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Japanese Inflation is Rising – Of Course!

August 30, 2013 2 comments

The Financial Times today carried an article entitled “Japan Inflation Rises to Highest in Nearly Five Years.” Core inflation in Japan reached -0.1%, which is actually the highest since early 2009, so not quite five years (see chart, source Enduring Investments, below). More importantly, however, the year-on-year figures are near the highest in the last decade-plus, with base effects likely to push core inflation above zero in the near future.

japancoreThis should be shocking to no one, since Japanese M2 growth recently reached the highest year-on-year growth level since … wait for it … 1999, and is now actually growing slightly faster than European money supply for the first time in a long, long time. Because, you see, money growth is intimately related to inflation. News flash!!

But the Japanese have only just begun to increase their money supply, and it is going to go a lot higher. As will inflation in Japan.

Now, here’s the conundrum of the day. If the Japanese pat themselves on the back because they are near to exorcising the deflation demon with quantitative easing, then how can Bernanke, Yellen, Summers, et. al. be so confident that our QE will not increase inflation? It can’t be the case that QE is effective at ending deflation (which was one benefit that Bernanke trumpeted in the past, too), but doesn’t tend to increase inflation. Well, I suppose it can be the case, but it would be quite weird.

The difference between the US and Japanese response to money growth over the last few years is that money velocity in the US has been declining with interest rates, while the Japanese already had rates so low that velocity had nowhere to go but up. As I have noted previously, even if velocity in the US merely levels out, 7% money growth will produce an uncomfortable rise in inflation.

So before settling into the belief, as Summers has expressed, that quantitative easing has “few harmful side effects,” it seems to me that we ought to reflect on the Japanese QE example.

 

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Not Broken, Just Bent?

August 29, 2013 2 comments

Equity market bulls are a tenacious bunch. In August, with increasing tensions in the Middle East – Egypt and, this time, Syria – along with uncertainty over the future course of monetary policy and steadily rising interest rates, the S&P 500 has lost all of 2.8% after hitting a new all-time high early in the month. Investors who focus purely on the price charts and on the behavior of the indices should be delighted in how stocks have performed with this bad news and fairly weak earnings.

Of course, it should be noted that stocks have still not reached the 2007 highs, much less the 2000 highs, in real terms (see chart, source Bloomberg: this is just the S&P 500 divided by the CPI index). This isn’t to belittle the rally, which has roughly doubled the value of equity investments, in real terms, since the bottom. But it should remind us that this is not a secular bull market, yet, even though we have reached new nominal highs.

realsp

As we step away from the pure equity focus, though, the picture grows progressively uglier. After a period of stability in late June through early August, interest rates have begun to rise again. The 10-year note is at 2.76% (but last week approached 2.90%). The 10-year TIPS is at 0.65% after challenging 0.80%. The further selloff makes the consolidation in July look like just a pause in the middle of an otherwise-steady uptrend in yields. We were at 1.60% as recently as May! This selloff has been unusual, but then we all know that it’s because yields shouldn’t have been that low in the first place. Some of this selloff is merely returning from a ridiculously expensive position. (With all that being said, I must admit that after this kind of selloff, I would want to be taking a shot from the long side as we move into September).

Commodities are higher, with the DJ-UBS index comfortably above the 100-day moving average for the first time this year (see chart, source Bloomberg). And this isn’t merely a reflection of energy prices moving higher, because spot crude oil at $108.80 is actually back within the range it has held since early July: $104-$109. Over the last month, grains are 4% higher, livestock 2.5% higher, precious metals 10% higher, industrial metals 5% higher. So this movement in commodities has been fairly broad-based (the softs are down), even with the dollar treading water over that period.

djubs

So, while stocks are merely bent, not broken, at this stage, I’d prefer to own bonds – even nominal bonds – to them at these levels, and of course I still like commodities. I do think there is a halfway decent chance that the stock market could transition from bent to broken in the next month.

Both commodities and inflation-linked bonds did poorly today, though, at least partly because an article in the Wall Street Journal today (by Jon Hilsenrath) suggested that Yellen is “playing down her chances of getting the job,” and that therefore Summers is the front-runner.

It is probably safe to say that Summers is less-dovish than is Yellen, although we don’t know much about his monetary policy views since he seems to have few of them. We do know that he sees “few harmful side effects” from QE, which should be automatically disqualifying (almost as automatically disqualifying as being a super-intelligent academic economist should be). With either of these candidates – and it seems as if these really are the only two, since no one else has been mooted in the press – we are going to get a very dovish central banker by almost any historical standard. Central bankers have known for decades about the perils of quantitative easing…that’s why they didn’t do it in the recession of the early 1980s, or the recession of the early 1990s, or the recession of the early 2000s. Each of those recessions was plenty deep enough to warrant quantitative easing if there are few harmful side effects. But we know there are harmful side effects. So if Summers thinks there aren’t any, this just means that he is very current with the “new” wave of monetary thinking and too dismissive of the old, time-tested views (which is, after all, one of the weaknesses you can expect from a ‘brilliant academic’ who has already proven himself unable to manage one institution filled with other brilliant academics).

Now, I find it personally distressing that the market is so concerned with who the Fed Chairman will be. It shouldn’t matter that much, and here is something to reflect on: it wouldn’t matter so much if monetary policy were as straightforward and as much of a science as central bankers are trying to convince us that it is. The fact that the market thinks it matters (as do I) is all the evidence you need that it does matter, and that central banking is more art than science. And you can guess what I think about most modern art too, by the way.

In the context of the fact that the Fed itself appears to be pretty much broken, not bent, I guess I take solace in another thought: given the quantity of “excess reserves” in the system, the Fed can’t do much, positive or negative, for a while. The die has been cast, and it won’t really matter who takes the Chairman’s crown from Bernanke unless that person has a brilliant way to hit the delete key and make those reserves vanish. Otherwise, those reserves are going to press on the transactional money supply, and continue to push inflation higher over the medium term.

It’s Risk Parity, Not Risk Party

August 15, 2013 6 comments

I am disinclined to take victory laps when most people are losing money, but the recovery in commodities prices over the last week at the same time that bond and equity prices are both declining is a taste of success for my view that has been rare enough lately. That is, of course, the burden that a contrarian investor bears: to be wrong when everyone else is having fun, and to be right when no one wants to go out and celebrate. In fact, if you find yourself sharing your successes too often with other people who are having the same successes, I would submit you should be wary.

It is worth noting that the commodities rally has not been led by energy, despite the terrible violence in Egypt which threatens, again, to ignite a spark in the region. Today, the rise in commodities was led by gold and grains; yesterday by cows and copper (well, livestock and industrials).

I don’t think that this is because of a sudden epiphany about inflation. In fact, although breakevens have been recovering from the oversold condition in June (more on that in a moment), the inflation data today did nothing to persuade inflation investors that more protection is needed. I gave some thoughts about the CPI report earlier today in this post, but suffice it to say that it was not an upside surprise. (And yet, there are starting to appear more-frequent smart articles on inflation risks. I commend this article by Allan Meltzer to you as being unusually clear-eyed.)

And commodities are not moving higher because of renewed enthusiasm about growth, I don’t think. Today economic bell cow Wal-Mart cut its profit forecast because higher taxes are causing shoppers to be more conservative (perhaps in more ways that one). And, while today’s Initial Claims figure was good news (320k versus expectations for 335k), weakness was seen in Industrial Production (flat, with downward revisions, versus expectations for +0.3%) and both Empire Manufacturing and Philly Fed came in slightly weaker than expectations. None of this is apocalyptic, but neither is it cause for elation about domestic or global growth prospects.

While the nascent commodity rally makes me personally feel warm and fuzzy, the more-momentous move is in what is happening to interest rates. And here I need to recognize that until very recently, I thought that bonds would follow the typical pattern of a convexity-exacerbated selloff: after a rapid decline, the market would consolidate for a few weeks and then recover once the overhang had cleared. I’ve seen it aplenty in the past, and that was the model I was operating on.

But I believe rates are heading higher. Although the overhang from the prior convexity selloff has probably been distributed, there is a new problem as illustrated by the news today about Bridgewater’s “All Weather” fund. The All-Weather Fund is an example of a “risk parity” strategy in which, in simplified form, “low-volatility” strategies are levered up to have the same natural volatility as “high volatility” strategies. The problem is that levering up an asset class with a poor risk-adjusted return, as fixed-income is now, doesn’t improve returns or risks of the portfolio at large. The -8% return of the AWF in Q2 illustrates that point, and makes clear to anyone who bought the great marketing of “risk parity” strategies that they probably have much more rate risk than they want (although according to the Bloomberg article linked to above, Bridgewater “hadn’t fully grasped the interest-rate sensitivity” of being long 70% of net assets in inflation-linked bonds and another 48% in nominal bonds. I do hope that’s a mis-quote).

The unwinding of some of that rate risk (Bloomberg called the panicky dumping of a relatively cheap asset class, TIPS, into the teeth of a retail and convexity-led selloff “patching” the risk) helped TIPS bellyflop in May and June, and to the extent that institutional investors wake up and reduce their levered long bets on fixed income we might see lower prices much sooner than I expected across the entire spectrum of fixed-income. Indeed, without the Fed or highly levered buyers, it’s not entirely clear what the fair clearing price might be for the Treasury’s debt. I was at one time optimistic that we would get a bounce to lower yields after a period of consolidation, but this news is potentially a game-changer. Although the seasonal patterns favor buying bonds in August and early September, the potential downside is much worse than the potential upside.

A Summary of My Post-CPI Tweets

August 15, 2013 6 comments

Here are my post-CPI tweets from this morning. You can follow me @inflation_guy:

  • CPI #inflation +0.2% core. But here’s the thing: that’s with housing showing unexpected softness. And housing markets are bubbling.
  • Unrounded core inflation 1.698%. That’s the last we’ll see of 1.6% handles for years.
  • Core inflation actually barely rounded up, at +0.155% m/m. But, again, that’s with housing inexplicably weak.
  • Core services 2.4%. Core goods still plodding along at -0.2%, and holding overall core inflation down. That won’t persist.
  • CPI major groups accelerating: Food/bev, Housing, Apparel, Transp, Rec, Educ/Comm (89.5%). Decelerating: Medical and Other (10.5%).
  • …but housing only accelerated b/c household energy. OER was unch at 2.2% and primary rents 2.8% from 2.9%. That’s a quirk.
  • certainly nothing in today’s inflation data to scare the Fed into a faster taper.
  • bonds are breaking lower; although the convexity overhang has been worked off, we never got the expected bounce! Not sure why they’re weak.
  • higher rates->higher velocity->more inflation pressure, ironically. in this case, higher rates won’t affect money supply as offset to that

Of all of the places I expected to see a downside surprise, housing was not it. Of course, econometric lags aren’t the same as destiny, so the fact that the leading series all turned higher at the “right time” to cause a rise in Owners’ Equivalent Rent right about now is helpful information for investing, but not necessarily a timing tool!

At 2.2%, OER is still well above core inflation and primary rents at 2.8% are as well. But core goods continue to drag on the overall core inflation number (and to hold core inflation well below median inflation, which comes out later this morning).

I feel I should nudge lower my forecast for 2013 core inflation again, to a range of 2.4%-2.7% from 2.5%-2.8%. I am doing this for two practical reasons related to housing. One is that every month that passes without the expected acceleration is one less month over which inflation can accelerate to reach my year-end target. The other is that every month that passes without the expected acceleration increases the odds that I’m simply wrong, and something is holding down rents even though home prices are launching higher. I don’t think that’s true, but I want to be cognizant of overconfidence bias! However, at this point my nudging of the forecast is more about the former point: my 2014 forecast range remains 3.0%-3.6% for core.

 

The Right Clearance for the Bumpy Road Ahead

August 12, 2013 4 comments

There are many reasons to be scared of the financial system in Europe. The interweaving of sovereign risk and inter-sovereign risk with bank guarantees and the symbiosis in which countries guarantee (implicitly or implicitly) banks which then buy sovereign paper that is not considered a risk asset is enough to make anyone who looks closely pretty queasy. If Portuguese banks fail, what effect does that have on Spanish banks, or on the Europe-wide guarantee facilities? Is anyone even somewhat confident that they know?

However, with all of the reasons to fear a resurgence of the European banking crisis, the manufactured “underfunding” story  is not one of them. According to the Financial Times, “Europe’s biggest banks will have to cut €661bn of assets and generate €47bn of fresh capital over the next five years to comply with forthcoming regulations aimed at reducing the likelihood of another taxpayer funded bailout.”

Those are big numbers, and scary, but … what do they mean? Do they mean that banks are underfunded by that amount?

Well, the numbers only mean that if somehow the Basel III requirement is magically the “right” number. And even then, I am not sure what it means to have the “right” number. If you have trouble driving your Cadillac on a country road, and it leads you to design a car with a higher clearance, how do you know you have the “right” clearance? It sort of depends on the road, doesn’t it? If the road is smooth, then you’ll be too high, but if the road is too rough, your higher clearance might not be high enough. Without seeing the road, all you can do is guess at the trade-off between the cost of the higher clearance, and the benefits of the higher clearance.

And we have no idea what the road ahead looks like in Europe, or anywhere else for that matter. So declaring a certain “clearance” as being the “right” clearance is presumptuous. Sure, we now know that roads can get bumpy even when central banks are trying to smooth them (and in some cases because they are trying to smooth them), so we think we need more clearance…but how much more? Never mind the fact that this isn’t as straightforward as measuring a car’s undercarriage clearance – if a rule can be written into Basel III, it can be engineered around by a bank. (That’s why we didn’t stop at Basel I.)

In general, I am skeptical that the right answer is reached by central banks, or even worse an international committee of central banks such as the BIS, sitting around in a room with a lot of smart economists counting angels on the head of a pin. Not that Jamie Dimon showed great risk acumen in allowing the London Whale to lose six billion bucks, but at least he makes decisions on risk on a regular basis instead of at annual banker meetings where there are presentations on how to tell a CDS from a CMO.

We clearly need to consider how to increase incentives for bank management and shareholders to capitalize banks correctly, where “correctly” means that the shareholders and stakeholders are taking the amount of risk they feel comfortable with, and that there are no unpriced externalities. It is this latter problem that is the issue, of course; a free government guarantee is simply value that bank management seized for themselves. It allows any bank to take more risk than they would if it was their own money. But limiting risk, or raising the “insurance” premium, just raises the clearance of the car. What we need, if banks are large enough to pose systemic risks, is a way to make the costs of poor risk decisions assessable in retrospect rather than in prospect. That is, remove the corporate veil for banking licenses. Require all banks to have a general partner or partnership group which has unlimited liability.

Here is what would happen in such a case. Small banks would have a general partner who would secure liability insurance (possibly paid for by the bank shareholders). Larger banks would find it more difficult and expensive to secure that insurance in amounts that completely covered the possible losses for the general partner, which would mean that the biggest banks would likely choose to break into smaller banks. And what is wrong with that? One of the solutions that has been put forth is to have banks sell off assets. Splintering into a number of smaller banks is the same as selling off all of the assets.

And then, you wouldn’t need implicit or explicit government guarantees (although deposit insurance might best be provided by, or backstopped by, a government entity). There’s already someone to go to in order to cover the losses: the general partner, or the insurer, or the reinsurer. Together with derivative clearing arrangements, a system built from smaller and redundant parts would likely be much more resilient than one built with just a few critical “TBTF” parts.

Why Aren’t Delinquencies Falling Faster?

The great news today is that mortgage delinquencies dropped to their lowest level in five years. Look at the chart (source: Bloomberg)! Doesn’t it look great?

mortdelThis was actually a bit surprising to me. With the Unemployment Rate doing about what it usually does in recoveries, and the economy adding something a bit shy of 200,000 new jobs per month, and with interest rates low and housing prices rising, you would think that delinquencies would have improved much more than they have.

Pretty much all of the delinquency data looks the same way. Here is a chart of new foreclosure actions as a (seasonally-adjusted) percentage of total loans.

foreclosurestartedWhile well off its highs, this would have been a record level just a few years ago.

Is this a symptom of the “part-time America” phenomenon, in which all of these new jobs are being generated as part-time work, so that the improvement in the lot of the average worker is not paralleling the improvement in the jobs or unemployment rate numbers? (I’m not disputing that such a phenomenon exists; in fact I think it does. I am asking whether this is a symptom of that, or if there is another cause?) In any event, it isn’t a very good sign, and is one reason that even once QE ends, the Fed will endeavor to keep rates low for a very long time.

By the way, it also makes me wonder whether the celebrated move of institutional investors into the private residential real estate market is having a smaller effect than many people think it is. If there were big players looking to buy bank REO on the offered side, then wouldn’t you think banks would be accelerating foreclosures and that the delinquencies would be dropping faster (as homeowners either get into the foreclosure process, whereupon they aren’t in the delinquency stats, or get serious about becoming current)? I don’t know the answer.

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Here is a technical point for institutional investors in inflation-indexed bonds and/or swaps – something worth watching for.

There has been much concern in some quarters recently about the coming increase in demand for high-quality collateral to back swaps under Dodd-Frank regulations.  One way this could manifest in the inflation markets is to narrow the spread between inflation “breakevens” and inflation swaps. As the chart below (Source: Enduring Investments) illustrates, the inflation swaps curve is always above the “breakeven” curve. In theory, both curves should be measuring the same thing: aggregate inflation expectations over some period.beivszcAnd, in fact, they do. But while the inflation swaps market is a relatively-pure measure of inflation expectations, breakevens have some idiosyncrasies that make them less useful for this purpose. Predominant among these idiosyncrasies is the fact that nominal Treasury bonds act in the market as if they are very, very good collateral and so often trade at “special” financing rates. That is, when you buy a Treasury bond you not only buy a stream of cash flows, but you pay a little extra for it since you can borrow against it at attractive rates sometimes (if you are an investor who does not utilize the bonds for collateral, then you are paying for this value for no reason). However, TIPS are much more likely to be “general” collateral, and to offer no special financing advantage. There is no fundamental reason for this: TIPS are Treasuries, and are just as valuable as collateral to post as margin as are nominal Treasuries. There just isn’t a deep short base, and the main owners of TIPS are inflation-linked bond funds that actively repo them out so that they are rarely in short supply. It is unusual, although no longer unprecedented, to see a TIPS issue trade special.

The consequence of this is that Treasury yields are lower than they would otherwise be, by the amount of the “specialness option,” and TIPS yields are not affected by the same phenomenon. Therefore, breakevens are lower than they would otherwise be.

If, in fact, there becomes a shortage of “good” collateral to use to post as swaps margin, one place I would expect that to show up would be in the TIPS market. I would expect that TIPS issues would begin to go on special more-frequently, and to start to behave like the good collateral they are. The consequence of that would be to cause TIPS yields to decline relative to nominal yields as they gain the “specialness option,”, and for breakevens to rise towards inflation swap levels. (As an aside, that would also cause TIPS asset swaps to richen of course).

A long time ago, I summarized this argument here,[1] and a slightly more-rigorous draft of a paper is here.[2]

As I said, this is a technical point and not something the non-institutional investor needs to worry about.


[1] I am bound to include this notice with any online use of the article: “This article was originally published in The Euromoney Derivatives & Risk Management Handbook 2008/09. For further information, please visit www.euromoney-yearbooks.com/handbooks.”

[2] Frankly, I need to update this paper and get it published, but the last time I submitted it I had one referee tell me “this is wrong” and the second referee said “this is obvious” so I decided in frustration to let it drift.

The Disturbing Evolution of Central Banking

August 7, 2013 7 comments

One of the more disturbing meta-trends in markets these days is the direction the evolution of central banking seems to be taking.

I have written before (and pointed to others, including within the Fed, who have written before[1] ) about the disturbing lack of attention being paid in the discussion and execution of monetary policy to anything that remotely resembles money. Whether we have to be concerned about money growth in the short- and medium-terms, ultimately, will depend on what happens to the velocity of money, and on how rapidly the central bank responds to any increase in money velocity. But there are trends that could be much more deleterious in the long run as the fundamental nature of central banking seems to be changing.

Today the Bank of England released its Quarterly Inflation Report, in which it introduced an “Evans Rule” construction to guide its monetary policy looking forward. Specifically, the BoE pledged not to reduce asset purchases until unemployment dropped below 7% (although Mark Carney in the news conference verbally confused reducing asset purchases with raising interest rates), unless:

“in the MPC’s view, CPI inflation 18 to 24 months ahead is more likely than not to be below 2.5 percent; secondly, if medium-term inflation expectations remain sufficiently well anchored; and, thirdly, the Financial Policy Committee has not judged the stance of monetary policy — has not judged — pardon me — the Financial Policy Committee has not judged that the stance of monetary policy poses a significant threat to financial stability, a threat that cannot otherwise be contained through the considerable supervisory and regulatory policy tools of various authorities.”

This is quite considerably parallel to the FOMC’s own rule, and seems to be the “current thinking” among central bankers. But in this particular case, the emperor’s nakedness is revealed: not only is inflation in the UK already above the 2.5% target, at 2.9% and rising from the lows around 2.2% last year, but the inflation swaps market doesn’t contemplate any decline in that inflation rate for the full length of the curve. Not that the swaps market is necessarily correct…but I’ll take a market-based forecast over an economist consensus, any day of the week.

So, for all intents and purposes, while the BOE is saying that inflation remains their primary target, Carney is saying (as my friend Andy the fxpoet put it today) “…the BOE’s inflation mandate was really quite flexible. In other words, he doesn’t really care about it at all.”

Along with this, consider that the candidates which have so far been mooted as possible replacements for Bernanke at the US Fed are all various shades of dovish.

Here, then, we see the possible long-term repercussions of the 2008 crisis and the weak recovery on the whole landscape of monetary policy going forward for many years. In some sense, perhaps it is a natural response to the failure or monetary policy to “get growth going,” although as I never tire of pointing out monetary policy isn’t supposed to have a big impact on growth. So, the institutions are evolving to be even more dovish.

At one time, I thought it would happen the other way. I figured that, since the ultimate outcome of this monetary policy experiment is clearly going to be higher inflation, the reaction would be to put hawkish central bankers in charge for many years. But as it turns out, the economic cycle actually exceeded the institutional cycle in duration. In other words, institutions usually evolve so slowly that they tend not to evolve in ways that truly hurt them, since the implications of their evolution become apparent more quickly than further evolution can kick in and compound the problem. In this case, the monetary response to the crisis, and the aftermath, has taken so long – it’s only half over, since rates have gone down but not returned to normal – that the institutions in question are evolving with only half of the episode complete. That’s pretty unusual!

And it is pretty bad. Not only are central banks evolving to become ever-more-dovish right exactly at the time when they need to be guarding ever-more-diligently against rising inflation as rates and hence money velocity turn higher, but they are also becoming less independent at the same time. A reader sent me a link to an article by Philadelphia Fed President Plosser, who points out that the boundaries between fiscal and monetary policy are becoming dangerously blurred. It is somewhat comforting that some policymakers perceive this and are on guard against it, but so far they seem ineffectual in preventing the disturbing evolution of central banking.


[1] Consider reading almost anything by Daniel L. Thornton at the St. Louis Fed; his perspective is summed up in the opening sentence of his 2012 paper entitled “Why Money Matters, and Interest Rates Don’t,”  which reads “Today ‘monetary policy’ should be more aptly named ‘interest rate policy’ because policymakers pay virtually no attention to money.”

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