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All Men Are Mortal

March 6, 2013 6 comments

Hugo Chavez, dictator of Venezuela and socialist extraordinaire, passed away on Monday in Caracas. The world will little note nor long remember what Chavez did for/to his country, and yet we care about his passing – not because of what he was, but because of what Venezuela could be and could have been.

I visited Venezuela in 1997 or so – pre-Chavez – when I was the main US fixed-income strategist for Bankers Trust. I had dinner with several members of the central bank, who said quite frankly that if they chose, they could easily pay off Venezuela’s external debt with their oil revenues. And that, mind you, was with oil prices around $20/bbl. It was also approximately the high point of Venezuelan production, which has fallen from 3mbpd to 2.4mpbd since then. Venezuela provides about 3% of the world’s supply of crude, despite the fact that it has among the biggest, if not the biggest, reserves of oil in the world. And yet, according to Capital Economics as cited by the Wall Street Journal, oil prices below $100/bbl could trigger a balance of payments crisis. The dictator milked his nation’s natural resources for billions upon billions – some of it went to “the people” in ways that were wasted by the typical inefficiencies of a socialist economy, and much of it to secure his own power.

It’s not quite as easy as saying that the next Presidente should develop Venezuela’s oil resources. Venezuela isn’t just a member of OPEC; it is a founding member of OPEC along with Iran, Iraq, Kuwait, and Saudi Arabia. So it isn’t as if the country can just start pumping wildly and change its fortunes through improved revenues. For the good of the country, most of what will need to happen under Presidentes in the future will be structural and expenditure-side. (Where have we heard that before?)

Accordingly, oil prices are likely to remain relatively undisturbed by this development, unless it appears that the next Presidente is a pure capitalist who plans to exit OPEC. Don’t hold your breath for that. In fact, to the extent that there is any unrest or confusion in the country because of a power vacuum, it might increase oil prices in the near-term. For now, Chavez’s vice president (Nicolas Maduro) will become president and a new president theoretically elected in thirty days. However, the history of Chavez, Maduro, and their party does not make most observers comfortable that this will necessarily happen in the way it is written in the Venezuelan constitution.

Meanwhile, Venezuela’s inflation is a hardly-worth-noticing 21.6%. They must have a really positive output gap, right? Of course, such inflation might have something to do with the fact that the money supply is up 600% since the end of 2007…nah, couldn’t be. The chart below (source Bloomberg, with my annotations) shows M2, GDP, and CPI for Venezuela, normalized to January 31, 2008 (just after a redenomination of old Bolivars into Bolivar Fuerte at 1000:1, which would have made the chart look screwy).

venez

Notice a couple of things. First, notice that the huge money-printing has done nothing whatsoever to Venezuelan growth. Second, note that the huge money-printing has, however, drastically increased prices in Venezuela. Third, notice that the increase in prices has been similar in magnitude to the increase in money (technically, the increase in money divided by GDP, but as I said GDP didn’t move much) – which is just exactly what theory predicts, and what has been seen time and time again in hundreds of countries spanning scores of years.

This isn’t an instance of “hyperinflation;” rather there has been consistent inflation in the 20-35% per annum range since 2008. That’s high, but not so high that it’s completely divorced from our experience of the reaction of prices to monetary policy. It is, or should be, a precautionary lesson. As bad as Chavez’s mismanagement of the Venezuelan economy was, which helped produce the stinky growth, it was the mismanagement of the money supply that caused the inflation.

It is interesting, too, that since inflation tends to increase wealth inequality if the wealthy can own assets other than money, the inflation itself tended to keep the poor – the main constituency of a populist – in a position of greater need and greater reliance on the State. Increasing inequality and plausible deniability as to whether it is the leader’s policies that are creating that inequality: that’s a delicious cocktail if the leader has a desire to hold and increase his power.

So we take notice of Chavez’s passing, for its potential impact on oil markets but even more for the opportunity it gives us to reflect on the lessons we could have, and should have, learned from the operation of his regime.

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.

For Want of a Nail

December 6, 2012 Leave a comment

The latest fiscal cliff follies are redolent of that old proverb:

For want of a nail the shoe was lost.

For want of a shoe the horse was lost.

For want of a horse the rider was lost.

For want of a rider the message was lost.

For want of a message the battle was lost.

For want of a battle the kingdom was lost.

And all for the want of a horseshoe nail.

On Wednesday, Treasury Secretary Geithner – one of the worst, if not the worst, Treasury Secretaries in history, I am pretty sure – said in an interview on CNBC that the Administration would “absolutely” send the country off the fiscal cliff if the rates on the top 2% of Americans don’t go up.

Now, I’ve heard lots of numbers bandied about, and decided I wanted to get the source data directly. The latest information i can find from the IRS is from tax year 2009, but it is instructive. According to the IRS, in 2009 there were 104,164,970 tax returns filed. The number with adjusted gross income above $200,000 was 3,912,980, or about 3.8% of all returns. They don’t break it down any more than that, so let’s call those successful people “the rich” and work from there.

Those 4 million returns covered $1.626 trillion in modified taxable income (32% of the total taxable income) and produced $429bln in tax (45% of the total tax generated). Now, let’s suppose that the top tax rate rose from 35% to 39.6% in tax, and for grins we’ll pretend that taxpayers are completely indifferent about this and so they do nothing to try and reduce taxable income (by, say, buying municipal bonds rather than corporate bonds). You might think that the tax take will rise by $74.8bln (4.6% * 1.626 trillion). But you’d be wrong, because the increase wouldn’t affect all of the taxable income paid by high-earners, but only that income that is taxed at the top marginal rate. In 2009, only $485bln in income was taxed at that rate, so a 4.6% increase in the marginal rate would only raise $22.3bln per year, or around $250-300bln over the next 10 years.

Now, over the last year the deficit has been about $1.1 trillion, so if I understand Geithner correctly, the Administration is willing to push the country over the cliff about an issue that amounts to 2% of the deficit, and would increase aggregate revenues by only 1%.

It’s one thing to argue for the philosophical point, but to say that you’re willing to put a hole in the bottom of the boat because you don’t like the seat you were offered…it seems a bit irrational.

What might be even more irrational is the sudden optimism that is breaking out all over Capitol Hill, about how great the economy will be if the fiscal cliff can just be averted. Today a Republican Senator being interviewed on CNBC said “The economy is ready to explode. There’s no doubt about that,” echoing what President Obama had said just a couple of days ago.

Do they mean implode, perhaps?

There is certainly no sign whatsoever that “the economy is ready to explode” ecstatically if the fiscal cliff is averted. Indeed, I think part of the reason we’re likely to go over the cliff is that the President wants to be able to blame the poor growth for the next few years on the Republicans in the same way he spent the last four years blaming the previous President. And the Republicans, since the Administration has offered no spending cuts and has dismissed entitlement reform altogether, don’t really have a choice unless they want to completely capitulate – at least with the fiscal cliff, some spending will be cut. Since, if austerity is enforced, there will be no way to test the counterfactual, it makes sense to build up how great it would have been. But the point I want to make is that to proffer such a claim only makes tactical sense if no deal is in the offing…because if a deal is struck, then we’ll quickly find out that the economy isn’t going to explode higher at all, and those statements will be exposed as completely moronic.

We will on Friday find out how much the economy is not exploding – surely, because of the impending cliff – when Payrolls (Consensus: 85k vs 171k) and Unemployment (Consensus: 7.9%) are announced. These figures will be impacted by Hurricane Sandy, so it will be difficult to interpret them. Or, perhaps I should add cynically that this uncertainty will make it even easier for politicians to claim whatever the heck they want!

With 10-year yields already at four-month lows (1.59%) and the bullish seasonal pattern having run its course, I think the risk is for higher bond yields both tomorrow and going forward. Now, the 1.82% level has mostly contained any selloff since April, but I think we will be headed in that direction. Equities have downside risk in my view after this recent rally (an even more impressive rally when you consider that Apple was dragging on the index!); I think there is far too much optimism about an imminent resolution to the fiscal cliff, and I don’t think we’ll see any resolution until after the new year.

Fiscal Baby Steps Aren’t Worth the Angst

December 3, 2012 1 comment

Unless today’s unseasonably-warm temperatures in the New York area (through some metaphysical conservation-of-energy mechanism) means that Hell is freezing over, we are a long way from resolution on the fiscal cliff discussions.

The Republicans countered President Obama’s proposal for a $1.6 trillion tax hike with their own plan that would cut the cumulative deficit (according to static scoring, as all of these proposals are) by $2.2 trillion through a combination of closing special interest loopholes, introducing deduction caps on high earners, increasing the Medicare eligibility age, cutting some discretionary spending, and using chained CPI as the Social Security escalator in order to slow the growth of benefits. After having previously lambasted the Republicans for not offering specifics, the White House today labeled the proposal “nothing new,” apparently without irony.

To be fair, the Republicans had called the President’s proposal a “la-la land offer.” So you can see, we are obviously very close to a deal and a smiling, hand-shaking, giddy signing ceremony in the Rose Garden.

All of this is sheer madness. These hikes and cuts are measured over the projection horizon, so we’re arguing about cutting perhaps 20% per year from the current trillion-dollar deficits. Good heavens, it’s a good thing we’re not trying to do something radical, like balance the budget. The combination of the national debt and the Social Security and Medicare liabilities add up to over $1.1million per taxpayer (Source: www.usdebtclock.org), and the debate is over cutting around $20,000 per taxpayer over the next decade. Don’t strain yourselves, fellows.

It’s incredible that some of these things are even subject to argument. The Medicare eligibility age will eventually be effectively infinity, because the program is not viable on this planet with health care such as we have come to expect, and since the liability is in real terms (units of healthcare, not of dollars) we can’t inflate our way out of it. So gradually moving the eligibility age a whole lot higher is something that we simply will have to do. Why not now?

People who say that cutting the deficit by $2.2 trillion over 7-10 years is hard to do have not actually tried it. It is actually pretty easy to get the budget back to some semblance of balance, as long as you don’t have to run for re-election or if you consider the future of the country to be more important than winning another term (and you know, there’s even a chance your constituents may reward that bold sacrifice!). All that you have to do is to reverse most of the things we’ve done to the budget over the last decade and you’re close – of course, the interest costs now are a lot higher, and will only climb in the future. But if you put entitlement reform on the table, it gets downright easy…again, if you don’t have to run for re-election.

Now, that interest portion of the deficit is somewhat scary. The chart below comes from Bloomberg, and it’s one of my favorite Bloomberg functions (DDIS). It shows the debt maturity distribution of U.S. Treasuries, and shows the interest and principal amounts currently scheduled.

uglydebt

It appears as if the interest costs (right column) max out at $196bln in 2013 and then decline, but keep in mind that these numbers ignore the fact that debt will be rolled when it matures. The $196bln is something closer to the baseline expectation, in the event that the Fed keeps interest rates anchored pretty near zero. It may be disturbing to note that the Treasury next year needs to roll $1.26 trillion in maturing securities, in addition to the $1 trillion of new money they need to raise due to the deficit; in 2014 the problem will start to grow even scarier as all of the 5-year issuance from 2009 starts to come due, along with all of the debt that has been rolled in the last couple of years. If you want to point to a come-to-Jesus moment in the bond market, it is likely to be in 2014 when this fact intersects with the expectation of the end of QE. It’s one thing to sell $2.26 trillion in Treasury securities if the Fed is committed to buying $1 trillion of them. It’s a little harder when they’re not, or if they are (as they claim they can) actually trying to sell some Treasuries from their own vaults. Good luck.

That’s why I don’t think we ought to be arguing over $200bln per year in the fiscal cliff. The problem is already much larger than that.

Now, that presumes that QE actually ends sometime in 2013. Some Fed officials have recently made noises to suggest that there is no reason that QE needs to end any time soon, and that the Fed is “nowhere near” the limit of what it can do. The problem is that 2014 will force a very serious choice on the Fed, because I think inflation is going to continue to rise throughout next year (our point forecast for core inflation is about 2.8% for 2013, but with all the tails to the upside), while I seriously doubt that Unemployment will get below 7%. And, as just noted, the market reality is that without Fed buying, the Treasury is going to have a devil of a time placing its debt in 2014 without higher yields (as an aside, I also suspect all dollar swap spreads will be negative in the next few years).

I’m not the only one who thinks that inflation is likely to be rising. While the nominal interest rate debacle is, in my opinion, not likely to hit us until 2014, rising inflation is happening today and the expectation of a continuation of that trend is being reflected in inflation swap rates. The chart below (Source: Bloomberg) shows that 10-year inflation swap rates are again up around 2.75%.

10y infl

Now, if inflation expectations are rising but the Fed is going to fix nominal 10-year rates at 1.60%-1.80% where they are now, then the scary result is that TIPS yields, already ridiculously low, could go further. I am not bullish on TIPS, because as a rule I won’t buy something that is rich on the expectation that it might get richer. That way lies madness, since when the thing you bought goes down you have no plausible excuse. Moreover, speaking for myself, I know that I would be unable to maintain a position that I knew to be fundamentally mispriced the wrong way. But if 10-year inflation expectations went to, say, 3.6% and 10-year nominal yields were fixed at 1.6%, real yields would be forced to -2.00%. This is the reason I won’t short TIPS in the current environment, although I view them as overvalued.

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What article would be complete without news from Europe? Today Greece offered to pay up to  €10bln to buy back their own bonds, with bids due Friday. Completion of this buyback is a precondition to Greece’s receiving the next tranche of the bailout, but it will be challenging if they refuse to pay market prices (as the Euro finance minister communiqué released last week suggested, since it limited the prices paid to those prevailing on November 23rd). It still is a philosophical step forward, since at least it serves to recognize the unrealized gains that Greece effectively has when its liabilities are priced where they are now. This is, after all, essentially the same thing that happens in a default: in that case, Greece would offer to pay 35 cents on the dollar for all of its debt. In this case, they’re trying to “default” on just enough of the private debt so that the public debt can be carried at par for a while and maybe, someday, be paid off at par.

I just wonder if they can make it to “someday.”

Do Androids Shop With Electric Money?

November 26, 2012 2 comments

“Cyber Monday” sounds like something dreamed up by Philip K. Dick for his book “Do Androids Dream of Electric Sheep?” (which later, of course, became the basis for the movie Blade Runner). So, how did it go?

Who cares?

The amount of time, money, and energy spent figuring out how “Black Friday” and “Cyber Monday” is going is all out of proportion to the amount of money actually being made by retailers those days. To be sure, this is an important selling season, and these are some of the most important days in that season. But it’s still a small number. Today eBay gained 4.9% and Amazon.com gained 1.6% in a market that was flat-to-lower all day (the S&P ended -0.20%).

Having said that, the frenzy seemed to be less intense than in years past, perhaps because the global economy (and the markets) face very real challenges in the next month, quarter, and year. On Friday, the tiny European nation of Cyprus asked for, and received, a financial bailout, according to government officials there (although denied by the EC). It’s good to be small – allegedly, their bailout could be as much as 100% of Cypriot GDP, but that’s only about $28bln. According to the story, the bailout includes “unpleasant measures.”

Not half as unpleasant, I’ll wager, as what would have happened if Cyprus had been forced to leave the Euro. As small as Cyprus is, it’s a cinch that no one would let that be the first domino. The first domino will fall when everyone has lost the capacity, or the will, to force the unmatched puzzle pieces to artificially jam together in an apparently cohesive unit. This denouement may still be some time away. As my friend Andy F wrote in his daily (FX markets) commentary today, “German Chancellor Merkel has been very clear that Greece will not fail, regardless of the fact that it already has.”

Now tonight, supposedly, we can again temporarily put aside the fears of a Greek exit from the Euro as the IMF and European finance ministers reached a deal on the (revised) terms of the Greek bailout. ECB President Draghi said that the agreement “will certainly reduce the uncertainty and strengthen confidence in Europe and in Greece,” and we will doubtless be told that repeatedly over the next few days.

Here is the full text of the Eurogroup statement on Greece, if you are curious, but in the interest of summarizing, I present here just the beginnings of the paragraphs, except for one paragraph worth quoting in full, and you can judge how much important content there is and how much progress was made in this meeting:

The Eurogroup recalls that…

The Eurogroup in particular welcomes…

The Eurogroup noted with satisfaction that…

The Eurogroup again commended the authorities…

The Eurogroup noted that the outlook for the sustainability of Greek government debt has worsened…

The Eurogroup considered that…

The Eurogroup was informed that Greece is considering certain debt reduction measures in the near future, which may involve public debt tender purchases of the various categories of sovereign obligations. If this is the route chosen, no tender or exchange prices are expected to be no higher than those at the close on Friday, 23 November 2012.

The Eurogroup considers that, in recapitalizing Greek banks…

Against this background and after having been reassured of the authorities’ resolve to carry the fiscal and structural reform momentum forward and with a positive outcome of the possible debt buy-back operation, the euro area Member States would be prepared to consider the following initiatives:

  • A lowering by 100 bps of the interest rate charged to Greece…
  • A lowering by 10 bps of the guarantee fee costs paid by Greece…
  • An extension of the maturities of the bilateral and EFSF loans by 15 years and a deferral of interest payments of Greece on EFSF loans by 10 years…
  • A commitment by Member States to pass on to Greece’s segregated account, an amount equivalent to the income on the SMP portfolio accruing to their national central bank as from budget year 2013.

The Eurogroup stresses, however…

The Eurogroup is confident that…

As was stated by the Eurogroup on 21 February 2012…

The Eurogroup concludes that the necessary elements are now in place for Member States to launch the relevant national procedures required for the approval of the next EFSF disbursement…

The Eurogroup expects to be in a position to formally decide on the disbursement by 13 December…

To my mind, the interesting part was the “Eurogroup was informed that Greece is considering” part, where what Greece is considering is “certain debt reduction measures” in which debt that is trading at, say, 34 cents on the dollar would be paid 34 cents on the dollar. Now, I am no expert on international bond law, but since the last “rescue” deal resulted in Greece taking on more debt, in terms of notional, in exchange for lower current interest rates, it seems like it may eventually dawn on the Greeks that if the Germans and Finns and French really want to keep the Euro inviolate, they might consider actually writing down some of the debt burden.

I have no idea how such a deal would work mechanically, and clearly it would have to be coercive (since if Greece is offering to buy all bonds at $0.35, they clearly will trade a tiny bit above that since there’s a chance they may be worth more). But I have long scratched my head about why the Greeks were so keen to stay in the Euro at the cost of extended deflationary economic depression in Greece. Could leaving the Euro really make things dramatically worse? Maybe before, when there was hope that the bailout deal would improve conditions, it was worth a smidge of obsequiousness. But nothing between the first loan request in April 2010 and the bailout/restructuring in February 2012 has had any effect at all on the suffering in Greece (and many people think it has exacerbated it). The chart below (source: Bloomberg) shows the Greek Unemployment Rate.

Moreover, as we recently pointed out in our Quarterly Inflation Outlook to our clients, the effect of having one rigid currency rather than 17 has been that inflation experiences have diverged dramatically rather than, as between nations which freely float a currency, tending to equalize. In the first 10 months of 2012, inflation has risen 0.1% in Germany, 0.8% in the Netherlands, and 0.8% in Finland (collectively representing a third of Euro GDP) while in Italy it has declined  1.2%, it is -1.3% in Portugal and -1.3% in Greece (collectively adding up to a quarter of Euro GDP). Interestingly, in France inflation has fallen -0.4%, as it has begun to migrate PIIGS-ward. The chart below (Source: Eurostat, Bloomberg) shows the acceleration in inflation for these countries (and Austria, -0.1%) versus their 10-year bond yields. The logarithmic function fit to those points shows an R2 of 0.73, which actually gets better if Greece is removed.

Clearly, the weaker countries are being forced into deflation as an alternate leveling mechanism because they cannot float their own currency lower. Why Greece, Portugal, and Italy would want to allow this to happen (rather than leaving the currency union) is beyond us, and if the trend continues then Finland and the Netherlands will be none too pleased as well for the opposite reason.

But for today, we can all pop champagne corks and celebrate the “Grexit has been averted again!” all the while ignoring the fact that the countries themselves have not voted on the “agreement” and Greece is at least tacitly threatening to take matters into its own hands unless the deal is pretty good.

This is not to say that last week’s U.S. equity rally had anything, really, to do with optimism about the European circumstances, our own fiscal cliff, or Japan’s election. Immediately after our own election, intelligent taxpayers began to try and realize gains in 2012 so that the potentially drastically-higher tax rates to be imposed next year will occur on profits realized from a higher tax basis. But as I noted at the time, that by itself is not a net negative for the market, since sellers will rotate into other names that they consider bargains at lower prices. So, while Apple plunged from $700 in late September to nearly $500 in mid-November, it is back to $589 today as some investors (including some who sold in September and have waited the requisite 30 days) have leapt back in with delight. It has also helped that a number of companies have paid large cash dividends in 2012 to beat the tax hikes, making the index dividend yield look artificially higher (and therefore the market look cheaper) than it really is.

There are other reasons to be skeptical about the medium-term trajectory of the market, of course, and I am not sanguine about the opportunities which the equity market offers at the moment. I think the key thing to keep in mind is that we are on the cusp of December, and “holiday style trading volumes” have been happening earlier and earlier every year it seems. Today’s volume was on less than 600mm shares, and fully one-third of that was in the last fifteen minutes of trading. Expect volatility to continue, but don’t get married to the price action.

Categories: Europe Tags:

Clearer Communication in the Wrong Quarters

November 14, 2012 Leave a comment

Whether it is that the passage of the U.S. election released Europe to begin fighting amongst themselves again about Greece, or instead that they’ve been fighting the whole time and we just didn’t notice because we were so introspective, it’s certainly happening and heating up again. The Eurozone finance ministers are bickering, publicly, over whether Greece should be given two more years to hit its financial targets. (See articles here and here.)   Also, and more importantly, the IMF wants the government owners of Greek bonds to write off some of their losses and lessen the Greek burden while some of the finance ministers (e.g., German Finance Minister Schauble) insist “that’s not legally possible.” Guess what? It’s going to happen whether it’s legally possible or not – but not this month. Greece will probably eventually get its tranche/lifeline this month, but the battle will be engaged with increasing intensity as time goes on.

That, however, is not the reason why stocks keep sliding (S&P -1.4% today) and bonds keep rallying (albeit gently today, with the 10y note yield down to 1.59%). I think that is happening because one week post-election, there is no sign that either Democrats or Republicans are budging on their positions vis a vis the fiscal cliff. The Democrats are winning on messaging, as they usually do these days, with the “Papa John’s Pizza approach” in which they have seized on the part of Romney’s budget proposal that they liked  (reducing deductions for high-income taxpayers) while ignoring the connection of that element with the intention to keep tax rates down. I call it the Papa John’s Pizza approach because it reminds me of the commercial with Peyton Manning.

Republicans: So how are we going to do this?

Democrats: We loved Romney’s idea, and we agree with you. We’ll cut deductions.

Republicans: No, no, no, no, no…you mean we’ll cut deductions and keep income tax rates from rising.

Democrats: Right. We’ll cut deductions.

Republicans: …you mean we’ll cut deductions and keep rates from rising.

Democrats: I’m glad we agree. We’ll cut deductions. See how open minded we are? We’re using Romney’s plan!

Say what you want about the class warfare approach, the Democrats run rings around the Republicans when it comes to communication.

One place where better communication is actually destructive, but ironically one of the only places where we’re actually moving towards better communication, is at the Federal Reserve. A Wall Street Journal article today was entitled “Fed Leans Toward Clearer Guidance,” and indicated that “the Fed would state how high inflation would have to rise or how low unemployment would have to fall before it would begin moving rates, which have been near zero since late 2008.” This was the main newsworthy point that Fed Vice-Chair Janet Yellen made yesterday, and it was driven home today in the release of the minutes from the October Fed Meeting:

“A number of participants questioned the effectiveness of continuing to use a calendar date to provide forward guidance….Many participants thought that more-effective forward guidance could be provided by specifying numerical thresholds for labor market and inflation indicators.”

Since June, a “soft” Evans Rule based on this idea has been in place, as I pointed out at the time. It is not terribly surprising that the Fed would move towards a more explicit formulation of the rule, because Fed economists have never figured out why ambiguity is a good thing when it comes to policy-making. If they really do manage to reduce the Fed’s deliberations to a series of simple and public rules, then they should just finish the job and replace the Fed with a computer, as Milton Friedman proposed many years ago.

As I’ve written frequently (and borderline obsessively), clarifying the exact path that the Federal Reserve will take in the future reduces the uncertainty that investors face. This is good in the absence of leverage, but if the opportunity to leverage exists then the decrease of apparent uncertainty causes an increase in the leverage desired by investors. The problem is that a margin of safety doesn’t only protect an investor from known uncertainties, which would decrease in this instance, but also from unknown uncertainties, which would not be affected and for which a margin of safety is absolutely crucial if we desire to avoid another financial market meltdown. But no one is listening to me.

Commodities rose today, despite the continued decline in equities. This is not unreasonable. I think that commodities and stocks are telling two different stories. If there’s a recession, it should hurt stocks and commodities (but more directly should hurt stocks) while further QE3 ought to help them (but more directly help commodities). Right now stocks are going up on QE3 while commodities are going down on the recession … exactly the opposite of what ought to be happening. To my mind that just means the ‘value gulf’ is getting wider and wider. The chart below (Source: Bloomberg) shows the ratio of the S&P total return index to the DJ-UBS index.

Right now there is an enormous loathing for commodities that I don’t really understand – it seems to me to be the bipolar nature of commodities investors that they either love or hate the stuff. It probably comes from the fact that there are no “value” investors in commodities since the theory on what constitutes “value” is so light. Right now it looks to me like stocks are relatively expensive, although they’ve been that way for a while.

For tomorrow’s CPI figures, the consensus forecast calls for an 0.1% rise month/month for both the headline and core indices (seasonally adjusted), maintaining the y/y core increase at 2.0%. Last month, core rose to 1.98%, and we’re ‘dropping off’ a +0.17% on the y/y comparison. If economists are right, and 0.1% is the rounded change in core inflation on the month, then the y/y rise in core inflation will more likely decline to +1.9% than stay at +2.0% (of the possible prints that would lead to +0.1% on the monthly, from +0.05% to +0.149%, anything from +0.05% to +0.129% would cause a downtick in the y/y figure while only monthly changes in the range of  +0.130% to +0.149% would keep the number stable.

However, I don’t see what will cause core to droop like that. I think economists are paying too much attention to the last several monthly changes and ignoring the fact that the weak prints were caused by outlier points (as evidenced by the fact that the Median CPI of the Cleveland Fed and the Sticky CPI of the Atlanta Fed, both different measures of central tendency, remain at +2.3% and +2.2% respectively). Moreover, housing CPI – the main driver of core inflation – is accelerating with both primary rents and owner’s equivalent rent rising last month, and all indicators of housing tightness from housing inventories to apartment tightness continue to suggest that higher price increases are more likely than lower price increases ahead. Moreover, we’re seeing upside surprises in other countries, such as in Greece that I mentioned yesterday, the in the UK where core inflation rose to +2.6% y/y versus 2.2% expected (see Chart, Source Bloomberg), befuddling most economists there.

That doesn’t mean the y/y core figure in the U.S. will definitely rise back to +2.1% this month; to do that, core would need to print +0.23% for the month, meaning the main body of the economist profession was off by half. Come to think of it, that’s not so far-fetched. If the last three months of core prints (+0.090%, +0.052%, and +0.146%) are quirky-low, then there should be a payback at some point. It’s hard to call for that in any given month, though.

Conservative Positions For A Liberal World

November 12, 2012 2 comments

Wow, where do we begin after a hurricane-induced hiatus? So much has happened. Since I last wrote, the U.S. elections have fallen into the rear-view mirror, the Bank of Japan has increased its asset purchases again, Greek inflation has accelerated to 0.9% from 0.3% (while Greek Industrial Production contracted for the 49th of the last 53 months, illustrating again how helpful it is to look at the growth rate of a country as a guide to deflationary pressures), and the stock market has moved to 3-month lows (and 10y note yields to 2-month lows) while the dollar has strengthened.

By far the largest event of the last couple of weeks, besides the restoration of power to my home, has been the U.S. elections. The immediate weakness in equity markets is completely understandable, but for the most part doesn’t reflect a vote against the President. Real equity market returns will be weaker over the next couple of years, but that’s because current valuation levels are high and future earnings will be lower than they would be under a more capitalist government. I don’t think investors are putting prices lower on that theory; indeed, as I wrote just before Sandy I thought that stocks are more likely to go higher than lower in the short-term with an Obama victory.

But let me define short-term, because in that post I completely neglected the very short-term effect of the days just after an Obama victory. I think an important part of the selling of equities now is reflecting investor realization of tax gains now, versus in the future when capital gains and income tax rates are likely to be at least somewhat, and potentially significantly, higher. That’s not a long-term effect, because those investors will also buy companies they perceive to be relative bargains in the case of a profligate spending policy (which is what everyone agrees we are likely to get – although some people think that’s a good thing; I suppose your own feeling on that matter likely defines how you voted). So this is mostly a cycling of positions, a re-setting of tax basis at a higher level, and shouldn’t amount to a major selloff by itself.

There still may be some net selling while the twin risks of the “fiscal cliff” and the Greek exit from the Euro remain uncertain and near-term. And here is where I am getting somewhat uneasy with my bullish argument (which hinged on the notion that typically myopic investors would prefer a 2013 recession that is shallower, due to heavy government spending, than a deeper one due to a Republican shrinking of government aka “austerity”). I think there are some bigger issues that are hard to look past right now, and they are related to those twin risks I just mentioned.

One of those issues concerns the “fiscal cliff.” Perhaps I am cynical, but I have long expected the issue to be averted at the eleventh hour (as usual – for example, see the annual ‘doc fix’ for Medicare). But it now occurs to me that the Republicans have absolutely no reason to compromise on their demand for no increase in taxes. Under a President Romney, the Republicans would have been able to leverage their control, make a few key concessions, and avert much of the damage. Under a President Obama, forcing the cliff to take effect is now the only way that the minority party of smaller government can force any austerity over the next few years. Especially if you believe – and I think it’s worth considering – that the failure of the Republicans to unseat a President with sub-50% approval ratings and an ~8% Unemployment Rate indicates that the argument is lost that we should take short-term pain in order to restore fiscal sanity, this represents the best remaining hope for fiscal sanity. The only way I can see the Republicans giving in on the ‘fiscal cliff’ is if (a) they sell their principles, which is always a possibility, or (b) the Democrats promise considerable compensation in terms of future legislation. I can’t imagine what that would be. So, in short, I think the odds that there will be a resolution of the ‘fiscal cliff’ have dropped considerably.

The second issue is the one of Greek exit from the Euro. I think I have been very consistent on this issue: I do not believe there is a viable future path in which Greece remains in the Euro. Whether the exit is clean and negotiated or sudden and traumatic or painful and drawn-out is the issue. This has been clear for months, even years, now. Yet, for a couple of months there has been relative quiet on this front, until the last week or two as the Eurogroup considers the distribution of the next aid tranche to Greece. We’ve also stopped hearing much about Spain, Italy, and Portugal although the Spanish 10-year bond yield is creeping back to 6% again (5.88% today). I don’t think this silence heading into the U.S. elections was accidental. The relationship between the U.S. President and the citizens of the world ex-U.S. is a very strong one, and I have no doubt that the politicians in Europe recognized that their chances of getting help from U.S. taxpayers would be much better after November 6th if Obama won re-election. Now that he has, the European issue must be confronted as world growth is weakening again. I have no idea whether the U.S. will try and contribute to a solution (which would ensure a painful and drawn-out resolution in which Greece would still, at the end, leave the Euro), but in any event this set of events is back in motion, and is not positive in the short-term for world growth or equity markets.

So in short, while I still think we can trust the myopia of equity investors to push markets higher over the next couple of months, I am less sure of that than I was. The election was a trigger for a lot of potentially bad outcomes, and with equity markets remaining rich I would certainly be maintaining a conservative risk posture here.

At least something can be conservative.

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