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But How Near is the Fall?

September 16, 2013 Leave a comment

I will resist the temptation, succumbed to by many others, to offer a pithy title turning on some pun involving Larry Summers’ name. For example, I will not title this article:

  • Summers’ Not Lovin’
  • Summers of Our Discontent
  • Summer Happy, Summer Not So Happy
  • Cruel Summers
  • School’s Out For Summers, or
  • Lazy-Hazy-Crazy Days of Summers

Such tomfoolery is occasioned by the news yesterday that Larry Summers has withdrawn his name for consideration to be the next Fed Chairman, succeeding Bernanke. The markets reacted with similar tomfoolery. Although the equity markets hadn’t exactly plunged as Summers became the odds-on candidate (at a conference I went to last week, all six of the panelists during one segment said Summers would be the selection), stocks rocketed higher today as this supposedly makes a dovish Chairman more likely. Bonds rallied as well, and the dollar fell – all of these for the same reason. Strangely (but not so strangely if you have been watching commodities for the last couple of years), commodities fell on the potential for a more-dovish Chairman.

The odds-on favorite just became Janet Yellen, with Donald Kohn the runner-up. Both of these are considered to be more-dovish than Summers, which is odd because it is generally acknowledged that Summers had virtually no track record expressing his opinions on matters of monetary policy, and was essentially a policy unknown.

In any event, markets for the nonce are enjoying the notion that a Chairman Yellen or Kohn would bring “continuity” to the Federal Reserve and make the adjustment from the Bernanke years seamless. You can be a short seller of that idea. Volcker to Greenspan, Greenspan to Bernanke…neither of those transitions was expected to make a dramatic difference in monetary policy, but of course ultimately they did. Going back further, Volcker was chosen partly as an antidote for G. William Miller, so it is not surprising that things changed under Volcker – but we were looking for change). You probably have to go back to the Arthur Burns/G William Miller transition in the late 1970s to find a transition that truly didn’t matter very much, although that was mostly because Burns had made such a mess of things and triggered such an ugly inflation by adding too much liquidity to the system in order to cure the recession that the only thing Miller thought he could do was to continue on…

Oh. I see the parallel now.

In any event, a Chairman Kohn or Chairman Yellen is very likely to turn out to be something different from what we think we are getting, or from what the President thinks he is getting (not necessarily the same thing). It is much like appointing a Supreme Court justice: after donning the robes, physically or metaphorically, a justice might vote in a way very different from the way his nominator expected him or her to. Just ask G.H.W. Bush. So, regardless of whether the next Chairman is Yellen, Kohn, or some as-yet-unknown candidate, the bottom line is that investors should expect surprises. If your investment strategy is reliant on there not being any surprises, then I advise you to reconsider that strategy!

Speaking of surprises, Tuesday brings the CPI report. The market consensus is for +0.2% on headline and +0.2% on core inflation, with the y/y core inflation reading rising to 1.8% from 1.7%. However, since last year’s CPI print was a mere +0.06%, forecasting a rise is very easy. If the monthly figure is only 0.105%, y/y core inflation will still tick up to 1.8% (rounded). Indeed, the risk here is that it only takes a +0.21% to produce a 1.9%, which would make for some panicky portfolio adjustments even though it would not be an extreme outlier.

In my view we are probably overdue for a +0.25% print on core inflation. The current rise of core CPI back towards median CPI, which has been either 2.1% or 2.2% for a year and a half, is happening because some of the unusual effects that pushed core CPI later are waning. Moreover, as I have written about expansively previously, housing inflation appears to have turned up but a more-substantial move higher is due (or perhaps overdue).

The CPI report and the adjustment to the market’s expectations about the next Fed Chairman are somewhat related. There is a notion out there – which I think is foolish – that the removal of Summers from consideration as the next Chairman, coupled with slightly weak recent data, lessens the chance that the “taper” will be announced this week. I do not think that either event bears on the probability that a taper will be announced. While I originally expected the taper to come later in the year than this, the voluminous statements of Fed Governors and Fed Presidents seems to indicate that it will begin imminently. The likelihood that a dove will take the Chairman’s seat does not change that. However, to the extent that the stock and bond markets rallied because they think a taper is less likely, a CPI print that takes core to 1.9% on the year will extinguish that frail hope. I think today’s stock market rally is subject to a near-term disappointment if this happens, and this is likely the case, although less so, for the bond market as well.

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

December 18, 2012 7 comments

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 1st. 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.

inflationsurprise

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.


[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.

Summary Of My Post-Employment Tweets

September 7, 2012 1 comment

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

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

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

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

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

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

A Time To Refrain From Embracing

Today’s bit of wisdom comes either from Ecclesiastes, or from The Birds (depending on your religious background): to everything there is a season, whether for casting away stones or for gathering them together, whether for embracing or for refraining from embrace.

This too is good market wisdom – and in the current circumstance, it appears it is a time to refrain from embracing. Two sovereign wealth funds have apparently stopped buying European sovereign debt, according to stories out today. One is China’s CIC (which is interesting: I suppose they figure that their pledge to the IMF is more than sufficient exposure to the region! If that is the case, then surely this falls in the category of an unintended consequence!). The other is Norway’s $610bln oil fund, which will actually divest holdings of Eurozone sovereigns. It had held 50% of its total bond holdings in Eurozone sovereigns and has cut (or maybe will cut – the story is unclear) its exposure to under 39%, according to this story on Reuters.

Frankly, if I was another sovereign wealth fund, I would read these stories and wonder whether it is time for me to cut my exposure as well, since I surely don’t want to be the last one out. As I said, perhaps this is a time to refrain from embracing.

That being said, as I wrote on Tuesday “I think it’s likely that European prices will rise at least as fast as US prices” and opined that “I think Europe is going to be catching up to the U.S. in the monetary-profligacy race.” I wrote that, and today a story appeared in Der Spiegel: “Breaking a German Taboo, Bundesbank Prepared to Accept Higher Inflation.” The ECB is already losing its “Bundesbank DNA” since being taken over by Mario Draghi. Now it looks like the Bundesbank itself is losing its singlemindedness when it comes to inflation.

This is a game-changer, obviously, when it comes to inflation in Europe (German inflation carries about a 25% weight in the calculation of Euro inflation) but also when it comes to inflation globally. I noted yesterday that Euro M2 accelerated to a 3.1% pace in the year ended March, and that that was the highest pace since September of 2009. I can’t imagine these two things – an acceptance by Germany of potentially higher inflation, and faster Euro-area money supply growth – are unrelated.

This may or may not be an error. If Germany is acceding to higher inflation because she believes that faster inflation will be a result of faster Euro-area growth, it’s an error since inflation derives from money growth, not real growth. But if Germany is allowing inflation to rise in Germany relative to the rest of the Eurozone, as a way to ‘rebalance’ her economy relative to the Eurozone, then it’s not a bad idea; the only problem is that since Germany doesn’t have a lever to pull on monetary policy that’s separate from the ECB’s lever, I don’t see how they can raise Germany’s inflation rate relative to the other nations. Between countries with flexible currencies, this adjustment happens through the money supply and currency. How do you effect such a ‘rebalancing’ in this case? I don’t know.

Speaking of errors, JP Morgan announced a whopper today after the close. About a month ago, a story circulated about a trader at JP Morgan who had amassed positions in corporate credit-related derivatives that were so large they were affecting the indices of credit risk. Today, JP Morgan revealed that the unit where the trader works (the chief investment office, which is meant to hedge firm-wide risks rather than to take positions) had lost $2bln on synthetic credit instruments. JP Morgan CEO Jamie Dimon said on a call today that the losses could ‘easily get worse,’ implying that the positions remain open for now.

There will be many questions about how the bank amassed a $2bln loss in the short time that has passed since quarter-end, especially given relatively sedate trading in the credit markets. There are both positive and negative fact sets that could apply. On the positive side, we could posit a smart risk-management officer that read those earlier stories and investigated whether the book was being marked at levels that were being affected by the trading of those instruments by the book, or whether they were fairly considering the likely loss in the event of liquidation. Discovering that they were not being marked conservatively, Risk Management and the CEO decided to disclose the loss as soon as they knew it should be. If that is what happened, it would be hard to fault the bank’s disclosure even if you could fault some of their controls. But Dimon is also a pretty crafty fellow, and I can certainly imagine a circumstance where the bank figured “if we announce the loss on the credit hedge now, then when the gain on the other side shows up in the regular earnings we might be able to persuade analysts to treat this as an ‘item.’”

So what I’d want to know if I was a regulator, or a reporter, or an investor, is whether the error here was that the chief investment office departed from its hedging function and made some bad prop trades. If the answer is yes, then I want to know how that happened in large size without senior approval. If the answer is no, then the next question is whether this loss was offset by a gain somewhere in the bank, since it must be a hedge. If the answer to that question is no, then we simply have some stupid hedging. If the answer to that last question is yes, then I want to know why an announcement was made at all because the hedge worked! Sometimes hedges lose money, after all…when the thing being hedged shows a gain.

On Friday, Dallas Fed President Fisher is speaking on the topic of “Too-Big-To-Fail.” How timely.

Also due out on Friday are Michigan Confidence (Consensus: 76.0 from 76.4) and PPI (Consensus: 0.0%/+0.2% ex-food-and-energy), neither of which is an important release. Have a nice weekend.

Inflation Stable, But Only In Passing

March 1, 2012 2 comments

It’s a busy day for me, with month-end just past (and month-end was a busy day for many, with the first pan-billion-share day on the NYSE this year), but there is just too much to talk about to skip a comment today. But I will make it brief.

Front and center must be the huge rise in Crude Oil and Gasoline futures. Crude rose over $3 with NYMEX Crude topping $110. Some of this was due to rumors that a Saudi pipeline had been attacked and damaged, but a good portion of the run-up occurred before the rumor went around, and after the Saudis denied the rumor prices only fell back somewhat. The chart below (Source: Bloomberg) exaggerates the move in gasoline somewhat due to the fact that the front month rolled (the April contract rallied 9.45 cents/gallon, but March expired as the front month on Wednesday at $3.04 and April is now at $3.35), but however you want to look at it, this is a very high price for March 1st – in fact, the highest ever – and retail gasoline prices were already up to $3.74/gallon before this spike.

Meanwhile, the core PCE price index for January was reported this morning. While the month-on-month change didn’t round higher, the number was just enough higher-than-expected that the year-on-year number became 1.9% while economists were expecting 1.8%. Recall that core PCE is what the Fed is targeting to keep at 2.0%, and they were busy saying that the inflation dynamic had cooled (more on that later).

The Fed had previously assiduously avoided acknowledging the 15-consecutive-month acceleration in core CPI by saying that headline inflation (which they don’t normally care about) was ebbing, but now with energy prices rallying again they can’t retreat to that platitude. Core PCE is clearly still rising, and headline inflation is going to re-accelerate. I suppose Bernanke will have to focus on Nat Gas prices…that’s about the only price that’s actually falling.

Oh yes, Bernanke. Today’s second day of the Monetary Policy Report to the Congress (neé Humphrey-Hawkins) brought humor to an otherwise dry day. The Chairman was called on to defend the Fed’s extraordinary actions during the crisis (which honestly, isn’t really fair if you were busy cheering him on when they were happening, as most in Congressional oversight roles were). His defense was that  (1) “we’ve had about 2.5 million jobs created,” which it turns out are the same 2.5 million jobs that the Congress and the Obama Administration say were due to their policies, (2) “We’ve seen big gains in stock prices, improvement in credit markets,” which is odd considering that he has previously claimed QE2 didn’t pump up asset markets, and (3) the actions helped produce a “more stable inflation environment.” In honor of baseball’s spring training: strike three, you’re out! I suppose a snapshot of a vase falling off a table looks stable too, as long as you don’t wait until it hits. Inflation happens to be near 2%, but that’s a coincidence of timing. It’s around 2%, on the way to someplace not particularly near 2%.

And it’s not just me who is saying so. Yesterday, Plosser was predicting the Fed could tighten policy this year and I noted a St. Louis Fed economist highlighting inflation risks; today FRB Atlanta President Lockhart predicted that if the Fed started QE3 it could cause inflation while not spurring lending. However, do not fear tighter policy yet; Lockhart considers that things have only just begun to show positive effects and just wants to ride the loan volume increase and inflationary increases for a while longer.

There are positive economic signs, but I fear these may be the best we see for a while. Auto sales, which have long languished at weak levels, surprised in February to post the strongest annualized sales pace since 2008 (see Chart, source Bloomberg). The level is almost back to the record levels where the car companies were bleeding losses back in the mid-2000s! The worst seems to be past for the automakers, although there is some suspicion that balmy weather (for February) helped the comparisons for the month. Still, the trend seems to be clear, for now.

Claims are improving, auto sales are improving, manufacturing is doing generally well (although ISM was weaker-than-expected today). As I’ve said for a while, the economy has been improving slowly, and at this point continues to improve steadily. However, the stock market has priced in a robust recovery, and with all of the great economic news out there we also have sharply rising energy prices and other tax increases (such as the expiry of the increased depreciation allowance, which may have helped provoke the weak Durables number this week). We also have Western Europe (and the less said about that right now, the better). There is plenty of time to bask in the good news by being short bonds (the 10y yield rose above 2%, again, today), hoping that I’m wrong about the disappointments we are going to begin to see, I think, this month.

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