Now, now, children! Stop fighting! This is unbecoming!
It is apparent now that the disagreements in the FOMC – while nothing new – are becoming more significant and the hurly-burly is spilling into the public eye. It is somewhat amazing to me that the Fed is allowing this argument to be conducted in public (traditionally, all remarks by Fed officials are first vetted by the Chairman’s office). Today Dallas Fed President Richard Fisher actually questioned the Fed’s credibility! This article is worth reading, and not just for the part where Fisher says that Yellen is “dead wrong on policy.” It’s also fascinating that Fisher attributed the decision to delay the taper to “a perceived ‘tenderness’” in the housing recovery.
Below is a chart (source: Enduring Investments) of the ratio of median existing home sale prices to median household income. If this is “tenderness” in a recovery, it only shows a lack of knowledge of history: this is the second highest ratio of home prices to income we have since this particular data begins…and the first highest ratio sunk the global economy for a half-decade and counting.
On the other side of the fence were the New York Fed’s Bill Dudley and the Atlanta Fed’s Dennis Lockhart, who lamented that (Dudley) there has been no pickup in the economy’s “forward momentum” and asked (Lockhart) “Is America losing its economic mojo?” These questions, and the result of these questions during the recent FOMC meeting, illustrate two points. First, that the bar for removing never-before-seen levels of monetary accommodation has been raised so high that doves believe it is appropriate to keep the foot on the accelerator until growth is drastically above-average. As I illustrated back at the beginning of August, it is unreasonable to expect more than about 200,000 new jobs per month to be created by the economy. Repairing all of the damage is simply going to take time. We would all love to see 5% growth, but is the Fed’s job really to make sure that happens, or to try and manage the downside (or, as I personally believe, to merely manage the price level)?
The second point that the Fisher/Dudley/Lockhart comments illustrate is that the doves at the Fed are clearly in control. The hawks were completely unable even to get a marginal tapering, although the Fed had clearly indicated previously that such a taper was likely to happen.
It is a Dudley/Bernanke/Yellen Fed (and they have allies too!), and anyone who thinks that the Fed is abruptly going to find religion once CPI peeks above 2% is fighting against all historical indications. One need only consider the fact that the post-FOMC meeting statement pointed out a “tightening of financial conditions observed in recent months,” a clear reference to the rapid rise in interest rates that accompanied the initial talk about tapering. But if the Fed begged off on the taper partly because of the tightening of financial conditions, that is the rise in interest rates that was caused by an expectation that the taper would stop, then the argument circular, isn’t it? It’s impossible for them to stop, since any indication that they were going to stop is obviously going to cause interest rates to rise, which would be a tightening of financial conditions, which would keep them from stopping… Does anyone seriously think that a core inflation print of 2.1% would change that?
To the extent that cutting from 20 cups of coffee per day to 19 cups of coffee per day could be called a “bold step,” wouldn’t the best time to take such a “bold step” with monetary policy be when the equity markets are at their highs and real estate markets back above their long-term value anchors?
And yet, the initial enthusiasm for the stock market for the continuation of QE seems to have faded rapidly. The entire post-FOMC rally that caused such joy around the offices of CNBC last Wednesday has been erased. Interestingly, the initial spike in commodities prices has also been erased, which is more curious since commodities prices don’t depend on growth as much as they do on inflation. And 10-year inflation expectations are back around 2.25%, basically the highest level they have seen since the Q2 swoon (see chart, source Bloomberg). So, as usual, I am flummoxed by the behavior of commodities.
I know that there is a great deal of confidence in some quarters that the Federal Reserve can keep its foot on the gas until such time as inflation actually rises to a level that concerns them. I cannot imagine the reason for such confidence when the drivers of the car are such committed doves. There are multiple problems undermining my confidence in such a possibility. There is the “Wesbury hypothesis” that the Fed will adjust its definition of what worries them about inflation – a hypothesis which, after this month’s FOMC meeting, should be even more compelling. There is the fact that there is no evidence I am aware of that the Fed was able to easily restrain inflation after it came unglued in any prior episode (and no one knows where and when and how it will come unglued). And finally, it isn’t clear to me how the Fed would go about restraining inflation anyway, given the overabundance of excess reserves and the fact that those reserves insulate any inflation process against the tender ministrations of the central bank.
One thing seems to be sure. The food fight at the Fed is not likely to end soon, and together with the dysfunction on Capitol Hill is raises the very real question of whether anything economically helpful is going to be accomplished in Washington DC this year.
I wrote recently about money velocity and reminded readers that theory says higher interest rates tend to increase money velocity because it decreases the demand for real cash balances. This was around the discussion of whether the enormous demand for Verizon bonds could be anecdotal evidence that velocity is increasing.
Yesterday the blog Sober Look – which is one of my favorites because it gives intelligent looks at many different markets – ran an article entitled “Could rising rates fuel credit growth in the US?” in which they in turn cite Deutsche Bank research. It’s a very quick article and worth a read, because it sheds some light on one of the mechanisms by which credit growth may increase with higher rates. Ordinarily, higher rates inhibit money growth at the same time that they increase velocity, partly because the yield curve flattens. But in this case, higher rates may increase both credit growth and money velocity – at least when rates initially rise – since the market is moving ahead of the Fed and steepening the yield curve in a selloff.
It’s just another puzzle piece to rotate in your mind, to try and see how it all fits together!
Here is a summary of my tweets after the CPI release this morning. You can follow me @inflation_guy.
- CPI +0.1%/+0.1% core, y/y core to 1.8%. Core only slightly weaker than expected as it rounded down to 0.1% rather than up to 0.2%.
- Housing CPI was weak, second month in a row. Rents will eventually catch up w/ housing prices…but not yet.
- Apparel CPI was weak after a couple of strong up months. I’ll have the whole breakdown in a bit.
- Core was actually only 0.13%, suggesting last August’s 0.06% and this August’s number might merely be bad seasonals.
- Market was only looking for 0.17% or so, so it’s not a HUGE miss. Still disappointing to my forecasts as upturn in rents remains overdue.
- Core CPI now 1.766% y/y. More difficult comparison next month although still <0.2%.
- Accelerating major grps: Apparel, Medical Care, Educ/Comm, Other (20.9%); decel: Food/Bev, Housing(!), Transp (73.1%), unch: Recreation
- Housing deceleration actually isn’t worrisome. Primary rents were 3.0% y/y vs 2.8% last. OER was 2.23% vs 2.19% last.
- Housing subcomponent drag was from lodging away from home, household energy, other minor pieces. So housing inflation story still intact.
- Core services inflation unch at 2.4% y/y; core goods inflation up to 0% from -0.2%. Source of uptick: mean reversion in core goods.
- So OER still reaches a new cycle high at 2.23%…it’s just not accelerating yet as fast as I expect it to. Lags are hard!
The initial reading of this number, as the tweet timeline above shows, was negative. The figure was weaker-than-expected, and Housing CPI decelerated from 2.26% to 2.17%. This seemed to be a painful blow to my thesis, which is that rising home prices will pass through into housing inflation (expressed in rents) and push core inflation much higher than economists currently expect.
Housing CPI is one of eight major subgroups of CPI, the other seven being Food and Beverages, Medical Care, Transportation, Apparel, Recreation, Education and Communication, and Other. Housing receives the most weight, at 41% of the consumption basket and an even heavier weight in core inflation. So, a deceleration in Housing makes it very hard for core inflation to increase, and vice-versa. If you can get the direction of Housing CPI right, then you’ll have a leg up in your medium-term inflation forecast (although it isn’t very helpful in terms of projecting month-to-month numbers, which are mostly noise). Thus, the deceleration in Housing seemed discouraging.
But on closer inspection, the main portions of Housing CPI are doing about what I expected them to do. Primary Rents (aka “Rent of primary residence”) is now above 3%, in sharp contrast to the expectations of those economists and observers who thought that active investor interest in buying vacant homes would drive up the price of housing but drive down the price of rents. Though I never thought that was likely…the substitution effect is very strong…it was a plausible enough story that it was worth considering and watching out for. But in the event, primary rents are clearly rising, and accelerating, and Owners’ Equivalent Rent is also rising although less-obviously accelerating (see Chart, source BLS).
So, it is much less clear upon further review that this is a terribly encouraging CPI figure. It is running behind my expectations for the pace of the acceleration, but it is clearly meeting my expectations for what should be driving inflation higher. As I say above, econometric lags are hard – they are tendencies only, and in this case the lags have been slightly longer, or the acceleration somewhat muted, from what would typically have been expected from the behavior of home prices. Some of that may be from the “investors producing too many rental units” effect, or it might simply be chance. In any event, the ultimate picture hasn’t changed. Core inflation will continue to rise for some time, and will be well above 2% and probably 3% before the Fed’s actions have any meaningful effect on slowing the increase.
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 is the significance of the fact that Verizon on Wednesday managed to sell $49bln in bonds without any kind of hiccup?
Obviously, it means that the corporate market is doing okay, that investors who are starved for good spreads like the attractive spread the bonds were priced at, and that there is reasonable confidence in the marketplace that Verizon can succeed even as a much more-leveraged company. All are good things.
But here is another thing to think about. My friend Peter Tchir, who writes the excellent T-Report, noted this morning that “Investors weren’t selling other bonds to buy Verizon.” That is, a fair amount of the money may well have been coming out of cash to go into the Verizon bonds.
Why does this matter? Remember that the velocity of money is the inverse of the demand for real cash balances. That is, when everyone is holding cash, the velocity of money is low; when no one wants to hold cash, the velocity of money is high. I have shown the chart below (source: Enduring Investments) before and argued that higher interest rates will tend to increase velocity by decreasing the demand for real cash balances. At least, that usually is what happens.
What would a turn higher in velocity look like? Well, I think it may well look something like this. “I no longer have to reach as much for yield and take all the risk I had to in March to get a 3% yield. So it’s time to invest some of this cash.”
Now, the ultimate flows get a little confusing, because cash is neither created nor destroyed in this transaction. Cash is transferred to Verizon from investors; Verizon then transfers that to Vodafone investors, who perhaps put it back in the bank for no net change. But if those investors in turn say “I don’t want those cash balances, either,” and then go invest or lend it or spend it, then you’re starting to see how money velocity is increasing. The money essentially becomes a kind of financial “hot potato” now, moving more rapidly from investor to investor, from consumer to vendor, and so on. The volume of transactions rises, which increases prices and output as explained by the MV≡PQ monetarist credo.
And that is how higher rates can produce more inflation.
We are seeing other strange things, too, that could be consistent with this explanation. Another great blog, “Sober Look,” observed last week that 30-year jumbo mortgage loan rates have fallen below conforming mortgage loan rates. Their explanation of the phenomenon is worth reading, but note this part: “Flush with deposits, banks have access to extraordinarily cheap capital and are seeking to earn more interest income.” Yet this has been true for some time. What has changed is that interest rates are now higher, increasing the opportunity cost of cash in both nominal and real terms.
This doesn’t automatically mean that money velocity is increasing; it may just be an interesting bond sale and unusual market activity in jumbo mortgages. But it is worth thinking about, because as I note in that article linked to above, even a modest rise in money velocity could produce an aggressive response from inflation.
When I remark, from time to time, that I think the Fed has made a mistake in increasing transparency of its deliberations and actions, people occasionally look at me as if I had come out opposed to motherhood or apple pie. But my point is that transparency is good if it permanently decreases risk…but it doesn’t.
What matters is how market actors respond to increased transparency. It is much like the old debate about whether football players ought to wear helmets. It is clear that helmets decrease the likelihood of brain damage in any given collision, compared to the un-helmeted rider in an identical collision. But it is also clear that as helmets have gotten better and better, football players have played faster and faster, with more abandon, and lead with their heads a lot more than they did when all they had was a leather cap. The net effect is indeterminate.
In markets, increased transparency from a central bank or regulator leads to increased leverage in a very direct way. The central bank’s dial is for transparency, but the investor’s dial is for risk appetite and when the central bank turns its dial it does not change the investor’s risk preferences. The result is that increasing transparency, which decreases the risk at any given leverage and at any particular moment, leads to higher levels of leverage, which lowers the tolerance for error. And, as we have seen, central banks and regulators are quite prone to error.
In an interesting way, this is tied into the volume question. The chart below (source: Bloomberg) shows rolling 250-trading-day volume for the NYSE in billions of shares. As has been well-documented, market volumes have been steadily declining for years.
As we have mentioned here before, there are lots of excuses for lower market volumes on the major exchanges, and probably many of those excuses are part of the answer. But we can no longer simply attribute this to the movement of volumes to “dark pools.” There is simply less going on in the markets, whether in rates or in equities. Ask the dealers. Dodd-Frank and the Volcker Rule are simply decimating volumes. And this is not just bad for dealers, it is bad for everyone.
When a trade happens, there is information revealed. Indeed, in some markets a meaningful proportion of the volume transacted is between dealers who are testing the market to get more information. More trades means that there are more quanta of information. More quanta of information produces more confidence in prices. More confidence in prices means more support for the current prices, and more de facto liquidity.
Think of it this way. If a bond has never traded, and two counterparties come together to trade some at a price of 103, what is your estimate of the true market for another trade? Is it one tick around 103? If so, then you are displaying almost outrageous overconfidence – one data point between two counterparties, about whose motivations you know precisely nothing, tells you almost zero about what the true market (by which I mean, the prices at which you could buy, for an offer, or sell, for a bid, a typical-sized transaction) is, and even less about what the support market (by which I mean the prices at which you could transact in substantially larger sizes) is. And so bid/offer spreads, whether quoted on-screen or over-the-counter from a dealer in the security, must be wider since the market-maker just doesn’t know as much as he would if volumes were higher – and, more to the point, the market must be wider because the client who initiates the trade is likely to know more than the market-maker does about the right price. This is because the market-maker must make a market whether or not he knows the fair price, but the buyer or seller doesn’t have to trade unless he/she believes the fair price is outside of the quoted range. Of course, that’s where the information comes from: if the offer is lifted, it means someone is saying “I think the fair price is higher than your offer,” and that is information.
I mention this today for several reasons. First, because it has been a while since I showed the NYSE volumes chart in a while. Second, because there was an article on Bloomberg today entitled “Professor Who Helped Pop Junk Bubble Says Trace Slows Trade” which ties transparency to diminished volumes. To the extent that Trace produces true transparency and reduces the need for “testing” trades, it is a good thing…but then we should see tighter spreads for size, and while the study is suggestive it isn’t conclusive on this point. More interestingly, the professor in question also made the point that “less trading may hurt investors if, instead of reducing ‘noise’ from the market, the reduction slows how quickly new information alters prices.” And this point is also key:
”…if the decrease in trading activity is the result of dealers’ unwillingness to hold inventory, transparency will have caused a reduction in the range of investing opportunities. That is, even if a decline in price dispersion reflects a decrease in transaction costs, the concomitant decrease in trading activity could reflect an increased cost of transacting due to the inability to complete trades.”
So transparency, it seems, is not an unalloyed positive like apple pie. But lower trading volumes, which are partly the result of transparency (and partly the result of poorly-conceived rules like Dodd-Frank, the Volcker Rule, and Basel III), are very probably bad for everyone. This doesn’t just affect hedge funds. Markets which are deep and liquid are much less prone to sudden price breaks. With the US equity market still floating near the highs despite rapid increases in nominal and real interest rates and worst-ever outflows from ETFs last month, this is a point that may be more than academic at the moment.
 However, no one disputes that the faster game is a lot more fun to watch. What I suspect has happened is that the introduction of hard-sided helmets probably increased injuries until players essentially reached maximum speed/recklessness, after which point the further improvements in helmet design probably started to make the game safer again. But it is really hard to prove that.
Here are my post-Employment tweets. You can follow me @inflation_guy.
- Pretty weak NFP number since the payrolls figure (169k) plus revisions (-74k) is way worse than forecast. Decline in rate irrelevant.
- Actually think Fed spent so much time talking about starting taper that they may do it anyway, but have an excuse now to delay.
- Nothing like a weak NFP number to help the beleaguered bond market. Bounce may temporary but in Sep you don’t wanna fade rallies.
- I don’t watch it much, but avg hrly earns at 2.2% is highest since brief pop to 2.3% in mid-2011. Y do people hate TIPS here?
So 10-year note yields broke above 3% overnight, the highest level since 2011. More importantly, 10-year real yields had been approaching 1% (reaching 0.93% overnight) as fear-of-taper has investors quite reasonably fleeing fixed-income.
I said above that I don’t look much at average hourly earnings. This is because the evidence is that wages follow prices, rather than prices following wages in a mythical “wage-push” inflation. Moreover, we can intuit that this is the case because if wages led inflation, we would really like inflation since we would tend to see our wages increase before inflation did…we would be doing better all the time, rather than worse. In fact, we know intuitively that is wrong.
With that giant caveat, it is worth pointing out that average hourly earnings are above median CPI (which right now is a better measure of the central tendency of inflation because of the large one-off effects in medical care) by the most they have been since 2011 (see chart below, source Bloomberg).
The unemployment rate declined, but only because the Participation Rate plumbed a new post-Carter low at 63.2%. You have to go back to July 1978 to find participation rates this low, and back then there were a lot fewer women in the workforce.
All in all, this is a pretty ugly employment report, but the FOMC has carefully lined up its doves and even gotten a few hawks to say that tapering ought to begin this month. I suspect it is still likely that they start down that path, but probably the first steps are fairly small. Still, given how far rates have risen and the possibility that this will lead to some “taper: off” talk, and given the strong seasonal tendency for rates to decline in September and early October, I would not want to fade a bond market rally.
It didn’t seem when dawn broke in New York today as if the stock market would spend some time during this first post-summer session fighting to record a positive mark on the close. The S&P opened up 1% higher, partly because Chinese economic data was modestly stronger-than-expected, but mostly because hot money types sought to use the thin overnight session to try and create the impression that returning investors were flocking to buy “these cheap levels.”
But whatever the proximate cause of the overnight rally, it was met immediately with selling and three hours later the indices were flirting with unchanged on the day before a late charge produced a +0.4% finish for the S&P. I don’t think the turnaround had anything to do with the fact that Israel fired ballistic missiles into the Mediterranean as a test of anti-ballistic-missile technology last night – that information was known when we walked in, although there was some confusion about whether the U.S. was involved or not and whether it was supposed to be secret or not.
Indeed, the whole U.S. market seems far more interested in whether the Employment number this Friday is 160k or 180k than whether the U.S. or Israel attacks Syria, prompting a response from Iran and/or Syria on Israel and generally provoking the situation in the Middle East like a Mentos candy dropped into Diet Coke. This is why 10-year notes were down on the day, despite the fact that the terribly low float outside the Fed means any flight to quality could be explosive.
The odds of a flight to quality may be low, but the expected payoff is (probability of event) * (value given that event happens), the latter of which is quite high. This is one reason I would be more comfortable being cautiously long bonds at this point. I guess the counterargument is that any taper will have a disproportionate effect on the sectors with less float, but I would think that should be mostly priced in by now. Well, perhaps the Syrian conflict is priced in as well…after all, little is likely to happen very soon, unless Congress acts quickly to validate the President’s request for authorization of military action. The President doesn’t seem to be looking for a quick answer and would probably like the whole issue to just go away, so probably the most likely event is still that nothing happens in Syria that impacts U.S. interests very much.
But do keep in mind that the part of the value of a particular strategy that comes from a particular state of the world is, as I said above, (probability of the state of the world) * (value given that state of the world happens). For many financial options, the value of the option is determined not by the likely or median outcome, or even the distribution of likelihood of outcomes around the strike price of the option, but rather the outcomes in the tail, where there is very low likelihood and very high value. These are all “unlikely” events, in the sense that their independent probabilities are less than 50% and in most cases markedly less:
- a hot war in the Middle East,
- an abrupt taper from the Fed, or a decision from the Fed to increase purchases,
- Merkel’s party loses the vote and is unable to form a pro-Euro coalition,
- the Yen suddenly collapses,
- the US borrowing ceiling isn’t extended without fierce brinkmanship (in mid-October, the US won’t be able to pay for everything it wants to pay for, although it will still have plenty to make debt service and entitlement payments and so is not in even remote danger of an actual default unless the Treasury simply refuses to direct its ample revenues to debt service),
- …and others.
How does your asset allocation perform under each of these scenarios? Are there tails you have unhedged? If so, then you are doing what hedge funds have been doing for the last couple of decades: selling implicit options, earning a better return today as long as a bad event doesn’t hit. In hedge fund land, we talk about being short implied credit or liquidity options, but even retail investors have this sort of position on. What happens to your portfolio if oil goes to $200, or the US suddenly drops into recession, or the Euro breaks up over the weekend? What about if inflation goes from 2% to 6%? (Interesting fact: over the last 100 years, inflation accelerated by at least 4% from one year to the next fully 10% of the time. And the probability that inflation is over 10%, given that it is over 4.5%, is 37%…so in other words, the inflation tails are very long).
Don’t ask me for answers about what you should do in these cases – my purpose in these articles is not to distribute free answers to intricate questions that depend on your personal situation. My purpose is to present the question, and the question is, have you thought about how your portfolio will perform in the case of unlikely events?
If not, spend some time doing so. My fundamental belief is that a 70% or 80% equity position is almost never the right answer for any investor. If you are sufficiently wealthy that you could lose that 80% and have it not affect your lifestyle, either now or in the future, then you truly can plan for the long haul and ignore such risks (although even then I would not ignore valuations because you can add to your long-term returns by paying attention to them). For everyone else, “long term” is probably 10 years or less, and severe impairment of the portfolio does not admit to a certain 10-year cure. Just ask the people who had most of their retirement assets in Enron, or for that matter in the NASDAQ circa March 2000.
Watch your tail. The next month or two will be interesting.
 Technically, this is only true if all of the enumerated states of the world are distinct. To the extent that they are not, a covariance structure comes into play…for our purposes you can think of each separate event as creating option value, but you can’t simply sum those values.
The Financial Times today carried an article entitled “Japan Inflation Rises to Highest in Nearly Five Years.” Core inflation in Japan reached -0.1%, which is actually the highest since early 2009, so not quite five years (see chart, source Enduring Investments, below). More importantly, however, the year-on-year figures are near the highest in the last decade-plus, with base effects likely to push core inflation above zero in the near future.
This should be shocking to no one, since Japanese M2 growth recently reached the highest year-on-year growth level since … wait for it … 1999, and is now actually growing slightly faster than European money supply for the first time in a long, long time. Because, you see, money growth is intimately related to inflation. News flash!!
But the Japanese have only just begun to increase their money supply, and it is going to go a lot higher. As will inflation in Japan.
Now, here’s the conundrum of the day. If the Japanese pat themselves on the back because they are near to exorcising the deflation demon with quantitative easing, then how can Bernanke, Yellen, Summers, et. al. be so confident that our QE will not increase inflation? It can’t be the case that QE is effective at ending deflation (which was one benefit that Bernanke trumpeted in the past, too), but doesn’t tend to increase inflation. Well, I suppose it can be the case, but it would be quite weird.
The difference between the US and Japanese response to money growth over the last few years is that money velocity in the US has been declining with interest rates, while the Japanese already had rates so low that velocity had nowhere to go but up. As I have noted previously, even if velocity in the US merely levels out, 7% money growth will produce an uncomfortable rise in inflation.
So before settling into the belief, as Summers has expressed, that quantitative easing has “few harmful side effects,” it seems to me that we ought to reflect on the Japanese QE example.
I am disinclined to take victory laps when most people are losing money, but the recovery in commodities prices over the last week at the same time that bond and equity prices are both declining is a taste of success for my view that has been rare enough lately. That is, of course, the burden that a contrarian investor bears: to be wrong when everyone else is having fun, and to be right when no one wants to go out and celebrate. In fact, if you find yourself sharing your successes too often with other people who are having the same successes, I would submit you should be wary.
It is worth noting that the commodities rally has not been led by energy, despite the terrible violence in Egypt which threatens, again, to ignite a spark in the region. Today, the rise in commodities was led by gold and grains; yesterday by cows and copper (well, livestock and industrials).
I don’t think that this is because of a sudden epiphany about inflation. In fact, although breakevens have been recovering from the oversold condition in June (more on that in a moment), the inflation data today did nothing to persuade inflation investors that more protection is needed. I gave some thoughts about the CPI report earlier today in this post, but suffice it to say that it was not an upside surprise. (And yet, there are starting to appear more-frequent smart articles on inflation risks. I commend this article by Allan Meltzer to you as being unusually clear-eyed.)
And commodities are not moving higher because of renewed enthusiasm about growth, I don’t think. Today economic bell cow Wal-Mart cut its profit forecast because higher taxes are causing shoppers to be more conservative (perhaps in more ways that one). And, while today’s Initial Claims figure was good news (320k versus expectations for 335k), weakness was seen in Industrial Production (flat, with downward revisions, versus expectations for +0.3%) and both Empire Manufacturing and Philly Fed came in slightly weaker than expectations. None of this is apocalyptic, but neither is it cause for elation about domestic or global growth prospects.
While the nascent commodity rally makes me personally feel warm and fuzzy, the more-momentous move is in what is happening to interest rates. And here I need to recognize that until very recently, I thought that bonds would follow the typical pattern of a convexity-exacerbated selloff: after a rapid decline, the market would consolidate for a few weeks and then recover once the overhang had cleared. I’ve seen it aplenty in the past, and that was the model I was operating on.
But I believe rates are heading higher. Although the overhang from the prior convexity selloff has probably been distributed, there is a new problem as illustrated by the news today about Bridgewater’s “All Weather” fund. The All-Weather Fund is an example of a “risk parity” strategy in which, in simplified form, “low-volatility” strategies are levered up to have the same natural volatility as “high volatility” strategies. The problem is that levering up an asset class with a poor risk-adjusted return, as fixed-income is now, doesn’t improve returns or risks of the portfolio at large. The -8% return of the AWF in Q2 illustrates that point, and makes clear to anyone who bought the great marketing of “risk parity” strategies that they probably have much more rate risk than they want (although according to the Bloomberg article linked to above, Bridgewater “hadn’t fully grasped the interest-rate sensitivity” of being long 70% of net assets in inflation-linked bonds and another 48% in nominal bonds. I do hope that’s a mis-quote).
The unwinding of some of that rate risk (Bloomberg called the panicky dumping of a relatively cheap asset class, TIPS, into the teeth of a retail and convexity-led selloff “patching” the risk) helped TIPS bellyflop in May and June, and to the extent that institutional investors wake up and reduce their levered long bets on fixed income we might see lower prices much sooner than I expected across the entire spectrum of fixed-income. Indeed, without the Fed or highly levered buyers, it’s not entirely clear what the fair clearing price might be for the Treasury’s debt. I was at one time optimistic that we would get a bounce to lower yields after a period of consolidation, but this news is potentially a game-changer. Although the seasonal patterns favor buying bonds in August and early September, the potential downside is much worse than the potential upside.