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Turbulent Flows

With the holidays rapidly approaching, it seems the market is striving to get the volatility out of the way as soon as possible. Tuesday was one of those days when the under-the-water turbulence (that I recently referred to in these terms) comes boiling to the top.

At low rates, a fluid’s flow may be laminar; at some point, as the fluid’s rate of flow increases, it turns turbulent. The flow rate today managed to exceed the critical point, and suddenly things appeared to be growing less predictable.

Ireland was one obvious source of concern. Today, a subtle change took place as Irish 10-year yields rose 29bps. Until now, although there were clearly behind-the-scenes discussions about market conditions, Ireland staunchly denied that it had any need for additional funds before the middle of next year. Today, the Irish government conceded that these discussions were taking place, but Irish Prime Minister Cowen attributed these discussions to circumstances outside of Ireland:

“The turbulence in the markets over recent weeks has been about issues of wider concern than Ireland’s situation. It is appropriate therefore that we discuss with our partners, as we are, how these issues should be addressed.”

See, it isn’t about Ireland but rather about the general turbulence in the markets…which just happens to come knocking at Ireland’s door. EU Economic Minister Olli Rehn said the problem was in Ireland, but attributable (of course!) to those darn bankers. He said:

“The (European) Commission, together with the ECB, the IMF and the Irish authorities, are working in order to resolve the serious problems in the Irish banking sector.”

Now, the fact that Ireland is running massive deficits and undertaking austerity measures that will probably make things worse in the short run is conveniently overlooked. After all, despite all of those problems, Ireland was funded through the middle of next year until it had to bail out its banks. The Irish government had painted itself into a corner and made it almost impossible to accept help without admitting defeat; this nuance change allows it to save face by pointing out that it would have been okay but for the problems with Irish banks.

The same basic process happened with Greece earlier this year: there is no problem. There is a problem but it isn’t a bad one. There is a problem but it is not about us. There is a problem but we can solve it. Okay, we will accept some help just so that markets can calm down. Well, maybe we do have a little problem. Actually, the problem is somewhat worse than we said. Help. Now.

And speaking of Greece, that saga is not yet finished either. Greek bond yields rose 21bps (for the 10y) as Austria threatened to withhold payment of its next tranche payment (due in December). This is one reason that the “shock and awe” deal back in the early summer never seemed very credible to me even though the market loved it for a few months. Each country in the EU – and there are a couple of dozen – needs to write a check every time Greece needs another tranche. In this case, it is easy for Austria to put up a fight, because Greece is not meeting the targets they needed to with respect to cutting the deficit. Austrian Finance Minister Josef Proell said that the current progress “doesn’t give us any reason to approve the December tranche.”

So why didn’t the EU just collect all of the money up-front when they passed the hat for Greece? The answer is obvious: if they had demanded that governments write checks back then, they couldn’t have gotten the unanimous vote they required. Some governments went along, assuming that it would be politically more palatable to write checks later “once things calmed down.” But what were the odds that all of the EU members would be able to write the checks later? Nearly nil, I would say, and now we are starting to see how rotten that deal was.

Pressure will be brought to bear on Austria. EU President Van Rompuy pulled out the superlatives today when he said “We are in a survival crisis. If we don’t survive with the euro zone we will not survive with the European Union.” This seems accurate, and scary considering that two or three weeks ago no one was worrying much about this.

Turbulent flows are inherently chaotic. They will form unpredictable vortices that impede and redirect the flow. In a laminar flow, the transit time of a given molecule of the fluid is highly predictable and distributed normally; in a turbulent flow, the transit time of a given molecule is highly unpredictable. We anthropomorphize such flow: we call the rapids “angry” waters. Right now, the waters are angry.

The dollar loves the EU turmoil, and strengthened again today. Stocks, not so much: the S&P dropped 1.6%. The decline of the indices from the highs is not yet very dramatic, but now all of the oscillators have turned and it will be much harder to rally back through the April highs now that momentum has flagged.

Bonds sold off, and then rallied to end modestly higher into the close. There were dueling Fed speakers today, with one (Bullard) implying that there was no guarantee the Fed would use the full $600bln they have allotted and another (Rosengren) that he “fully anticipate(s)” the Fed will use the full charge. In fact, they both said almost the same thing: if the economy booms, they won’t need to spend all the money. They merely accented the statement differently.

But the bigger news Fed-wise was that there is a strengthening move afoot to change the Fed’s mandate. A group of former Fed and Congressional officials, plus the brilliant Cliff Asness of AQR, wrote a letter to Chairman Bernanke imploring him to stop QE2 before it blows up into serious inflation. The story is here.

At the same time, Congressmen Corker and Pence introduced a bill that would replace the Fed’s “dual mandate” with one that focused only on inflation. Helping the bill is the fact that Rep. Barney Frank, who routinely is on the dumb side of history despite being generally perceived as one of the smartest Congressmen in terms of raw IQ, said “The notion that the Fed should be indifferent to unemployment is a terrible idea, damaging to the economy.” Since Mr. Frank is usually wrong, this is good for the bill.

Of course, saying the Fed shouldn’t be indifferent to unemployment is like saying the Fed shouldn’t be indifferent to the plight of the Giant Panda. Sure, but the Fed can’t do anything about either. (Okay, so perhaps because of money illusion the Fed can do something about unemployment as a side-effect of monetary policy. But managing to the side-effect seems absurd).

This seems as good a time as any to state that I completely support the notion of narrowing the Fed’s mandate to one it actually can do something about. In fact, in my book (by the way, have you considered buying an autographed copy as a holiday gift?) I devote the entirety of Chapter 4 to “Fed Problem 3: An Impossible Mandate.”

“The multiple prongs of the Fed’s mission are, unfortunately, significantly in conflict. No, that’s not strong enough: as practiced, they’re inherently inconsistent.”

And, later in the chapter, I edit the first bullet point of the Fed’s mandate statement this way:

Conducting the nation’s monetary policy by influencing the money and credit conditions in the economy in pursuit of full employment and stable prices. [Insert] Supervising the credit conditions in the economy and conducting monetary policy in pursuit of a stable monetary environment in which the natural economic cycle can play out.

So, needless to say, I am in support of the Corker/Pence efforts, although I cannot speak to the actual bill since I have not seen it.

I haven’t yet commented about the PPI release today. That is partly because there are other important things happening today, but in truth almost anything is more important than PPI to an inflation trader. The index surprised on the low side, with core PPI coming in at a breathtaking -0.6%, worse than during any month during the crisis. However, this is a great illustration of why we mostly ignore PPI. The decline was due entirely to a -3% fall in new cars and a -4.3% decline in new trucks. Yes, this is almost certainly due to faulty seasonal adjustment around the model-year changeover…without those two components, core PPI was up.

Now, inflation bonds significantly underperformed nominal bonds again, with CPI swaps ending the day down by 4-8bps. Some of that might be a reaction to PPI, but I think it is more likely that it is a reaction to the recent sharp selloff that is driving some investors who loved ‘em at 0.41% to hate ‘em at 0.75%.

Now, tomorrow’s data is a different story. CPI matters, although with the Fed just beginning QE2 it probably doesn’t matter all that much. The consensus is for +0.3% and +0.1% ex-food-and-energy. The short TIPS are expecting slightly lower numbers than that for the headline index, but the odds are for something a smidge higher. If we get the expected core print of +0.1% then year-on-year core CPI will hit 0.7%. I think there is a small risk of 0.2% on core, but either way this month’s figure ought to mark the trough in the year/year numbers as core prices were completely flat from October through January last year, and rose at only an 0.3% annualized pace between October 2009 and April 2010. Even if core inflation is only running at 0.8% between now and April, the year/year number will rise back to around 1% by the time the April number arrives…and I think that core has a good chance of moving somewhat faster, soon.

Also tomorrow, but of lesser import, are the Housing Starts data (Consensus: 598k from 610k). These numbers are at such a low ebb that even a significant percentage miss will barely show up as a wiggle on the chart. The inventory of new houses is quite low, which sets up Housing Starts for a move higher eventually; unfortunately, the inventory of existing homes is still far too great, and since existing homes are a substitute for new homes this means that whatever homebuilders build, they’ll have trouble selling.


  1. Lee
    November 17, 2010 at 10:42 am

    Another excellent essay – except for not pointing out that Corker and Pence are Creationists.

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