last April, I can’t find another month with no billion-share days to at least 2005 (which is the earliest data I have), and I suspect we have to go back into the 1990s to find one. Again, this isn’t very healthy.

And that’s why investors continue to flee into Treasuries and TIPS. That’s a very crowded trade at a very high price, and not a place I want to be. Bonds are in fact priced for depression. The 30-year TIPS yield has reached an all-time low of … wait for it … 0.60%. Think about that – if the economy grows at a feeble 2.1% for the next three decades, you are giving up 1.5% real growth versus just sitting around and participating pari passu in the economy.[1] With nominal 30-year bond yields at 2.94%, markets are also forecasting very weak long-term inflation.[2] Both Treasury and TIPS yields are going to go higher eventually, and not only will investors be selling them but so will the Fed, and all the while the Treasury will be trying to sell still more. I want to be on the side of the angels on that one, and am willing to risk the ‘Japan outcome’ (being carried out due to your bond short) to be short here.

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[1] This isn’t technically exactly right, since TIPS are based on CPI. Since the GDP deflator is usually about 0.25% lower than CPI over time, CPI+0.6% is like PCE+0.85%. But you get the point.

[2] Again, not to get too technical, but there are two offsetting effects here. One is that breakevens (Treasury yields minus TIPS yields) isn’t the best way to look at expected inflation; inflation swaps are cleaner and don’t suffer from the funding disadvantage of being short Treasuries so they are a better indicator of inflation expectations. The offsetting effect is that the 30-year breakeven or inflation swap probably includes a risk premium due to the length of the structure – that is, you’re willing to pay a bit per year more for 30-year protection than for 10-year protection.