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Not So Fast on the Trump Bull Market

December 1, 2016 2 comments

**NOTE – please see the announcement at the end of this article, regarding a series of free webinars that begins next Monday.**


Whatever else the election of Donald Trump to be President of the United States has meant, it has meant a lot of excitement in precincts that worry about inflation. This is usually attributed, among the chattering classes, to the faster growth expected if Mr. Trump’s expressed preference for tax cuts and spending increases obtains. However, since growth doesn’t cause inflation that isn’t the part of a Trump Presidency that concerns me with respect to a continuing rise in inflation.

In our latest Quarterly Inflation Outlook, I wrote a short piece on the significance of the de-globalization movement for inflation. That is an area where, if the President-Elect delivers on his promises, a lot of damage could be done in the growth/inflation tradeoff. I have written before about how a big part of the reason for the generous growth/inflation tradeoff of the 1990s was the rapid globalization of many industries following the end of the Cold War. Deutsche Bank recently produced a research piece (I don’t recall whether it had anything to do with inflation, weirdly) that contained the following chart (Source: as cited).

freetradeagreementsperyearThis chart is the “smoking gun” that supports this version of events, in terms of why the inflation dynamic shifted in the early 1990s. Free trade helped to restrain prices in certain goods (apparel is a great example – prices are essentially unchanged over the last 25 years), by allowing the possibility of significant cost savings on production.

The flip side of a cost savings on production, though, is a loss of domestic manufacturing jobs; it is this loss that Mr. Trump took productive advantage of. If Mr. Trump moves to increase tariffs and other barriers to trade, and to reverse some of the globalization trend that has driven lower prices for the last quarter-century, it is potentially very negative news for inflation. While there was some evidence that the globalization dividend was beginning to get ‘tapped out’ as all of the low-hanging fruit had been harvested – and such a development would cause inflation to be higher than otherwise it would have been – I had not expected the possibility of a reversal of the globalization dividend except as a possible and minor side-effect of tensions with Russia over the Ukraine, or the effect the Syrian refugee problem could have on open borders. The election of Mr. Trump, however, creates the very real possibility that the reversal of this dividend might be a direct consequence of conscious policy choices.

I don’t think that’s the main reason that people are worried about inflation, though. Today, one contributor is the news that OPEC actually agreed to cut production, in January, and that some non-OPEC producers agreed to an additional cut. U.S. shale oil producers are clicking their heels in delight, because oil prices were already high enough that production was increasing again and they are more than happy to take more market share back. Oil prices are up about 15% since the announcement.

But that’s near-term, and I don’t expect the oil rally has legs much beyond current levels. Breakevens have been rallying, though, for weeks. Some of it isn’t related to Trump at all but to other initiatives. One correspondent of mine, who owns an office-cleaning business, sent me this note today:

“Think of you often lately as I’m on the front line out here of the “instant” 25% increase in min wage.  Voters decided to move min wage out here from 8.05 to $10 jan 1.  Anyone close to 10/hr is looking for a big raise.  You want to talk about fast dollars, hand a janitor a 25% pay bump and watch the money move.  Big inflation numbers pending from the southwest.  I’m passing some through but market is understandably reacting slower than the legislation.”

Those increases will definitely increase measured inflation further, though by a lot less than it increases my friend’s costs. Again, it’s an arrow pointing the wrong way for inflation. And, really, there aren’t many pointing the right way. M2 growth continues to accelerate; it is now at 7.8% y/y. That is too fast for price stability, especially as rates rise.

All of these arrows add up to substantial moves in inflation breakevens. 10-year breaks are up 55bps since September and 30bps since the election. Ten-year inflation expectations as measured more accurately by inflation swaps are now at 2.33%. Almost all of that rise has been in expectations for core inflation. The oft-watched 5y5y forward inflation (which takes us away from that part of the curve which is most impacted by energy movements) is above 2.5% again and, while still below the “normal” 2.75%-3.25% range, is at 2-year highs (see Chart, source Bloomberg).

5y5y

So what is an investor to do – other than to study, which there is an excellent opportunity to do for the next three Mondays with a series of educational webinars I am conducting (see details below)? There are a few good answers. At 0.46%, 10-year TIPS still represent a poor real return but a guaranteed positive 1/2% real return beats what is available from many risky assets right now. Commodities remain cheap, although less so. You can invest in a company that specializes in inflation, if you are an accredited investor: Enduring Investments is raising a small amount of money for the management company in a 506(c) offering and is still taking subscriptions. Unfortunately, it is difficult to own inflation expectations directly – and in any event, the easy money there has been made.

What you don’t want to do if you are worried about inflation is own stocks as a “hedge.” Multiples move inversely with inflation.

Unlike prior equity market rallies, I understand this one. It is plausible to me that a very business-friendly President, who cuts corporate and personal taxes and reduces regulatory burdens, might be good for corporate earnings and even for the economic growth rate (although the bad things coming on trade will blunt some of that). But before getting too ebullient about the potential for higher corporate earnings, consider this: if Trump is business-friendly, then surely the opposite must be said about President Obama who did essentially the reverse. But what happened to equities? They tripled over his eight years (perhaps they “only” doubled, depending on when you measure from). That’s because lower interest rates and the Fed’s removal of safe securities in search of a stimulus from the “portfolio balance channel” caused equity multiples to expand drastically. So, valuations went from low, to extremely high. Multiples matter a lot, and right now even if you think corporate earnings over the next four years might be stronger than over the last four you still have to confront the fact that multiples are more likely to move in reverse. In short: if stocks could triple under Obama, there is no reason on earth they can’t halve under a “business-friendly” President. That’s not a prediction. (But here is one: equities four years from now will be no more than 20% higher than they are now, and might well be lower.)

Also, remember Ronald Reagan? He who created the great bull market of the 1980s? Well, stocks rallied in the November he was elected, too. The S&P closed November 1980 at 140.52. Over the next 20 months, the index lost 24%. It wasn’t until almost 1983 before Reagan had a bull market on his hands.


An administrative announcement about upcoming (free!) webinars:

On consecutive Mondays spanning December 5, December 12, and December 19 at 11:00ET, I will be doing a series of one-hour educational seminars on inflation. The first is “How Inflation Works;” the second is “Inflation and Asset Classes;” and the third is “Inflation-aware Investing.” These webinars will also have live Q&A. After each session, a recording will be available on Investing.com.

Each of these webinars is financially sponsored by Enduring Investments.

Who Keeps Selling These Free Options?

November 22, 2016 Leave a comment

It seems that recently I’ve developed a bit of a theme in pointing out situations where the market was pricing one particular outcome so completely that it paid to take the other side even if you didn’t think that was going to be the winning side. The three that spring to mind are: Brexit, Trump, and inflation breakevens.

Why do these opportunities exist? I think partly it is that investors like to be on the “winning side” more than they like ending up with more money than they started. I know that sounds crazy, but we observe it all the time: it is really hard (especially if you are a fund manager that gets paid quarterly) to take losses over and over and over, even if one win in ten tries is all you need to double your money. It’s the “wildcatter” mindset of drilling a bunch of dry holes but making it back on the gusher. It’s how venture capital works. There are all kinds of examples of this behavioral phenomenon. I am sure someone has done the experiment to prove that people prefer many small gains and one large loss to many small losses and one large gain. If they haven’t, they should.

I mention this because we have another one.

December Fed Funds futures settled today at 99.475. Now, Fed funds futures settle to the daily weighted average Fed funds effective for the month (specifically, they settle to 100 minus the average annualized rate). Let’s do the math. The Fed meeting is on December 14th. Let’s assume the Fed tightens from the current 0.25%-0.50% range to 0.50%-0.75%. The overnight Fed funds effective has been trading a teensy bit tight, at 0.41% this month, but otherwise has been pretty close to rock solid right in the middle except for each month-end (see chart, source Bloomberg) so let’s assume it trades in the middle of the 0.50%-0.75% range for the balance of the month, except for December 30th (Friday) and 31st (Saturday), where we expect the rate to slip about 16bps like it did in 2015.

fedl01

So here’s the math for fair value.

14 days at 0.41%  (December 1st -14th)

15 days at 0.625% (December 15th-29th)

2 days at 0.465% (December 30th-31st)

This averages to 0.518%, which means the fair value of the contract if the Fed tightens is 99.482. If the Fed does not tighten, then the fair value is about 99.60. So if you buy the contract at 99.475, you’re risking…well, nothing, because you’d expect it to settle higher even if the Fed tightens. And your upside is 12.5bps. This is why Bloomberg says the market probability of a 25bp hike in rates is now 100% (see chart, source Bloomberg).

fedprob

There is in fact some risk, because theoretically the Fed could tighten 50bps or 100bps. Or 1000bps. Actually, those are all probably about equally likely. And it is possible the “turn” could trade tight, rather than loose. If the turn traded at 1%, the fair value if the Fed tightened would be 99.448. So it isn’t a riskless trade.

But we come back to the same story – it doesn’t matter if you think the Fed is almost certainly going to tighten on December 14th. Unless you think there’s a chance they go 50bps or that overnight funds start trading significantly higher before the meeting, you’re supposed to be long December Fed funds futures at 99.475.

The title of this post is a question, because remember – for everyone who is buying this option at zero (or negative) there’s someone selling it too. This isn’t happening on zero volume: 7207 contracts changed hands today. That seems weird to me, until I remember that it has been happening a lot lately. Someone is losing a lot of money. What is this, Brewster’s Millions?

*

An administrative announcement about upcoming (free!) webinars:

On consecutive Mondays spanning December 5, December 12, and December 19 at 11:00ET, I will be doing a series of one-hour educational seminars on inflation. The first is “How Inflation Works;” the second is “Inflation and Asset Classes;” and the third is “Inflation-aware Investing.” These webinars will also have live Q&A. After each session, a recording will be available on Investing.com.

Each of these webinars is financially sponsored by Enduring Investments.

Why Are Inflation Expectations Rising?

November 2, 2016 5 comments

A persistent phenomenon of the last couple of months has been the rise in inflation expectations, in particular market-based measures. The chart below (source: Bloomberg) shows that 10-year inflation swap quotes are now above 2% for the first time in over a year and up about 25-30bps since the end of summer.

usswit10

The same chart shows that inflation expectations remain far below the levels of 2014, 2013, and…well, actually the levels since 2004, with the exception of the crisis. This is obviously not a surprise per se, since I’ve been beating the drum for months, nay quarters, that breakevens are too low and TIPS too cheap relative to nominals. But why is this happening now? I can think of five solid reasons that market-based measures of inflation expectations are rising, and likely will continue to rise for some time.

  • Inflation itself is rising. What is really amazing to me – and I’ve written about it before! – is that 10-year inflation expectations can be so low when actual levels of inflation are considerably above 2%. While headline inflation oscillates all the time, thanks to volatile energy (and to a lesser extent, food) markets, the middle of the inflation distribution has been moving steadily higher. Median inflation (see chart, source Bloomberg) is over 2.5%. Core inflation is 2.2%. “Sticky” inflation is 2.6%.

medcpia

Moreover, as has been exhaustively documented here and elsewhere, these slow-moving measures of persistent inflationary pressures have been rising for more than two years, and have been over the current 2% level of 10-year inflation swaps since 2011. At the same time inflation expectations have been declining. So why are inflation expectations rising? One answer is that investors are now recognizing the likelihood that the inflation dynamic has changed and inflation is not going to abruptly decelerate any time soon.

  • It is also worth pointing out, as I did last December in this article, that the inflation markets overreact to energy price movements. Some of this recovery in inflation quotes is just unwinding the overreaction to the energy swoon, now that oil quotes are rising again. To be sure, I don’t think oil prices are going to continue to rise, but all they have to do is to level off and inflation swap quotes (and TIPS breakevens) will continue to recover.
  • Inflation tail risk is coming back. This is a little technical, but bear with me. If your best-guess is that inflation over the next 10 years will average 2%, and the distribution of your expectations around that number is normal, then the fair value for the inflation swap is also 2%. But, if the length of the tail of “outliers” is longer to the high side than to the low side, then fair value will be above 2% even though you think 2% is the “most likely” figure. As it turns out, inflation outcomes are not at all normal, and in fact demonstrate long tails to the upside. The chart below is of the distribution of overlapping 1-year inflation rates going back 100 years. You can see the mode of the distribution is between 2%-4%…but there is a significant upper tail as well. The lower tail is constrained – deflation never goes to -12%; if you get deflation it’s a narrow thing. But the upper tail can go very high.

longtailsWhen inflation quotes were very low, it may have partly been because investors saw no chance of an inflationary accident. But it is hard to look at what has been happening to inflation over the last couple of years, and the extraordinary monetary policy actions of the last decade, and not conclude that there is a possibility – even a small possibility – of a long upside tail. As with options valuation, even an improbable event can have an important impact on the price, if the significance of the event is large. And any nonzero probability of double-digit inflation should raise the equilibrium price of inflation quotes.

  • The prices that are changing the most right now are highly salient. Inflation expectations are inordinately influenced, as noted above, by the price of energy. This is not only true in the inflation markets, but in forming the expectations of individual consumers. Gasoline, while it is a relatively small part of the consumption basket, has high salience because it is a purchase that is made frequently, and as a purchase unto itself (rather than just one more item in the basket at the supermarket), and its price is in big numbers on every corner. But it is not just gasoline that is moving at the moment. Also having high salience, although it moves much less frequently for most consumers: medical care. No consumer can fail to notice the screams of his fellow consumers when the insurance letter shows up in the mail explaining how the increase in insurance premiums will be 20%, 40%, or more. While I do not believe that an “expectations anchoring” phenomenon is important to inflation dynamics, there are many who do. And those people must be very nervous because the movement of several very salient consumption items is exactly the sort of thing that might unanchor those expectations.
  • Inflation markets were too low anyway. When 10-year inflation swaps dipped below 1.50% earlier this year, it was ridiculous. With actual inflation over 2% and rising, someone going short inflation markets at 1.50% had to assess a reasonable probability of an extended period of core-price disinflation taking hold after the first couple of years of inflation over 2%. By our proprietary measure, TIPS this year have persistently been 80-100bps too cheap (see chart, source Enduring Investments). This is a massive amount. The only times TIPS have been cheaper, relative to nominal bonds, were in the early days when institutions were not yet investing in TIPS, and in the teeth of the global financial crisis when one defaulting dealer was forced to blow out of a massive inventory of them. We have never seen TIPS as cheap as this in an environment of at least acceptable liquidity.

tipscheap

So, why did breakevens rally? Among the other reasons, they rallied because they were ridiculously too low. They’re still ridiculously too low, but not quite as ridiculously too low.

What happens next? Well, I look at that list and I see no reason that TIPS shouldn’t continue to outperform nominal bonds for a while since none of those factors looks to be exhauster. That doesn’t mean TIPS will rally – indeed, real yields are ridiculously low and I don’t love TIPS on their own. But, relative to nominal Treasuries (which impound the same real rate expectation), it’s not even a close call.

Do Shortages Cause Lower Prices?

September 19, 2016 3 comments

This is a quick post this morning because it is rainy and I am grumpy and feel like complaining.

Over the weekend I saw a post from a major market news website. I don’t want to name the website, because what they wrote was embarrassingly obtuse. I wouldn’t like it if someone cited my blog when I write something obtuse, so I won’t link to theirs. Consider it professional courtesy.

Here is what they wrote: “The global bond selloff was blamed largely on fears the European Central Bank and the Bank of Japan will eventually run out of bonds to buy.”

At this point, time yourself to see how long it takes you to figure out what’s wrong with that sentence. Score yourself with this table:

1 second or less: Congratulations! You have excellent common sense.

2-30 seconds: You have good common sense but maybe spend too much time around markets.

31-2 minutes: You are smart enough to figure this out, but you watch too much financial TV.

Over 2 minutes: You can be a Wall Street economist!

“I don’t see anything wrong” : You can write for the blog in question.

I could give an answer key, but in the interest of ranting let me present instead an analogy:

In a certain town there is a grocery store, whose proprietor sells apples for 50 cents. One day, a man walks in, flags down the proprietor, and says, “Hello kind sir. I see you have apples for sale. I would like to buy your apples. You see, I have bought all of the apples in this state, and in the surrounding state. I have bought every apple in this town. In fact, I have bought almost all of this year’s harvest. So, I’d like to buy your apples because I have money to buy apples and you have the only apples left.”

The proprietor responds, “Great! I will sell them to you for a nickel each!”

Because, you see, since the apple buyer has just about run out of apples to buy, the price of apples should fall. Right? Well, that’s exactly the point the blog made about bonds: because investors fear the ECB and BOJ will eventually run out of bonds to buy, bond prices fell. If there are really investors out there who think that when the supply of something declines, its price will fall…please introduce me to them, because I’d like to trade with them.

The fact that global central banks continue to buy bonds is the single, best reason to think that yields may not rise. In normal times, bond yields would be rising right now to reflect the fact that inflation is rising, just about everywhere we measure inflation (maybe not in Japan – core inflation in Japan was rising thanks to more-rapid money growth, but when the BOJ lowered rates into negative territory it lowered money velocity and may have squashed the recent rise). But if central banks are buying every bond they can, then prices are more likely to stay high and yields low – even in places like the US where the central bank is not currently buying bonds, because a paucity of Japanese and European bonds tends to increase the demand for US bonds. The risk to the bulls is actually that central banks stop buying bonds.

Maybe that is the weird reasoning that the blog in question was employing: once there are no bonds, central banks will have to stop buying them. And when the central banks stop buying bonds, their prices should fall. Ergo, when there are no bonds to buy the prices should fall. Sure, that makes sense!

The Destination Currency in the Global Carry Trade: USD?

If you are an investor of the Ben Graham school, you’ve lived your life looking for “value” investments with a “margin of safety.” Periodically, if you are a pure value investor, then you go through long periods of pulling your hair out when momentum rules the day, even if you believe – as GMO’s Ben Inker eloquently stated in last month’s letter – that in the long run, no factor is as important to investment returns as valuation.

This is one of those times. Stocks have been egregiously overvalued (using the Shiller CAPE, or Tobin’s Q, or any of a dozen other traditional value metrics) for a very long time now. Ten-year Treasuries are at 1.80% in an environment where median inflation is at 2.5% and rising, and where the Fed’s target for inflation is above the long-term nominal yield. TIPS yields are significantly better, but 10-year real yields at 0.23% won’t make you rich. Commodities are very cheap, but that’s just a bubble in the other direction. The bottom line is that the last few years have not been a great time to be purely a value investor. The value investor laments “why?”, and tries to incorporate some momentum metrics into his or her approach, to at least avoid the value traps.

Well, here is one reason why: the US is the destination currency in the global carry trade.

A “carry trade” is one in which regular returns can be earned simply on the difference in yields between different instruments. If I can borrow at LIBOR flat and lend at LIBOR+2%, I am in a carry trade. Carry trades that are riskless and result from one’s market position (e.g., if I am a bank and I can borrow from 5-year CD customers at 0.5% and invest in 5-year Treasuries at 1.35%) are usually more like accrual trades, and are not what we are talking about here. We are talking about positions that imply some risk, even if it is believed to be small. For example, because we are pretty sure that the Fed will not tighten aggressively any time soon, we could simply buy 2-year Treasuries at 0.88% and borrow the money in overnight repo markets at 0.40% and earn 48bps per year for two years. This will work unless overnight interest rates rise appreciably above 88bps.

We all know that carry trades can be terribly dangerous. Carry trades are implicit short-option bets where you make a little money a lot of the time, and then get run over with some (unknown) frequency and lose a lot of money occasionally. But they are seductive bets since we all like to think we will see the train coming and leap free just in time. There’s a reason these bets exist – someone wants the other side, after all.

Carry trades in currency-land are some of the most common and most curious of all. If I borrow money for three years in Japan and lend it in Brazil, then I expect to make a huge interest spread. Of course, though, this is entirely reflected in the 3-year forward rate between yen and real, which is set precisely in this way (covered-interest arbitrage, it is called). So, to make money on the Yen/Real carry bet, you need to carry the trade and reverse the exchange rate bet at the end. If the Real has appreciated, or has been stable, or has declined only a little, then you “won” the carry trade. But all you really did was bet against the forward exchange rate. Still, lots and lots of investors make precisely this sort of bet: borrowing money is low-interest rate currencies, investing in high-interest-rate currencies, and betting that the latter currency will at least not decline very much.

How does this get back to the value question?

Over the last several years, the US interest rate advantage relative to Europe and Japan has grown. This should mean that the dollar is expected to weaken going forward, so that someone who borrows in Euro to invest in the US ought to expect to lose on the future exchange rate when they cash out their dollars. And indeed, as the interest rate advantage has widened so has the steepness of the forward points curve that expresses this relationship. But, because investors like to go to higher-yielding currencies, the dollar in fact has strengthened.

This flow is a lot like what happens to people on a ship that has foundered on rocks. Someone lowers a lifeboat, which looks like a great deal. So people begin to pour into the lifeboat, and they keep doing so until it ceases, suddenly, to be a good deal. Then all of those people start to wish they had stayed on the ship and waited for help.

In any event, back to value: the chart below (source: Bloomberg) shows the difference between the 10-year US$ Libor swap rate minus the 10-year Euribor swap rate, in white and plotted in percentage terms on the right-hand scale. The yellow line is the S&P 500, and is plotted on the left-hand scale. Notice anything interesting?

carry1

The next chart shows a longer time scale. You can see that this is not a phenomenon unique to the last few years.

carry2

Yes, the correlation isn’t perfect but to me, it’s striking. And we can probably do better. After all, the chart above is just showing the level of equity prices, not whether they are overvalued or undervalued, and my thesis is that the fact that the US is the high-yielding currency in the carry trade causes the angst for value investors. We can show this by looking at the interest rate spread as above, but this time against a measure of valuation. I’ve chosen, for simplicity, the Shiller Cyclically-Adjusted P/E (CAPE) (Source: http://www.econ.yale.edu/~shiller/data.htm)

capevsspread

Now, I should take pains to point out that I have not proven any causality here. It may turn out, in fact, that the causality runs the other way: overheated markets lead to tight US monetary policy that causes the interest rate spread to widen. I am skeptical of that, because I can’t recall many episodes in the last couple of decades where frothy markets led to tight monetary policy, but the point is that this chart is only suggestive of a relationship, not indicative of it. Still, it is highly suggestive!

The implication, if there is a causal relationship here, is interesting. It suggests that we need not fear these levels of valuation, as long as interest rates continue to suggest that the US is a good place to keep your money (that is, as long as you aren’t afraid of the dollar weakening). That, in turn, suggests that we ought to keep an eye on rates of change: if the ECB tightens more, or eases less, than is priced into European markets (which seems unlikely), or the Fed tightens less, or eases more, than is priced into US markets (which seems more likely, but not super likely since not much is presently priced in), or the dollar trend changes clearly. When one of those things happens, it will be a sign that not only are the future returns to equities looking unrewarding, but the more immediate returns as well.

A Broken Clock That is Persistently Wrong

Durable goods orders, ex-transportation, showed a negative print today for the second time in a row. This was expected, in most senses of the word, but while I don’t put too much weight on short-term wiggles in Durables it is hard to ignore the fact that the year/year change in Durables has now been negative for more than a year (see chart, source Bloomberg).

coredurables

So the weakness in Durables is not new. But it bears noting that the last time core Durables went negative, in August 2012, the Fed followed with QE3 almost immediately. To be sure, at the time core inflation was all the way down at 1.9%, whereas today it is a heady 2.2%…

Look, any Fed watcher right now is and should be confused. Conditions which provoked QE just four years ago are now apparently spurring a tightening bias. Bill Gross can be excused for thinking that the Fed will go back to the old playbook and employ new QE, as he apparently did in his latest Investment Outlook – it is harder to excuse his saying that the Fed should drop money, given that it hasn’t worked yet.

But clearly, something is different in the way the central bank is approaching monetary policy. After all, nothing about this weakness is new. As noted, Durables have been negative on a year-over-year basis for a full year, and the Citi Economic Surprise index shows that economists have managed to be surprised on the negative side for an unprecedented fifteen months in a row (see chart, source Bloomberg).

cesi

Okay, the index technically turned positive once or twice for a day or two, but this is still the longest run of persistently optimistic errors that economists have had in a very long time. So this isn’t new – the economy is weak.

Unless…unless what is different is that in 2012, economists were pessimistic (the Citi Economic Surprise index turned positive right before the Fed started QE, which means that either the data was too strong or economists were too negative) whereas today they are more generally optimistic? It would be entirely consistent with how the Fed has been run for the last couple of decades if monetary policy was not being guided by actual data, but by forecasts of data. (See my book for more on monetary policy errors!)

Evidence is pretty clear that recently economists as a whole have not only been wrong, but wrong in a biased way, which is much worse. If you are merely a bad shot, you miss the target in all kinds of directions. But if you persistently miss the target in one direction, then it may well be that your weapon sights are not properly calibrated. The first sort of unbiased miss is not as dangerous, even if too much confidence is placed on the shot, because the errors will even out over time. You might eventually hit the target, by accident. But if the target sights are biased, then you will never hit the target until you realize you’re wrong. You would be tightening when you should be easing. A broken clock is right twice per day, but only if it is stopped and not just systematically two hours off.

Now, regular readers of these columns will understand that I don’t think the Fed should be easing. I don’t think the Fed can fix what ails growth, since monetary policy only affects the price variable, and easy money has only created the conditions for the inflationary upswing we are currently experiencing (Gross also acknowledges this, but sees the inflationary upswing somewhere in the unthreatening future while in fact it is here now). The Fed should have eschewed QE2 and QE3, and have long since begun to drain excess reserves. But what I think the Fed should do and forecasting what I think they will do are two very different things.

I suspect Gross is close to right. Absent some recovery in the real economy – something other than payrolls, which as we know lag – it strikes me as unlikely the Fed will be hiking rates again. Ironically, that may help keep inflation leashed for longer since it will help keep monetary velocity constrained – but I am not confident of that, given how low interest rates already are. Since inflation is very unlikely to wane any time soon, I think we are more likely to see the yield curve steepen from these levels, rather than flatten. A yield curve inversion is not a prerequisite for recession. Inverted yield curves tend to precede recessions only because the Fed is typically slow to lower interest rates in response to obvious weakness. In this case, rates are already low and the Fed isn’t likely to raise them and force a curve inversion. Yield curve inversions are not causal! This next recession may catch some people wrong-footed because they keep waiting for the inversion that never comes.

In my next article, I am going to revisit an issue I first addressed a couple of years ago and which might be especially relevant as recession possibilities increase: the question of how we can have both deflation and inflation, and how these concepts are often confused by those people who are stuck in the nominal world.

The Pendulum of Inflation Complacency

April 26, 2016 1 comment

I am sure that in my career I have seen weirder reactions, but when the Durable Goods number came out and plainly was significantly weaker-than-expected and energy rallied I must admit it was hard to think of one.

Presumably the reaction was an indirect one: weaker growth means the Fed is less likely to tighten, which means a lower dollar and hence, higher global demand for oil. But that seems a wild overthink. If there is a recession in the offing, and if we care about demand in oil markets (and I think we should), then weak economic growth from one of the world’s largest economies probably ought to be reflected in lower oil prices.

There is part of me that wants to say “maybe investors have finally realized that any given month of Durable Goods Orders is almost meaningless because the volatility of the number makes it hard to reject any particular null hypothesis.” I haven’t done this recently, but many years ago I discovered that a forecast driven by the mechanical rule of -0.5 times last month’s Durables change had a better forecasting record than Street economists. Flip the sign, divide by two. However, I don’t really think the market suddenly got wise.

I also don’t think it’s that a bunch of people got the API report, which came out at 4:30pm to subscribers only, early. That report supposedly showed a large draw in crude inventories when a build was expected – but I’m not into conspiracy theories. That would be too obvious, anyway.

The perspective of analysts on Bloomberg was that the oil market will “rebalance” this year, a point which isn’t very far from the point I made last week in my article “Don’t Forget Oil Demand Elasticity!” But rebalancing doesn’t mean that prices should go higher. They have, after all, already gone quite a bit off the lows. By our proprietary measure, the real price of oil is at a level which implies a 10-year expected real return of about 1% per annum. In other words, it’s within about 10% of fair value quantitatively; given the immense supply overhang that doesn’t seem to promise lots of upside from these levels.

It isn’t just energy. The Bloomberg Commodity Index is 15% off its January lows (see chart, source Bloomberg). Precious metals, industrial metals, softs, grains, and meats are all above their lows of the last 1-2 quarters.

bcom

Unfortunately, much of this is simply a function of the dollar’s retracement. The chart below (source: Bloomberg) shows the Bloomberg Commodity Index (left axis, inverted) against the broad trade-weighted dollar. Heck, arguably commodities are still lagging.

dollarcommod

But the winds of change do seem to be about. Last week, the Treasury auctioned 5y TIPS; though this isn’t an event in and of itself, the fact that the auction was strongly bid is certainly unusual. The 5y TIPS are a difficult sell. People who are concerned about inflation are typically looking to protect against the long-term. But TIPS also represent real interest rate risk, and if you think inflation is going to be rising near-term then you probably don’t want to own lots of interest rate risk. Sure, you’ll prefer inflation-linked real rates to nominal rates (see my timely comment from January, “No Strategic Reason to Own Nominal Bonds Now”: since then, 10y real yields have fallen 40bps while 10y nominal yields have fallen 7bps), but if you really think inflation is about to rear its ugly head then you don’t want any real or nominal duration but only inflation duration.

And inflation duration has lately been doing really well. The chart below (source: Bloomberg) shows the marked rebound in the 10-year breakeven inflation rate since February 9th.

10ybreaks

I think there’s some evidence that the pendulum of complacency on inflation has begun finally to swing back the other way. Core inflation is rising in Europe, the UK, Japan, and the US, and it was inevitable that someone would notice. Ironically, it took energy’s rally to make people notice (and energy, of course, isn’t in core inflation). But what do I care?

If in fact the pendulum of complacency and concern has finally reversed, then both stocks and bonds are in for a rough ride. Bonds may be marginally protected by a dovish Fed, but that only works as long as the inscrutable Fed stays dovish…or inscrutable.

(**Administrative Note: Get your copy of my new book What’s Wrong with Money: The Biggest Bubble of All! Here is the Amazon link.)

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