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Holding On For A Gyro


A bit of volatility today, but not really attributable to economic data. A round of applause for economic forecasters, who were very close to PPI (+0.7%/+0.1%), Claims (456k), and Existing Home Sales (5.35mm). Now if only they can explain why we shouldn’t be concerned that the Easter blip apparently occurred from a level around 460k rather than the 430k – and declining – they were forecasting a few weeks ago…

The volatility came from the continuing rout in Greece, where the various policymaker attempts to convince us that everything is okay are becoming increasingly easy to see through. Greece was downgraded (belatedly) by Moody’s, but the real judgement comes from the market where Greek bond yields are shooting higher. I said a month ago, when Greece was complaining about not being able to finance at the sub-6% rates to which it thought it was entitled, that the PM ought to hit the bid at 8%, if there is such a bid. That bid is evidently not there. Not even close. Look out – this is picking up speed as it rolls downhill.

Stocks took a bath overnight and opened weak on the Greece news, but then managed to rally for most of the day and end up positive. The S&P finished +0.2% after a bad open for good reasons. This is beginning to look more and more like bubble action, with two implications: first, it might go on for a long while (although it may also break tomorrow); second, the break may be ugly when it happens. Stocks are just not supposed to rally no matter whether the news is good or bad, especially when they are already at valuations that are stretched (to be kind).

Bonds did poorly, with TYM0 down 11.5/32nds and 10y yields up to 3.77%. The data, as noted, wasn’t particularly strong and news out of Europe would seem to enhance any safety bid, but the trading was the mirror image of stocks – open with a gain (although modest) and sell off throughout the day.

The Treasury announced that it will auction $11bln five-year TIPS on Monday (along with $44bln 2y, $42bln 5y, and $32bln 7y next week, plus bills). So what’s the inflation backdrop as we head into that auction?

The dollar is strengthening against the euro, and that is helping our relative inflation outlook (that is to say, helping to hold it down) compared to Europe’s. But our system isn’t exactly on a sound and stable basis; investors aren’t fleeing to our currency because it is the prettiest but because, at the moment, it is the least-ugly.

Inflation, fundamentally, has two sources: global inflation, and idiosyncratic (country-specific) inflation. If the latter is what threatens, then your currency ought to depreciate as well so that holding foreign securities provides a partial hedge. Similarly, if there is no underlying global inflation then a rallying currency can hold down domestic inflation (basically “exporting” it to weak-currency countries). In such a case, inflation is kind of a zero-sum game, as my deflation is your inflation and our currencies tend to reflect that.

But if what is threatening is a global inflation, then currencies may not move at all if there is no change in relative inflation outcomes at the same time that absolute inflation rises. What is suffering then is not your currency, on an exchange-rate between it and other currencies, but rather all currency compared to real goods. The price index is, after all, essentially an exchange rate between fiat money and real goods. This is, I think, what our current situation is. All countries are “stimulating” their economies, and all central banks are adding liquidity to a lesser or greater extent. In this case, a rallying dollar is solace, but small solace. Keep in mind that in the early 1980s, despite high inflation in the U.S. the dollar strengthened (the magazine cover below is from 1984). I am not significantly more sanguine about inflation now that I was before the dollar’s recent surge.

Inflation won't kill a currency by itself

On Friday, the economic data is in the form of Durable Goods (Consensus: +0.2%/+0.7% ex-transportation). Last month, Durables were strong (+0.5%/+0.9%), but it is unusual to have two back-to-back strong readings on core Durables even during expansions (see Chart below, source Bloomberg). Accordingly, I am cautious about the chance for a downside surprise.

Durable Goods, even core Durables, is highly mean-reverting.

Due out an hour and a half later (at 10:00 ET) is New Home Sales (Consensus: 325k from 308k). The consensus calls for a slight bounce from all-time lows. That doesn’t seem unreasonable. A further decline may be viewed with some alarm. At some level, I think what is happening is that distressed sales of existing homes are out-competing the sales of new homes, so that we ought probably to look at the sum of the two, but however you slice it the housing market still looks punk.

The stock market is set up to take a tumble at some point on growth disappointments. I don’t think tomorrow’s numbers are sufficiently important to trigger that, but I am on guard. The bond market, despite today’s trade, is certainly not falling apart and 3.75% 10-year yields seems to suggest bond traders are more sensitive about the chance of a growth surprise. I am bearish on bonds. I think stocks are expensive and bubbly, but from a trading perspective that makes me neutral and cautious. I don’t want to sell into a bubble (or if I do, I want to get out quickly) if one is forming; there will be plenty of time to sell a break once it happens.

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