If The View Is Bad, Don’t Look
Inflation came in a teensy bit weaker than the consensus expected. Headline inflation fell 0.1% (actually -0.069%) and core CPI was flat (actually +0.047%). Owner’s Equivalent Rent was unchanged, and core inflation ex-shelter actually fell to 2.2% on a year-on-year basis. That may be encouraging (if you are worried about inflation taking off due to the incredible injection of money in 2008-09) or scary (if you look at the current money growth and lending data and are worried about deflation being the phenomenon we ought to worry about).
I haven’t been worried about deflation, despite the decline in core, because that decline was almost entirely a shelter phenomenon. It is still, predominantly, a shelter phenomenon but the rapid decline in the money aggregates combined with a slackening in broad price pressures is at least cause for concern. Certainly, it makes a rise in short rates any time this year a distant long shot unless money and credit growth picks up (and I thought it was unlikely rates would be hiked even if money and credit was skating along smoothly). More on that in a moment.
Now, before we read too much into the decline of ex-housing core inflation a few caveats are in order. First, one consequence of removing the big, slow-moving elephant from the index is that the remnant is more volatile, and therefore any given month is less important when measured against the underlying hypothesis. Also, part of the decline in the year-on-year core-ex-shelter number this month is due to the removal of last year’s April figure, which was somewhat higher than the trend. Some bounce-back next month is likely. Finally, core inflation still shows a longer-term, broad upswing that is only modestly less worrisome given the decline over the last few months (see chart below).
It is fairly likely, I think, that the decline in housing is affecting other, related items. Despite the decline in core ex-shelter, the spread between the rate of change of that measure and the rate of change of shelter itself is still near the widest on record (see chart below). This means that (a) the bubble unwind is still clearly influencing the core numbers and (b) therefore, it still makes sense to look at the ex-shelter numbers since these numbers are likely to converge, more likely to the non-bubble-unwind part, once the unwind is complete.
Although the inflation numbers didn’t miss by very much, the inflation-linked bond market was thumped like an unwelcome Yuppie in a biker bar. Inflation swaps fell 7-10bps, although that is mostly a guess since the market was generally offered without a bid for much of the day. Inflation bond breakevens fell a bit more than that, with breakeven inflation at the very front of the curve off about 25bps. That’s a pretty big drop for a near-expectation number, but with the way the global economy is looking … and more to the point, the health of the global financial community … traders can be forgiven for recalling how buying modest weakness in 2008 was rewarded with a severe beating in a room without exits. Capital dedicated to arbitrage has never made it all the way back, nor even most of the way back, but the capital that is at work ironing out inefficiencies wants to make sure it sticks around to get the really cheap stuff in the next blowup.
Which, it bears noting, could come soon. Apparently no less a light than Dow Theorist Richard Russell has suggested that if stocks trade below the May 7th low, a “major crash” could very well be in store (as opposed to those pesky minor crashes, I suppose). I can’t say that I can dismiss this out of hand. Volumes continue to be pretty high in equities as prices keep slipping lower (the S&P finished -0.5% today after being down almost 2% at one point), and other measures of stress are not receding quickly as they did the first half-dozen times we had a scare. The 10y note is at 3.365%, only slightly better today even though the FOMC minutes made clear that asset sales are not likely to be on the horizon, and that removes one big potential seller from that market.
The description of the economy in the FOMC minutes generally echoed what dealer economists have been saying, that growth is recovering nicely although employment (a lagging indicator) and some other pesky things aren’t yet behaving. Two of those pesky things are mortgage delinquencies and foreclosures, which were released today (for Q1) at an all-time high (see Chart: the second-highest isn’t even close). Delinquencies should be a lagging indicator, especially now since there are a lot of properties on which lenders have been forbearing from foreclosing because of the market, but it does mean that the supply overhang in housing should stay higher for longer, and that doesn’t augur well for the full recovery of the construction sector or of consumer spending.
The FOMC minutes also made, surprisingly, only passing comment on the Greek crisis, and it seemed to have little effect on the Committee’s deliberations. This seems incredible, since as of late April the crisis was already in full flower. The staff appeared to naïvely believe that the authorities in Europe could easily contain the crisis, or in any event the troubles of small Greece weren’t likely to be a big event for the US. The good news is that since the Fed was purely relying on low core inflation staying low for a while as their excuse for keeping rates low (also gleaned from the minutes), there is very little risk of rates being raised for the foreseeable future. The bad news is that the FOMC appeared to be badly uninformed about the severity of the European developments and the implication for banks foreign and domestic.
Those implications of course are still unfolding, and we won’t know the full extent of the crisis or the damage from it for some time, I would guess. It will take even longer to assess that damage if policymakers follow the lead of the Bank of Italy, who on Tuesday evening declared that banks who hold European sovereigns in their available-for-sale portfolio would not need to charge losses in those instruments against capital. Apparently transparency is a good thing, unless what we see through the window is bad and then we draw the curtains.
Also not wanting to look, apparently is Senator Dodd. This morning, the Senator was considering a compromise to the financial Armageddon bill (not its official title) that would first have required that the implications of the dramatic step of separating swap dealers from their stable parent entities be studied before the rule was enacted. By the afternoon, however, he had publicly renounced the idea of looking before we leap. Really, what could go wrong with such a carefully conceived plan? They did after all spend whole weeks, even a couple of months, thinking about it.