The Bang We Have Already; The Bucks Are Yet To Come

Not that there was any great suspense about whether the Fed would be considering the shape of the QE2 campaign at the FOMC meeting next week, but if further confirmation was needed it came today in the form of news that the Fed asked dealers for their estimates of the size and time to complete of large-scale asset purchases (LSAP, or QE2) over the next six months along with the question of what the effect on yields may be. I have been on some of these calls in the past, and what the Fed usually asks is both “what is your firm expecting” and “what do you think other firms are expecting.” Bloomberg carries the story here.

The Fed probably only really cares about what one or two of its favorite dealers think, but since estimates have ranged from zero to $1-2trillion over all sorts of different time frames, it is prudent of the central bankers to get a feel for where disappointment would actually set in.

I expect that the Fed will announce a program that is near its maximum capacity, generally supposed to be around $100bln per month. Given that they cannot go out and buy $500bln or $1trillion in a few weeks, I don’t really see much advantage to announcing the total amount in advance. If it were my decision (on implementation, that is; if it were my decision on whether to do it or not the answer would be “no”), I would say something like “The Federal Reserve has determined to purchase approximately $100bln in Treasury securities per month until such time as …” and insert a condition. The particular position, of course, is where the rubber meets the road, and it could be a price-target approach (“…the compounded inflation rate from September 2010 onward reaches 2%”), a growth-target approach (“…measures of resource utilization become more fully utilized”), or a subjective approach (“…the average forecasts of FOMC members for year-ahead core inflation exceeds 2%”).

These are all problematic in different ways, though. The weighty drag of the housing bubble unwind will ensure that even if ex-Shelter core inflation were to be running near 4%, the “core CPI” could still be around 2-2.5%. This makes the traditional inflation measures to be bad target variables, because normal shades of monetary policy have no chance to affect the price of shelter when there is a 4mm-unit overhang. (Of course, outrageous amounts of money-printing would cause home prices to rise, but with that level of monetization I doubt the Fed would be worrying much about quarters and eighths of a percent). The Fed can therefore target 2% core inflation, but that would implicitly be letting the inflation genie out of the bottle for the 2/3 of the economy that isn’t housing.

The Fed meeting is still several days away, but while there are still economic releases to come it seems quite unlikely that the Committee will be dissuaded from action simply because Initial Claims came in at 434k rather than 455k (the BLS said the drop was related to post-Columbus-Day seasonal adjustments), or in the event that the Advance Q3 GDP report due tomorrow (Consensus: +2.0%, +2.5% personal consumption, +1.0% core PCE) or the Chicago Purchasing Managers Report (Consensus: 58.0 from 60.4) shows more growth than expected, or if the Employment Cost Index (Consensus: +0.5%) suggests inflation higher than the Fed’s forecast.

The train has gone too far to be derailed now. Moreover, we should not forget that what is provoking this action is not the perverse weakness in the economy right now but the visibility we have about the fiscal drag that will hit in Q1: higher taxes, potentially much higher if Congress does nothing; moreover, if the Republicans hold serve then they are also pledging to cut spending as well. This latter is certainly a good thing for 2012 and beyond, but there is no doubting the impact it would have on growth in 2011. QE2 is being initiated because the central bank feels it cannot stand idly by while this boulder is rolling towards us. And that means there is no time to waste. It will happen at the November meeting.

As for the market impact, QE2 has already induced the main part of its impact on the rate structure (as long as the actual program isn’t vastly different from the $500bln or so that I believe the market is expecting). The chart below (Source: Enduring Investments) shows 10y inflation swap rates in the UK, US, and Europe.

Inflation expectations have risen in the US. And only in the US.

You can see that since late August, US 10y inflation swaps have risen around 50bps (depending on the exact day you choose to count from). I choose August 27^th, because that is the day that Bernanke delivered his speech at Jackson Hole. 10y US CPI swaps closed at 2.08% that day; today those swaps finished at 2.54% (the latest 2 days are not reflected on the chart). I show the inflation swaps because it seems very clear that the move was not echoed in the UK or European inflation markets. US rates moved from being closer to the European standard (the ECB to date is assumed to be more hawkish on inflation because of its Bundesbank DNA, although I have my doubts how long that can hold) towards the regime where quantitative easing is already a reality.

The flip side of the coin is that 10y real rates (not shown) have fallen from 1.01% on August 27^th to 0.51% today.

People who are fixated on nominal rates (the poor, benighted souls) might believe that the market could move substantially lower in yield once QE2 is announced. Nominal rates are, after all, net unchanged since August 27^th (actually, +1bp). But clearly, there have been significant moves in rates, and in particular real rates have done exactly what the Fed wants them to do, and in a significant way. It strikes me as hard to believe that real rates can fall another 50bps without a truly massive program, and it seems unlikely that QE2 will lower inflation expectations, so I think we’ve already gotten essentially all the bang for our buck that we’re going to get.

The only thing left to see, as my good friend Marty said it yesterday, is whether the bullet once fired is destined to hit a bad guy…or a good guy.

Less Reason To Be Bored, But Bored Still

The bond market continues to worry, while the stock market continues to be bored by the whole lead-in to the election and Fed policy meeting next week. (The equity market traded lower in the morning but ended the day off a scant -0.3%.)

Bond investors are preoccupied with QE2, clearly. The Treasury market suffered a setback overnight on the basis of a Wall Street Journal article entitled “Fed Gears Up for Stimulus,” by Jon Hilsenrath. Hilsenrath is supposed by some people to be the current Fed ‘mouthpiece’ by which market expectations are adjusted while retaining plausible deniability for the Fed. In the article, citing no one (and thus doubly suspect for the specificity of the speculation), Hilsenrath states:

“The central bank is likely to unveil a program of U.S. Treasury bond purchases worth a few hundred billion dollars over several months, a measured approach in contrast to purchases of nearly $2 trillion it unveiled during the financial crisis. “

Investors, based on the reaction of the bond market, expect more than “a few hundred billion,” although the article did not suggest that amount “over several months” would be the sum total of the operation. Indeed, it is generally supposed that more than $100bln a month would be difficult operationally for the Fed, so such a pace is pretty close to full-throttle for QE2. I suspect that what was being run up the flagpole was the wording of the announcement, and whether the Committee should highlight just the near-term plan or whether it is necessary to allude to continuing purchases in the future. I suspect the answer will be the latter.

The worries about a less-dramatic-than-expected QE2 apparently trumped, for bond investors, the possible renewal (already) of the Greek tragedy. Greece’s Finance Minister said today (story here) that tax revenues have been falling short, and so the budget shortfall will be above 15%…quite a bit more than Prime Minister Papandreou suggested it would be as recently as October 7^th. Greek bonds got whacked, along with other European bonds. Golly, we thought that the ECB’s rescue would buy more than a couple months of peace!

While the Greek news helped the dollar (as did, probably, the speculation of smaller QE2), it didn’t boost Treasuries as much as one would have thought. Bonds also seemed indifferent to the weak Durables number. Durables ex-Transportation was -0.8% versus expectations for +0.5%, which means that core Durables actually declined over Q3, and Nondefense Capital Goods Orders ex-Aircraft fell an annualized 5.5% during the quarter. Shipments of nondefense capital goods still rose, so this will not much drag on Q3 GDP, but the outright decline in orders is a bad sign for future quarters and another indication that the post-Lehman bounce has run its course.

In other news, even without QE2 we got an inflation bump: the Metropolitan Transit Authority in NY announced that bridge and tunnel tolls will rise 7.5% on December 30th. This follows increases in train fares several months ago. While stochastic increases in tax rates and fees are not technically inflation (because they are not automatically repeated), they do raise the price level and so are beneficial to those holding indexed bonds.

Today, though, indexed bonds took a beating. The nominal 10y yield rose to 2.71%, but TIPS yields rose more than nominal yields rose, so inflation breakevens and inflation swaps declined 3-5bps. Some of this may be hangover from the 5y TIPS auction, but I suspect most of it is profit-taking in long-TIPS and long-inflation positions from much sweeter levels – taking chips off the table before QE2 especially if Hilsenrath is right and it will be underwhelming.

Fortunately, we are down to a blessed few days before we will get resolution to the two major uncertainties facing investors: the election and the Fed meeting. Not surprisingly, implied volatilities have risen for the last couple of days, and today the VIX peeked over 22 after starting the week at 18.78. After these two events pass, I would expect to see the VIX decline – unless there is a major market-affecting surprise from one of those two events.

On Thursday the only data is Initial Claims (Consensus: 455k vs 452k last week). There is not much to say about that. There is also the last auction of government duration prior to the big events, as the Treasury looks to unload $29bln of 7y notes. Even as investors are cutting positions, I would think the auction goes well simply because the issue is some 25bps cheaper than it was a couple of weeks ago. But I would think that dealers presently will be fairly interested in distributing the risk quickly, and a good auction may be met with selling.

Lend Us Some Rope!

The market continues to tread water and lose momentum as we wait for the seemingly-inevitable election results and second round of quantitative easing. However, the bond market didn’t get the “treading water” message, and the 10y yield rose to 2.64%, with 10y note futures losing 22.5/32nds in a steady bleed all day. Inflation breakevens rose modestly.

November was once a dangerous month for fixed-income, because many dealers had their fiscal year-ends in that month. As a consequence, market-making liquidity could occasionally seem December-like but investors remained nearly as active as normal. This produced big moves, especially when mortgage convexity was a big deal, and often to higher yields.

Now, though, some of the dealers (Lehman, e.g.) that had year-ends in November have ceased to exist and others (Goldman) enjoy a December year-end as the consequence of creating a 1-month “rump” period in 2008 where losses could be chucked. So November isn’t as chilling a prospect for bond investors as it once was.

On the other hand, general liquidity is lower thanks to various dealer-unfriendly regulatory actions implemented over the last year or so. I bring this up simply because an 8bp selloff on nothing, when other markets were essentially flat, is the sort of move we might have seen in November once upon a time. I wonder if it is a one-off seller in size, or whether bond market investors generally are merely lightening up before the equity investors decide to head for the exits. I suspect the latter.

Economic data today was once again not revelatory. Consumer Confidence came in near expectations, but with “Jobs Hard To Get” edging higher. The FHFA Home Price Index rose month-on-month (versus expectations for a fall), but the S&P/Case Shiller index was softer than expected.

Tomorrow we will continue marking time. Durable Goods Orders (Consensus: +2.0%/+0.5% ex-transportation) is expected to show that Q3 followed the same pattern as the last three quarters: a decline in core durables in the first month of the quarter, followed by a rise in the last two months. Even so, if the consensus estimates obtain then the average over the quarter of core Durables will be the lowest it has been since the first quarter of 2009 (at around 1% annual rate). Indeed, the 6-month rate of change in core Durables will decline to around 1.5% (annual rate) if the consensus obtains, as the chart below shows.

The bounce appears to be over in Durables, too.

In other words, the post-Lehman easy comparisons are now fully past. For some time, it has been clear that this was happening in Initial Claims, where the average for the last year has been almost exactly what it was just prior to Lehman’s demise. The horizontal line in the chart below shows the level of Claims for 9/12/08. I have shown charts of this type before, and readers will be familiar with the message: the “recovery” of early this year, so trumpeted by politicians, equity market shills, financial journalists, and even the NBER, is only a “recovery” because the baseline is taken to be the Lehman/Fannie Mae/Freddie Mac/AIG/etc calamity, and not the recession that was already in place prior to those events. It is as if a man walking along the bottom of the Grand Canyon falls into a hole; when he climbs out of the hole he is relieved to be “back on top” again. Of course, he is still in the Canyon…

Thanks to Lehman, 2009-10 looked like a recovery. It wasn't.

Insert whatever observation you wish to make about the effectiveness of the trillions of dollars that world governments have thrown at the recession. Whatever your observation is will be correct, if you choose your perspective correctly. The trillions “worked” because we were able to climb back out of the hole. The trillions “failed” because we are still in the canyon, and that was our only rope. Fine. All I know is that we’re trying to borrow more rope if anyone will lend it to us.

Also tomorrow, New Home Sales (Consensus: 300k) is expected to show an improvement, and may well exceed the consensus estimates as Existing Home Sales did. Again, your point of perspective matters. Prior to the last four months’ of sales (282k in May, 312k in June, 288k in July and 288k again in August), the lowest tally of New Homes sold ever was the 338k of September, 1981. So contain your enthusiasm.

Actually, containing enthusiasm seems to have been the easiest task for this market for some days now, and for the next few days the most likely occurrence would seem to be continued contained enthusiasm, or even ebbing enthusiasm as we are beginning to see in bonds.

Negative Real Yields Are Nothing New

It gets increasingly difficult to write a comment about the macroeconomy and the market implications thereof when the macroeconomic developments have ceased to have any important effect on the market. Every market bet now is a bet on the Fed: bonds, stocks, TIPS, commodities, the dollar…everything. So who cares about the data?

To be sure, I am one of those who believes that the better-than-expected Existing Home Sales number we saw today (4.53mm versus 4.30mm expected) is nothing to get excited about when the ’08-’09 low was 4.53mm, but ordinarily such a positive surprise can be counted on to jazz equities and razz bonds. Today, there was hardly a ripple.

The 5y TIPS reopening came at -0.55% real yield, which provoked many dramatic headlines about how this was the first ever negative yield for a Treasury auction. Those of us who live and breathe in the inflation-linked markets are accustomed to this sort of real-nominal confusion. In truth, there is nothing particularly extraordinary about an auction clearing at a negative real yield, and in fact there have been many, many Treasury auctions that cleared at a negative real yield. Apples to apples, folks – the most-recent nominal 3y Treasury note auction cleared at 0.569% on October 12^th. The 3y inflation swap was 1.50% on that day, so that auction cleared at a -0.931% real yield. Treasury Bill auctions routinely occur at sharply negative real yields; the only thing unique about a TIPS auction is that the real yield, and not the nominal yield is reported. There is nothing remarkable about the level of today’s TIPS auction.

Another way to think about it is this:

Treasuries will pay (required real yield + a priori expected inflation)

TIPS will pay (required real yield + actual ex post inflation)

With nominal Treasuries, since we’re setting in advance both the real yield and the expected inflation, the practice is to report the sum of the two rates. But that doesn’t mean an investor in Treasuries doesn’t care about the real rate he’s getting!

TIPS are very probably not expensive but on the contrary cheap to Treasuries, at these negative yields – at the short end of the curve, at least. The 5y TIPS at this level will perform better over its life than the 5y Treasury note as long as inflation averages 1.75% or more over the next 5 years (that is, as long as ex post realized inflation turns out to be greater than a priori expected inflation). As with the economic data, this bet boils down to whether the Fed can achieve the level of inflation (or the price level) that it desires. The folks buying the 5y TIPS believe that it can. (Circling back to the Existing Home Sales numbers, inventory is now above 4mm units, making such a bet on inflation more problematic in the short-term but five years is a lifetime in monetary policy – see Friday’s comment).

Inflation swaps widened after the successful auction (2.84 bid:cover was pretty good for the first ever auction that cleared at a negative real yield that we didn’t have to do math to see), increasing 2-6bps with the best performance around the 5y point.

Looking forward to tomorrow, the economic data that we will all ignore includes the Case Shiller Home Price Index (expected to be +2.10% on the Composite-20 y/y, down from 3.18% last month) and the FHFA Home Price Index (Consensus: -0.2% month-on-month vs -0.5% last), along with Consumer Confidence (Consensus: 49.9 from 48.5. Continue to watch the Jobs-Hard-To-Get subindex, which is a great coincident/short leading index of the Unemployment Rate and which rose last month to 46.1).

And regardless of that data, the bond and equity markets are both looking tired to me. With just one week to go before the election and another day after that before the presumptive QE2 kicks off, I wonder when the risk-shedding will begin. The technical indicators seem to warn of ebbing momentum and trend-followers have lots of profits to take. A six-month, 160bp rally like we have seen in the 10y note from April to October is not common, especially once we are well into a recession: we had such a rally in 2007 extending into early 2008 as the market realized the parlous economic state we were in and began to price it in, and of course in 2008 we had a bigger rally over a shorter period of time. In 2002 there was a similar-scale rally, albeit from higher yields. That is the entire roster of such rallies over the last decade. Yes, yields are 17bps above their low ebb, but this is one pullback I think could extend much further.

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A quick reminder: my book is finally available on Kindle (link to purchase: Maestro, My Ass!
). I will be getting around to putting it on the iPad soon; let me know if there is another e-book distributor where you’d like to see it offered.

One More Turn Before The Home Stretch

On a Friday with no economic data, and with one more turn to go before the home stretch to Election 2010 and QE 2010, the markets were predictably quiet. That quiescence survived the revelation – which by now is hardly revelatory – that Fannie Mae and Freddie Mac are bottomless pits sucking up taxpayer money. The FHFA estimated (see the Bloomberg story here) that the two GSEs could require as much as $363bln through 2013 if the housing market worsens, although the cost to taxpayers would “only” be a cool quarter-trillion dollars.

But we’re used to seeing ugly worst-case scenarios. What was a little more of concern to me, at least, is that under the best case scenario the total cost would be $221bln (a mere $142bln after dividend payments), or in other words another 50% or so more than has already been spent. That bears repeating. The best case scenario is that the GSEs will need another $73bln.

The other thing we know is that worst-case scenarios from government entities have had a nasty way of being exceeded by actual events (remember the “worst case” unemployment rate from the stimulus bill? The original Romer chart is below. For the record, we are around 3% above Romer’s projections for late 2010, and around 1% above her worst-case analysis).

 

Thank goodness we didn't get the worst-case scenario!

 

It bears noting that these FHFA projections do not contemplate the complete unwind of the GSEs. That is to say that even if these are accurate estimates for the cost of the current crisis, they do not include any costs of protecting us against the next crisis. These aren’t the numbers to get FNM and FRE to conservative leverage ratios and profitable, higher-quality lower-volume business. These are the numbers to get them off life support.

However, since the future of the GSEs, the economy, and the government may all see an inflection in the next two weeks, perhaps it’s reasonable to look away from these numbers. At the very least, it is advisable to do so if you are prone to nausea.

Monday’s data consists of another rotten Existing Home Sales number (Consensus: 4.30mm from 4.13mm) and activity indices from the Chicago Fed (no forecasts) and the Dallas Fed (Consensus: -8.0 from -17.7). Before July, the lowest ever Existing Home Sales number had been 4.53mm in November 2008, so keep any bounce in context! More important than the sales numbers, I think, are the inventory numbers, which have recently leveled off at the awful level of 4mm units. To get home prices to stabilize for the year ahead, that inventory needs to get back to 3.5mm units or below (see last month’s commentary here. The chart is reproduced below.

More supply? Lower prices.

I don’t, however, expect that the market will react very sharply to Existing Home Sales. More provocative next week are Consumer Confidence and the Home Price Index on Tuesday, Durable Goods on Wednesday, and the advance look at Q3 GDP on Friday. I expect sluggish trading otherwise, although we may start to see a little downward pressure on stocks later in the week as investors cut positions before the election and Fed meeting.

A Different Commodity Investment

Now that we have most of the important data that we are going to have by the time the Fed next meets, and now that we have heard from virtually every Fed official regarding their personal feelings about QE2, the market seems to be starting to feel a little ambivalence. Stocks rallied early today, then financials led the way lower as investors learn more about what John Mauldin has called “The Subprime Debacle: Act 2“, and then buyers and sellers fought their way to a draw at the close. Bonds ended lower, with the 10y yield at 2.53%; TIPS held up well and inflation swaps widened 2-4bps on the day.

Initial Claims and Philly Fed were both on target, although last week’s ‘Claims number was revised upward by 13k because some states were unable to get their numbers in on time and the BLS’s estimates turned out to be too low. There is nothing really revelatory about these numbers, more’s the pity since they are the last data of the week.

So, without much to say about economic developments, I want to mention an inflation-related investment I recently discovered.

I occasionally am asked about what investment alternatives are available that may provide some inflation protection. As I have discussed previously, there is no good alternative to TIPS if you want a low-volatility investment in real space. Since TIPS are explicitly indexed, buying a TIPS bond with a duration equal to your decision horizon is a zero-volatility investment (or essentially zero volatility) in inflation-adjusted terms. They are even less-volatile than TBills, in those terms. The chart below is from an article I wrote several years ago with Bob Greer of PIMCO, called “History of Commodities as the Original Real Return Asset Class” and available in the book Inflation Risks and Products, by Incisive Media (2008). The method of analysis, though, is from Rob Arnott, the brilliant Chairman of Research Affiliates, and first appeared I think in the Financial Analysts Journal. The usual connection between “risk” and “reward” is done in nominal, not real space; this chart puts the returns relative to the performance of an inflation-linked annuity – which would be the minimum possible risk. Notice the position of TIPS.

Investment returns and risks, through 2006 only, in terms of real purchasing power

But there are several reasons to look at other inflation-sensitive investments. One is for diversification reasons. I am sure I am not alone when I say I am not completely comfortable in putting all my eggs in one basket, even if that basket is held by the world’s only military superpower. Another reason, particularly poignant these days, is for incremental performance. With TIPS’ real yield negative out to 2017 (see Chart below, Source: Enduring Investments), other riskier alternatives start to make real sense.

Yipe! Lots of negative real yields here!

Commodity indices are (as Bob and I discussed in that chapter) neat inflation-resistant investments because they not only have exposure to real stuff, but also a source of real return over time. This is not true of direct investment in commodities: unless your investment is making, mining, or growing more stuff, you’re going to end up with the same pile of stuff and definitionally a zero real return.

There are a number of ways to invest in commodity indices, but I found an interesting one today (disclosure: I bought some of this ETF but receive no compensation of any kind for discussing it). The symbol for the United States Commodity Index Fund is USCI. It has $34mm under management and is only two months old.

USCI has an expense ratio of 0.95%, which isn’t egregious for a commodity fund. It has two significant items in its favor. One is its design, which I’ll get to in a minute; the other is its pedigree. The fund is managed by SummerHaven, which is a company co-founded by Yale University Professor Geert Rouwenhorst and advised by Gary Gorton. These two guys wrote a terrific paper back in 2005 called “Facts and Fantasies about Commodity Futures (link), which ought to be required reading if you are investing in commodities. In this paper, they demonstrated that investing in an index of commodity futures, compared to investing in spot commodities, offered a far different (and better) source and distribution of returns. For example, they showed that a buy-and-hold strategy in spot commodities would have earned a compounded return from 1959-2004 of 3.47%, compared to 4.13% compounded inflation (and this ignores storage, insurance, and other carry costs). However, investing in commodities via collateralized futures contracts would have earned 10.31% compounded. The chart below makes that point visually, and is from that paper.

Commodity futures have crushed spot commodity returns.

So, these guys know a little bit about commodities.

Their knowledge of the drivers of commodity returns lends itself to the design of a credible commodity index product. The USCI takes advantage of the observation that in the return of a commodity futures strategy, it matters quite a bit whether the futures curve is in “backwardation” (meaning that forward months trade at a lower price than the spot month) or “contango” (which means that the forward months trade at a higher price). In a contango market, when the investor who is long the spot contract needs to roll to the next contract, he is selling the lower-priced contract and buying the higher-priced contract. This is the reason that USO (which owns front-month Crude Oil contracts and rolls monthly) has underperformed spot crude oil dramatically since inception (spot oil up 16%, USO -49% since 4/10/06).

A normal commodity index owns a broad group of commodities. It owns the ones in contango and the ones in backwardation. But USCI only owns 14 of the 27 eligible commodities at any one time. It selects the commodities it is invested in, monthly, based on a number of factors of which the degree of contango or backwardation is an important one. An index created using the rules USCI uses outperformed the S&P GSCI over the last five years by 255% (see Chart below). Yes, that’s right, 255%. Of course, that doesn’t include expenses, so subtract 5%. And there are other slippages to an actual product compared to the index. But 50% per year outperformance will cover a lot of sins.

Selectively choosing the 14 "best" commodity futures seems to be a good idea

The chart here is instructive for another reason – the massive drawdowns that occasionally happen are not fun, and even with a good commodity index, you still have significant volatility. When people ask me “how much of my portfolio should be in commodities,” my answer is “it depends entirely on your risk budget. Your investment will be constrained by the risk you are willing to take. I suggest thinking about the class of commodity investments the way you would think about a single stock. How much of your portfolio are you willing to risk on a single stock? The answer to the question about the limits of a commodity investment will be of the same order of magnitude. If you are willing to risk no more than 3% of your portfolio on a single stock, I might say that 5% is a reasonable concentration in commodities. If you typically risk as much as 10% of your portfolio on one idea, then 10-15% in commodities is an amount of risk you may be comfortable with. If you’re risking more of your portfolio than that on one concept…then you may want to reconsider your risk! (Of course, these are only guidelines – your situation is unique and ought to be addressed as such).

Many Indictments, No Conviction

One day after reversing recent trends, due to what appeared to be a sudden realization that something-could-still-go-wrong, markets were back in the reflation trade today. Stocks rallied back 1.1%. Volumes have been better of late, with share numbers above 1bln for the last week or so; clearly, there is money flow into the market. Where is it coming from? Well, just about anywhere…if you believe there is going to be lots of liquidity coming this way, and that there is a Bernanke put if it turns out you are wrong (in the sense that if the market plunges in disappointment the Fed will eventually ease anyway), then any asset is better than cash, stocks are better than fixed-income, and commodities better than stocks.

Please note that I said if. I have no doubt that the Fed is going to do QE2, but I have serious doubts that it will affect the money supply very much and I expect that the desire to take 2010 profits before 2011 income tax rates kick in will be on display for November and December. Equities, I fear, are setting themselves up for a fall.

One of the interesting QE2-trade-trends that resumed today was the dollar’s weakness. Now, if the Fed is the only one doing quantitative easing, then surely an increase of the supply of dollars relative to yen, Euros, and pounds sterling will tend to drop the price of the greenback. That doesn’t appear to be the case, however, and today in particular there was a stark reminder to that effect. To wit, the Monetary Policy Committee (MPC) of the Bank of England, while voting to keep monetary policy unchanged, made it clear that the members were leaning towards further monetization. From the minutes of the MPC, as reported in this story:

“Some of the members felt the likelihood that further monetary stimulus would become necessary in order to meet the inflation target in the medium term had increased in recent months.”

Some analysts (and I am one of them, although I hasten to add that I am not qualified to be an MPC-watcher) feel that a movement to purchase more bonds could come in November, which of course would provide a certain synchronous harmony with the FOMC’s move that is likely in the same month. I would not be terribly surprised to see the other major central banks follow suit as well, if only because they hold lots of dollars and probably would prefer it if the dollar didn’t go into freefall for an easily-preventable reason. But despite this fairly-obvious offer to join the Fed’s campaign to create more paper currency, Sterling beat the buck almost as badly as the Euro did. That doesn’t seem to me to make a lot of sense.

There are many reasons to be negative on stocks, and for that matter bonds, here. Valuation is one of these. The declining transactional liquidity and widening spreads (although as I said equity volumes are doing better) is one. The fact that the Fed (through its managers Pimco and Blackrock) is suing a bank that they are also responsible for monitoring, in a surprising conflict of interest. An ebbing of momentum. Rotten political dynamics in terms of actually finding solutions (although gridlock is admittedly better than the recent policy of causing harm). Monetary policy that seems to be heading towards some acceptance of inflation greater than what has been tolerated in the past; as I’m fond of pointing out, equities tend to do poorly when inflation is either negative or above 2-3%. Bonds wouldn’t do great in that scenario either.

If prices were lower, then some disappointment along any of these lines could be tolerated. It isn’t clear to me that it can be tolerated with prices at the current level, so I expect the market to being sputtering soon (both bonds and stocks).

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A quick announcement: the Kindle edition of my book is now available (here) and I hope to soon have an iPad version out. Of course, you can still buy the real-paper version here.

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Thursday’s data includes Initial Claims (Consensus: 455k from 462k), Leading Indicators (Consensus: +0.3%), and the Philly Fed Index (Consensus: +2.0 from -0.7). Optimism springs eternal. The bounce last week in ‘Claims is expected to be reversed, and the bounce last month in Philly Fed from -7.7 to -0.7 is expected to be extended. I don’t see the reason for such optimism, although to be sure these would be pretty marginal improvements and probably not worth a pizza party. St. Louis Fed President Bullard is actually giving a press briefing specifically on monetary policy at 2pm ET; in the evening Hoenig is going to tell everyone why the Fed needs to start hiking rates when he expounds on the US Economic Outlook at a speech in Albuquerque. Finally, the Treasury will announce the size of the 5y TIPS reopening tomorrow.

At this point, I expect markets will hold serve for at least another week but may begin to lose steam as the Fed meeting approaches. I wouldn’t be looking to ride the last 2%, though, and I don’t see the potential for another 10%.

We’ve Had Better Days

Stocks took it on the chin on Tuesday, the extended position being exposed by a couple of fairly innocuous developments.

Bank of America reported a $7.3bln loss for the quarter, rather worse than expected. But don’t worry! Since the reported P/E of the S&P these days is usually shown ex-companies-with-losses (except for the number reported in Barron’s, which still calculates it properly), this won’t make the S&P look more expensive. BOA made $3.1bln before a $10.4bln ‘one time’ write-down of goodwill due to recently-enacted laws that (according to Bloomberg) could slash debit-card revenue as much as 80%. It seems to me that if they didn’t see this one coming, it’s hard to believe they know it’s a one-time charge. Both barrels of the legislature are trained on the banking sector, and sometimes they hit.

That news set stocks back in the pre-open hours, as did Apple’s guidance (after announcing a solid ‘beat’ today) that they would miss analysts’ expectations in the current quarter. These are hardly watershed events, but negative enough considering how far the market has come recently.

Housing Starts surprised on the high side, with 610k units (annual pace) being started last month. But the chart (see below) gives the proper context – this is hardly earth-shattering news either. The new construction part of the market isn’t the part that still needs to normalize: that would be the overhang of existing homes. But as long as ‘Starts stay low like this, it helps to reduce the total stock of housing for sale (new and existing) and that will eventually heal the housing market. Not this year, but eventually!

The recovery is 'L-shaped' in Housing Starts, at least.

Stocks spent the first half of the day shaking off the overnight weakness, or trying to, but then took a big leg lower when Dallas Fed President Fisher said that the Fed’s “debate on possible easing may not be completed in November.” See how much of the market’s ebullience is based on the greater-fool theory that the Fed will be flushing free money into the system to push asset markets higher? But Fisher simply hasn’t gotten the memo. He is correct that the debate will not be completed in November; for all intents and purposes it was completed in October. Chicago Fed President Evans, just today, was discussing how the Fed needs “large purchases” to get inflation’s behavior to be what they want it to be. NY Fed President Dudley also supported that notion today. And they are hardly alone. Fisher may be trying to throw down the gauntlet, but all that really needs to be decided is whether there are two dissents or only one. Let’s just say that if the Fed does not actually initiate QE2, the whole “transparent communication” policy needs to be re-thunk because there is a pretty strong consensus right now that QE2 is coming and no dovish Fed official is doing anything to discourage that notion. (Regular readers will know that I favor more opacity, but if you’re going to say you’re transparent you’d better actually be transparent. The double-agent routine would deliver a crushing blow to markets).

After the Fisher bombshell (which, as I say, isn’t really much of a bombshell because we knew where he stood), stocks never really could recover very much. Bonds ended higher, with the 10y yield down to 2.47%, but bond folks know how to read the Fed chatter and probably realize this doesn’t signal that the Fed is backing off at the last minute.

A late rally cut the S&P’s loss to -1.6%. The dollar streaked higher, and commodities were set back hard. Inflation-linked swaps declined 1-4bps. All in all, it was a rough day for trend-followers.

On Wednesday, regional Fed Presidents Plosser and Lacker will both be speaking (in addition to the speakers still remaining today). The Beige Book will be released. And there are more earnings announcements. It remains to be seen if today’s technical damage, more than the events themselves, is enough to make investors somewhat wary to push prices back to their recent extremes.

Laissez-faire, Laissez-passer? Non!

As the strikes continue in the land of Bastiat and de Gournay (who is credited with the phrase laissez-faire, laissez-passer), American markets extended the “It Could Never Happen Here” rally.

The Physiocrats de Gournay, Quesnay, and Turgot believed that government’s function was to defend the rights of life, liberty, and property – this latter point famously became “the pursuit of happiness” in one particular document, which has led to much confusion through the years – and very little else. Bastiat, writing later and bridging traditions of the Physiocrats and the Austrian School, argued that the law can’t perform this basic function if it is also promoting socialist policies which tend to run counter to at least the last two of these elemental rights.

All of these guys were French.

In 2010, French truckers blocked highways today in an attempt to cut off fuel supplies from Paris, in support of the second week of refinery strikes and ahead of a full nationwide union strike tomorrow. This is all resulting from Monsieur Sarkozy’s plan to raise the official retirement age to mon dieu! 62 years old from 60.

It requires no great feat of imagination to contemplate what might happen in this country when (not if) the Social Security official retirement age is raised from 67 (which is what it is right now for taxpayers born after 1960) to 69 or 70. Now, this isn’t going to happen any time soon, because any proposal for intelligent discussion on the matter results in stories like this one, in which the Democratic incumbent is filleting the Republican challenger for suggesting that he would consider the economic merits of raising the retirement age to 70. The challenger, Bill Flores, blamed a headache for making him say such a rational thing.

So he needs an aspirin, which ironically is all that Medicare will be able to afford to buy him when he retires.

As I said, U.S. markets remain blissfully unconcerned about our own fiscal challenges, apparently because the riots so far have been limited to Tea Party members. Equities also remained blissfully unconcerned about the surprise decline in Industrial Production (-0.2% when +0.2% was expected), some of which was related to utilities but not all. Stocks rallied again, +0.7%, with the 10y Treasury rate down to 2.49% and a small drop in inflation markets. I sold all of my 5y and longer TIPS today, and will invest the proceeds in OSM, short-term TIPS, commodity indices (GSG, possibly DBB), and cash.

Citigroup reported profits of $2.17bln. That result was sort of helped by the $1.99bln in loan-loss reserves. With the reserves decline, they beat estimates by 2 cents; without it they would have missed by 4-5 cents. To be fair, part of that decline in reserves happened because they disposed impaired assets at better-than-expected prices (their Citi Holdings division lost $4.64bln on loans, but released $1.54bln in reserves), but of course the impaired assets that are disposed of early are likely to be the best-priced of those assets. I continue to be amazed that with the mortgage refinancing mess likely to shove huge amounts of mortgages back on banks’ books, loss reserves are shrinking rather than growing. How huge? Well, JP Morgan analysts estimate $55-$120bln, spread over the next 5 years (see story here). I guess that bank’s loss will be mortgage investors’ gains, but it makes me scratch my head further at valuations in that sector. But what do I know, I’m an inflation guy.

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Since we seem to be moving inexorably towards QE2, I want to revise and extend my remarks on IOER. I have been writing that the payment of interest on reserves is a primary reason, probably the primary reason, that QE1 went almost entirely into excess reserves. As the chart below shows, the sudden appearance of excess reserves is pretty closely related to the appearance of IOER; banks may “have a blank check to create money,” as one Fed official put it recently, but they have chosen not to do so largely because they are being paid not to.

 

Blue line is excess reserves (left scale).

 

As I like to say in my talks, the money multiplier is broken but we know who broke it and we know how to fix it. Just lower the IOER, even make it a penalty rate, and the excess reserves will turn into money quite quickly.

Now, you can see from the chart that excess reserves are gradually slurping back into the system even with the IOER where it is. Unfortunately, M2 money growth at 3.3% over the last 52 weeks (about 5.4% pace over the last 26 weeks) just isn’t going to do the trick. Lower IOER and you won’t even need QE2, at least not yet.

So why are excess reserves balances declining at all? Well, there are really three ways to get excess reserves to turn into loans. Banks hold excess reserves because the opportunity cost, in terms of the risk-adjusted expected return on the loans they would otherwise make, is too low to make that a superior alternative to holding riskless cash. We can change that calculus in three ways:

1. Decrease the expected return on reserves. That is, cut the IOER or make it negative, as I have suggested.
2. Increase the risk-adjusted expected return on loans by letting banks charge what the market will bear in interest. While big companies are not seeking bank loans, mid-size companies are, and are having difficulty finding credit. The reason they are having trouble finding credit is that banks know if they charge the rate that is necessary for them to make the required return on equity, Senator Chuck Schumer (D, NY) will be calling them the next day to ask why they hate America so much. Actually, he will probably just call the NY Times and hold a press conference to lambaste management. So the bank prefers not to offer such a rate. It is important to remember that when banks are forced to decrease leverage, they require a much larger margin on each loan to reach the same return on equity.
3. Increase the risk-adjusted expected return on loans by improving credit quality. This will naturally happen over time, which is the reason reserves are slowly bleeding into the money supply. Note, though, that this is very pro-cyclical…if credit quality improves enough, the excess reserves will start gushing into the money supply, adding money in a spastic reinforcement to the upthrust of the natural cycle. You want inflation? That’s how you’ll get it.

I think that’s it. I favor the IOER approach because no one can control Chuck Schumer, because we don’t want to turn back the clock and force banks to increase leverage, and because we have no good way to forcibly improve credit quality unless we were to offer banks guarantees on certain lending (and that doesn’t seem like a good idea to me). If you have another idea, I’d like to hear it!

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Tomorrow, in addition to another rotten Housing Starts number (Consensus: 580k from 598k),  we will be peppered throughout the day by speeches and remarks from the Fed’s Dudley (NY), Evans (Chicago), Lockhart (Atlanta), Fisher (Dallas, but speaking in NY at the NABE luncheon), Kocherlakota (Minn), Bernanke (Chairman), and Duke (Governor). Keep a scorecard handy; 6 opinions in favor of QE and 1 opinion against is what I would expect. Any worse than 5-2 and it might mean we ought to rethink how certain we are about QE coming at the November meeting. Frankly I expect to hear much more about how QE2 will be implemented than whether.

Fire When Ready, Sir!

We now have had a weaker Employment number than was expected, and a softer CPI figure than was expected. Bernanke is sounding increasingly strident about the need to flush even more money into the system (the operative word here may be “flush”). The only mystery left about QE2 is how big it will be, and whether the Fed will also eliminate the payment of interest on excess reserves (IOER), without which the quantitative easing is likely to be fairly ineffectual in the near-term. There is some small suspense about timing, but it would be hard to come up with a good reason to delay past November if, in fact, the Fed feels that QE is necessary at all. With many of the Fed speakers having held forth recently, only two seem to have serious reservations about the plan (Fisher and Hoenig). Those guys aren’t going to come around any time soon (Hoenig because he is entrenched; Fisher because he is strongly influenced by the gold price), so the Committee is unlikely to develop a stronger consensus a month later. So why wait?

The CPI figure was surprising, and presumably doubly so to those investors who had been buying TIPS with reckless abandon over the last week. The inflation markets set back hard, although the weakness retraced only a very small part of the recent outperformance. That market still looks very strong, as well as currently expensive with real yields negative to 2017 and only 0.45% at the 10-year point.

The internals of the CPI figure, however, have turned more broadly disinflationary than has recently been the case. The deflationary sectors are still Recreation (-1.3% y/y), Apparel (-1.2%), and Housing (approximately -0.9% y/y ex-energy), with Housing of course being the largest chunk of that. Those three major groups are around 3/5 of the core index. Transportation (+4.6%) and Medical Care (+3.4%) still are rising relatively robustly, but Education & Communication (+1.6%) and Other (+1.5%) are edging closer to being flat. Core inflation ex-Shelter, which I have long been highlighting as being a better indicator of current inflationary trends in a post-housing-bubble world, dropped to 1.7%, the lowest it has been since early 2009. (Incidentally, that series is now available as a Bloomberg series: CPUPC+SL Index.)

The chart below shows Core-ex-Shelter. My assumption for some time has been that once housing stopped deflating, the core inflation number would begin to rise back towards core-ex-housing, but I have to admit the possibility that the housing deflation and the anemic money growth has lasted so long that perhaps the causal river is flowing the other way, and price trends are being dragged lower by the behavior of post-bubble housing.

Core ex-Shelter is softer but clearly not in deflation-danger zone.

To me, this chart still seems to be in a broad uptrend, and I would worry more about this picture if (a) my models didn’t have a bottom in core CPI predicted this month anyway (base effects create the risk of one more tick lower next month), and (b) the Fed wasn’t warming up the printing machine. I am skeptical that QE2 will have a rapid effect, but I am even more skeptical that deflation can take hold when the three major central banks are all racing to see who can add the most liquidity. Still, this chart bears watching.