Had a great interview with Chuck Jaffe on MoneyLife today! Interview is streamed at moneylifeshow.com/upcomingGuests… Look for me in the Wednesday, April 6th edition – about halfway down. Or click directly to the stream here.
(**Administrative Note: My new book What’s Wrong with Money: The Biggest Bubble of All has been launched. Here is the Amazon link. Please kindly consider buying a copy for yourself, for your neighbor, and for your library! If you are moved to write a review, or if you wander across a review that you think I may not have seen, please let me know. And thanks in advance for your support.)
With today’s trade, WTI Crude oil is now up 45% from the lows set last month! That’s great news for the people who had endured a 75% fall from the 2014 highs to last month’s low. More than half of the selloff has been recouped, right?
In a nutshell, a 45% rally from $110 would be a bit more impressive than 45% from $26.05, which was the low print for front Crude. And energy markets, in both technical and fundamental terms, have a lot of wood to chop before prices return to the former highs, or even the $40-60 range on crude that many people think reflects fundamental value.
So why the dramatic rally? Oil bulls will say it is because rig counts are down, so that supply destruction is happening and helping to balance the market. Perhaps, although rig counts have been falling for some time. Also, some producers have been talking about reining in production…again, perhaps this is important although since the US is the world’s largest producer of oil and neither Saudi Arabia (#2) nor Russia (#3) are in a good economic position to reduce revenues further than they already have been reduced by falling prices this would seem to be a marginal effect. And I might also add the point that thanks to the very long fall in prices, energy commodities are much cheaper than other commodities – which have also fallen, but far less – on a value metric. But no one trades commodities on value.
The real reason is that being short energy has become a very crowded trade. This is partly because of the large overhang of crude and other products in storage, but also partly because the energy futures curves are enormously in contango, which means there are large roll returns to be earned on the short side by being short – because, when the delivery month approaches, the short position buys back the front month and sells the next, higher-priced, contract. In this way, the seller is continuously selling higher prices and rolling down into a well-supplied spot market. See the chart below (source: Enduring Investments), which shows the return you would earn if you shorted the one-year-out Crude contract and rolled it in to the current spot price.
Obviously, the main risk is if spot prices suddenly rally, say, 45%, leaving you with a heavy mark-to-market loss and the prospect of only making some of it back through carry. That is what has started to happen over the last couple of weeks in crude (and some other contracts). It was a crowded carry trade that is now somewhat less crowded.
What happens over time, though, is that it is hard to sustain these flushes unless the carry situation changes markedly. Once oil prices rise enough that the short on fundamentals is at least a not-horrible bet, the carry trade re-asserts. It is, simply put, much easier to be short this contract than long it. What changes the picture eventually is that the fundamental picture changes, either lowering future expected prices (flattening the energy curve relative to spot, and reducing the contango) or raising spot prices as the supply overhang is actually absorbed (raising the front end, and reducing the contango). In the meantime, this is just a crowded-trade rally and likely limited in scope.
Tomorrow, I will mention another crowded-short trade that has recently rebounded, but which is less likely to re-assert itself aggressively going forward.
I will give the Fed this much. Although they have historically been lousy forecasters, I think that at least a few of them may be dovish at this moment not just because they are always dovish, but because they believe there is a legitimate reason right now to be dovish. That is, they are afraid that the recent global retreat in equities is not merely a correction from lofty multiples – it is that, at least, of course – but signs of something more fundamentally amiss. Heck, a member of the FOMC suggested in the most-recent “dot plot” that negative policy interest rates may be appropriate this year and next year!
Probably, China scares them quite a bit; I am not sure it should because I think China’s impact is generally exaggerated in terms of its effect on the US, given the relatively small amount of trade that we do with China, but it is reasonable to be concerned about that large economy right now.
The recent plunge in domestic manufacturing indices may also be disconcerting. While many of these are relative indices (are conditions better or worse than they were last month?) rather than absolute indices (how are conditions now, compared to what they were in some fixed base period?), it is difficult to ignore that today the Richmond Fed index dropped to -5 from 0, when +2 was expected, which puts it at the lowest level in a couple of years. Actually, the Richmond Fed Index alone would be quite easy to ignore, but last week’s surprise in Empire Manufacturing (-14.67, versus expectations for a bounce to -0.50) made back-to-back months that were the worst since 2009; the Philly Fed Index fell to -6 when +6 was expected (and -6 is the lowest level since 2012); and both Capacity Utilization and the Michigan Sentiment index have continued their decline from highs set late last year.
At some point, even if these are all small fry, one begins to sense a pattern. Even if one has a Ph.D. in economics and works at the Fed!
So I will give the Fed credit, or perhaps I ought to say the benefit of the doubt, that they are delaying tightening because they perceive weakness on the horizon. I believe that they are likely correct in that. In my view, this does not mean the Fed ought not to tighten but merely means they are so far overdue that they completely missed the opportunity to normalize policy during the expansion and now face another recession with no bullets. Policy still needs to be normalized, but in this case that perhaps means returning rates not to the mid-expansion norm but the recession norm (say, 3% on Fed funds rather than 5% on Fed funds). However, I will give them credit at least for recognizing at last that they are in a box. I wonder how long it will take them to understand that the box is of their own making; that the Fed ought long ago to have led the world’s central banks in raising rates rather than pursuing more and bigger QE to do what monetary policy cannot do well, if at all: buoy real variables.
And I will give credit to Governor Bullard, who is not always perhaps the sharpest knife in the drawer (why is it that whenever I give credit to the Fed it doesn’t sound like a good thing?) but was spot-on when he dissed Jim Cramer on CNBC on Monday. Not that Jim Cramer is the only cheerleader for permanent easing to permanently support equities, but he certainly is a standard-bearer. Bullard said:
“I’ve got a message for your friend Jim Cramer. The Fed cannot permanently raise stock prices. The idea that the Fed is going one way or the other, and this is what’s driving the stock market, is not true. He’s one of the great people at looking at businesses, how good is this business, what’s the profitability of the business, what’s this thing worth? And to have him cheerleading for lower rates 24-hours a day is, I think, unsavory.”
A the least, I can empathize with the Fed’s dilemma. They have missed a whole cycle by over-easing the last time around. Okay, that was all in the past. “Mistakes were made.” So now what? What does the Fed do with growth evidently slowing, but inflation at the target and employment below the target?
What they should do, probably, is tighten with all due haste, but as I said above tighten to what is still an easy policy. The problem, as I have pointed out before, is that (a) this will cause a further acceleration in inflation, by tending to raise money velocity without a corresponding decline in money growth, and (b) there isn’t a chance of them actually doing that. At this point, they may be stuck. Ray Dalio may be right. More QE…more disastrous QE…may be the next step. But let us hope that, having tried and failed by doing too much, our central bankers might attempt to succeed by doing as little as possible.
Administrative Note: For those who missed my appearance on Bloomberg TV’s “What’d You Miss” program last Wednesday, here is a link to my segment: http://bloom.bg/1Jo7DDb Hope you enjoy!
Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments. And sign up to receive notice when my book is published! The title of the book is What’s Wrong with Money?: The Biggest Bubble of All – and How to Invest with it in Mind, and if you would like to be on the notification list to receive an email when the book is published, simply send an email to WWWM@enduringinvestments.com.
Also note that I have been invited to be a guest on “What’d You Miss?” today at 4pm ET. Catch it!
- Core CPI +0.1%, but y/y stays at +1.8% as it was a “soft” 0.1%. Specifically 0.07%, weaker than expected.
- Core services remains +2.6%; core goods -0.5% y/y.
- The -0.5% drag in core goods remains about what we can expect from the dollar’s current strength.
- But remember core goods is the smaller part of core inflation (and the more volatile part).
- Bottom line on Fed has been: plenty of argument either way. This number doesn’t affect the argument either way. Doves will be doves.
- No idea if Fed hikes tomorrow, but SHOULD have removed extraordinary accommodation when extraordinary risks were past. Years ago.
- Speaking of housing: Primary rents 3.62% from 3.56%; OER at 3.02% from 3.00%. This acceleration will continue.
- Lodging away from home is a small piece (0.8% of total CPI) but always fascinates me. 1.7% y/y versus 5.7% six months ago.
- Medical care was unch, 2.47% vs 2.49%, but pharmaceuticals was 3.5% vs 3.2% while professional services 1.7% vs 2.1%.
- The weakness in medical care continues to be the main story holding down core vs median, since 2013.
- Motor fuel of course a big drag on headline, but New and used motor vehicles also still weak (a dollar effect): -0.1% vs +0.2%.
- I actually think Median stands a decent chance of an 0.2% month, based on my back-of-the-envelope calculation.
- If I am right, then Median may be at the highest level since the crisis ended. Currently 2.28%; 2012 high was 2.38%.
- We won’t know for a few hours and my calculator doesn’t seasonally adjust the regional housing indexes so don’t take that to the bank.
- But even if median just stays at 2.3%, that’s consistent with PCE inflation being at the Fed’s target.
- Really looking forward to this: On Bloomberg TV at 4pm ET with Joe and Alix.
- Good time to mention my book “What’s Wrong with Money: The Biggest Bubble of All” due out in Feb. Can preorder: http://amzn.to/1YbJT0p
- We don’t even have cover art yet! But the manuscript is done.
- Much more interesting discussion [than OER] is medical care. MUCH harder to measure than OER, because consumers don’t pay for it directly.
- We all know insurance costs are going up, but part of this is a price effect and part is a utilization effect.
- Part of the effect of the ACA is to get people to consume less health care by making them pay for smaller costs directly.
- …of course, that lessens overall welfare since your tradeoffs are worse. But I don’t want to get too ‘inside baseball’ in 140 char.
- BTW, it occurs to me I never mentioned y/y core CPI is 1.83% from 1.80%, so it rose a smidge even though a weak core #.
There wasn’t a lot that was new or different in this figure. Housing continues to be the main strain on consumer budgets, as housing costs continue to rise and, given the rise in housing prices generally, this ought to continue. On the other hand, the main drag to core continues to be in the core goods component, and this ought to continue for a while. However, I don’t believe it will intensify, so for a while core (and more importantly, median) inflation will just creep up gradually. At some point, core goods will revert higher, and at that point core inflation will move with more alacrity. The timing on this appears somewhat far off, however.
That said, two other points need to be made today.
The first point is that the Federal Reserve will either raise rates tomorrow, or they will not, and this number has virtually no bearing on that. This Fed does not care very much about inflation, which is why they focus on a number (core PCE) which is not only the softest of the available series but also currently is very clearly too low based on a number of temporary effects. Core PCE has a lot to recommend it theoretically. But myopic focus on it (and any discussion at all of headline inflation, which is near zero only because of the oil price crash) can only mean that Federal Reserve policymakers are biased to be doves. But we already knew that. Moreover, if the Fed raises rates tomorrow and does it without removing the quantities of excess reserves in the system, they really aren’t doing much. At least, not much that is helpful.
The second point is that the inflation market continues to price dramatically different inflation over the next few years than we are likely to get. Either energy prices are going to continue to crash – in which case buoyant core inflation will still result in low headline inflation, which is what trades in the market – or they are going to stop crashing, in which case inflation expectations are far too low. There is virtually no chance that core inflation declines any time soon. I can make a case that core will only converge to near median, and then go flat, but unless housing collapses suddenly and unexpectedly core inflation is not going lower. (Of course, one-off effects like the medical care effect can still pervert the core numbers from time to time, which is why I focus on median, but this is inherently difficult to forecast and the one-off effects of course might also be in the upward direction).
Here is a quick follow-up on yesterday’s column, along with an administrative note (at the end). Yesterday, I noted there that momentum investors will begin to lose interest in being long equities as the year-over-year price return goes towards zero. I thought of another way to illustrate the same point, which maybe gets to something more like the average investor thinks.
The average “retail” investor wants big returns, but has a very non-linear response to losses. The reason that individual investors as a whole tend to under-perform institutional investors is that the former tend to exaggerate the effect of losses while underestimating the probability of losses. So, what tends to happen is that individual investors are perennially surprised by negative equity returns (don’t feel bad – financial media is set up to reinforce this bias), and react harshly to mildly negative returns – but not harshly enough to significantly negative returns.
So, the chart below shows a simple calculation of the probability of an equity loss over the next twelve months assuming that the expected return is just the return of the last 12 months, and the standard deviation of the return is the VIX (and assuming distributions are normal…just to complete the list of improbable assumptions). This doesn’t seem unreasonable with respect to assessing a typical investor’s expectations: returns should continue, and volatility is forward-looking.
Maybe it’s just me, but in these terms it seems more amazing. For much of the last few years, the trailing 12 month return was so high that it would take around a one-standard-deviation loss (16% chance) to experience a negative year – if, that is, we use prior returns to forecast future returns. In general, that’s a very bad idea. However, I can’t argue that this naïve approach has failed over the last few years!
What is the trigger that makes investors want to get out? After years of gains are investors going to act like they are “playing with house money” and wait until they get actual losses before they get jittery? Or will a 30-40% subjective chance of loss be enough for them to scale back? I think that this way of looking at the same picture we had yesterday seems much more promising for bulls. But, again, this is only true if valuation doesn’t matter. Stocks look less scary this way…but this is probably not the right way to look at it!
**Administrative Note – I have just agreed to write a book for a terrific publisher. The working title is “What’s Wrong with Money?: The Biggest Bubble of All – and How to Invest with it in Mind.” I am very excited about the project, but it is a lot of work to turn the manuscript out by late August for publication in the fall. My posts here had already been more sporadic than they used to be, but now I actually have an excuse! If you would like to be on the notification list for when the book is published, simply send an email to WWWM@enduringinvestments.com and I will put you on the list!
Before getting into today’s column, let me first describe my plan of attack for the month of December. I plan to have several comments this week and next week, culminating in my annual “Portfolio Projections” piece at the end of next week. Then, for the last two weeks of the month, I plan to ‘re-blog’ some of my best articles from the last four years (editing out the current events, which will no longer be topical of course). Included in that list is an article on long-run returns to equities, one on Yellen’s defense of large-scale asset purchases, an article on the Phillips Curve, one on why CPI isn’t a bogus construct of a vast governmental conspiracy, and so on. Because I don’t expect some of the places where this column is ‘syndicated’ to post the re-blogs, you should consider going to the source site to sign up for these posts.
With that housekeeping complete, I want to turn today to a scholarly article I recently stumbled on which is worth a read even once you have read my synopsis and comments. The article, written one year ago by Samuel Reynard of the Swiss National Bank, is entitled “Assessing Potential Inflation Consequences of QE after Financial Crises.” It appears to be unpublished except as a working paper, which perhaps shouldn’t be surprising since it is so decidedly clear-eyed and takes the consensus view of QE to task.
What I love about this article is that Reynard’s view is remarkably consonant with my own – the only example I can come up with of a reasonably-placed central banker espousing such commonsensical views (Daniel Thornton at the St. Louis Fed gets an honorable mention though), backed with quantitative data and clear reasoning. Here is the paper’s abstract:
“Financial crises have been followed by different inflation paths which are related to monetary policy and money creation by the banking sector during those crises. Accounting for equilibrium changes and non-linearity issues, the empirical relationship between money and subsequent inflation developments has remained stable and similar in crisis and normal times. This analysis can explain why the financial crisis in Argentina in the early 2000s was followed by increasing inflation, whereas Japan experienced deflation in the 1990s and 2000s despite quantitative easing. Current quantitative easing policies should lead to increasing and persistent inflation over the next years.”
In the introduction, the author directly tackles current central bank orthodoxy: “It is usually argued that it is sufficient to monitor inflation expectations, and that central banks can avoid accelerating inflation by quickly withdrawing reserves (or by increasing the interest rate payed on reserves) once inflation expectations start rising. The monetary analysis of this paper however shows that there has never been a situation of excess broad money (created by the banking system) which has not been followed by increasing inflation, and that the increase in inflation occurs after several years lags.”
Reynard starts with the quantity theory of money (MV≡PQ), which I have discussed at length in this column. Regular readers will know that I am careful to distinguish transactional money from base money – as does Reynard – and that the sole reason inflation has not accelerated is that money velocity has declined. This decline is not due to the financial crisis directly, but as I have shown before it is due to the decline in interest rates. This makes monetary policy problematic, since an increase in interest rates which in ordinary times (that is, when there isn’t a couple trillion of excess reserves) would cause M2 to decelerate and dampen inflation will also cause money velocity to rise – offsetting to some extent the effects of the rising interest rates on the money supply. (Among other things, this effect tends to help cause monetary policy to overshoot on both sides). Reynard’s insightful way around this problem is to “model equilibrium velocity as a function of interest rate to reflect changes in inflation environments.” That is, the monetary equation substitutes an interest rate variable, based on a long-run equilibrium relationship with velocity, for velocity itself. In Reynard’s words,
“Thus the observed money level is adjusted…by the interest rate times the estimated semi-elasticity of money demand to account for the fact that, for example in a long-lasting disinflationary environment when inflation and interest rate decrease, the corresponding increase in money demand reflecting the decline in opportunity cost is not inflationary: the price level does not increase with the money level given that equilibrium velocity decreases.”
This is exactly right, and it is exceedingly rare that a central banker has that sort of insight – which is one of the reasons we are in this mess with no obvious way out. Reynard then uses his model to examine several historical cases of post-crisis monetary and inflationary history: Switzerland, Japan, Argentina and the 1930s U.S. He finds that there are downward rigidities to the price level that cause inflation to resist turning negative (or to fall below about 1.5% in the U.S.), but that when there is excess liquidity the link between liquidity and inflation is very tight with a lag of a couple of years. Reynard’s opinion is that it is this non-linearity around price stability that has caused prior studies to conclude there is no important link between money and inflation. As Fama observed back in the early 1980s, and I observe pretty much daily to the point that it is now a prohibited topic at the dinner table, when inflation is very low there is a lot of noise in the money-inflation relationship that makes it difficult to find the signal. But the money-inflation connection at higher levels of inflation and money, and over longer periods of time, is irrefutable.
In the last section of the paper, the author assesses the effects of current QE (through November 2012) on future inflation in the U.S. His conclusion is that “Excess liquidity has always been followed by persistent increases in inflation. Current quantitative easing policies should lead to increasing and persistent inflation over the next years.” The chart accompanying this statement is reproduced below.
As you can see, the model suggests inflation of 3-4% in 2013 and 5% in late 2014. While clearly inflation in 2013 has been lower than suggested by the chart, this isn’t supposed to be a trading model. I suspect that if get 3-4% in 2014 and 5%+ in 2015 (our forecast is for 3.0%-3.6% on core inflation in 2014 and 3.3%-4.8% in 2015), the issue of whether Reynard was essentially correct will not be in question!
There’s a bright golden haze on the meadow,
There’s a bright golden haze on the meadow.
The Dow is as high as an elephant’s eye,
An’ it looks like it’s climbin’ clear up to the sky.
Oh what a beautiful morning!
Oh what a beautiful day.
It’s far too pretty for trading,
So why don’t we play golf today.
With apologies to Rodgers and Hammerstein, it appeared as if the lovely spring day in the Northeast took its toll on market activity today. It has always been the case that good weather tended to cause trading to slow, but as trader bonuses have gradually disconnected from performance over the last few years it seems as if the pattern has been accentuated. True, there wasn’t much to trade on today…but in the past that didn’t seem to matter quite so much.
That said, I won’t stop at merely butchering show tunes as there are one or two recent stories I’d like to address from yesterday that I didn’t broach in that somewhat-lengthy article. The first is the news that President Obama’s latest tax plan includes a provision to cap IRAs at $3 million. To most of us, that’s a lot of money, although the article points out rightly that if you are a business owner who has contributed to a retirement plan as long as it has been available, it is fairly easy to get numbers above that level without needing extraordinary returns. Thrift, and compound returns, are two of the only three investing miracles that can produce great wealth with little effort (the third is rebalancing – look for my book “Only Three Miracles,” due out in roughly 2023).
But more disturbing is the fact that the White House has not said whether this $3mm level would be indexed for inflation (or, for that matter, whether it would affect defined benefit plans or Roth IRAs on which you’ve already paid taxes). If it is not indexed for inflation, then any readers of this column could be ‘capped out’ of tax-advantaged structures with sufficient inflation. And, since there is no reason that inflation could not reach scary levels, given the right circumstances, this is something that every investor should be aware of.
It is also disturbing to me, personally, that according to the story:
“The White House said in an April 5 statement that under current law ‘some wealthy individuals’ can accumulate ‘substantially more than is needed to fund reasonable levels of retirement saving.’”
Maybe I am the only person who is concerned about the use of the word “reasonable” here, as if my decision for what amount of savings I want to accumulate, rather than spend, is open to someone else’s validation of whether my savings is “reasonable.” But I suspect not. This statement isn’t part of the law, but it is part of the context under which laws are being proposed, and I think this means that we investors (including unreasonable ones, who should be spending much more and saving less, darn it) ought to be paying attention.
The other topic I want to include concerns the remarks of Chairman Bernanke yesterday at a conference in Georgia. I’ve previously pointed out in this space that selling assets from SOMA or letting those bonds run off are not feasible approaches for the Fed to take when it comes time to tighten. Apparently, the Fed now agrees, after having previously discussed (publicly) these options. Bernanke remarked in his response to audience questions that “asset sales are late in the process and not meant to be the principal tool of policy normalization” and that rather the Fed prefers to adjust the interest rate paid on excess reserves (IOER) as its main policy tool.
My main complaint about the IOER tool is that we have no idea how it is calibrated, and whether a small adjustment can cause important amounts of liquidity to be pulled back from the market. Moreover, I think this is a defensive tool – the Fed needs to keep the Excess Reserves from becoming Required Reserves by having banks expand lending too quickly. But consider the difficulty: if a bank has $1bln in excess reserves and $50mm in required reserves (for example), and increases lending by 50% so that required reserves rise to $75mm and excess reserves fall to $975mm, then by how much does the Fed need to raise IOER, currently at 25bps, to induce the bank to hold $1bln rather than $975mm in excess reserves? This is the problem – the Fed isn’t operating on the variable that they actually want to control.
The picture below is a slide from the presentation I will be delivering this month at the Inside Indexing event in Boston. Notice the relative sizes of the excess and required reserves slices. The Fed needs to take big swipes at the excess reserves piece without damaging the required reserves piece too much. This strikes me as being somewhat more challenging than the Federal Reserve currently seems to believe.
I continue to think that the best solution for the Fed, and also the one least likely to be deployed, is to raise reserve requirements to make official the unofficial policy of de-leveraging banks. By doing that, they will with one wave of the magic monetary wand cause excess reserves to vanish and they can operate again on required reserves.
Do you want to discuss any of this with me directly? Long-time readers know that I value the interaction with readers, as that feedback is the main compensation I get for writing this column. Well, I am introducing today a new way to interact with me, (and more importantly, for me to interact with you). I am offering (free) “office hours” to anyone who wants to sign up, to talk about pretty much anything in a free-form give-and-take. I’m starting with four 15-minute sessions per week, and we’ll see how it goes (of course, anyone who wants a deeper dive on an inflation topic is welcome to contact me about consulting through Enduring Investments). To sign up for my free office hours, click here and pick a date and time.