Today the 1-year CPI swap rate closed at 1.77%, the highest rate since 2014 (see chart, source Bloomberg).
The CPI swap (which, as an aside, is a better indicator of expected inflation than are breakevens, for technical reasons discussed here for people who truly have insomnia) indicates that headline inflation is expected to be about 1.77% over the next year. That’s nearly double the current headline inflation rate, but well below the Fed’s target of roughly 2.3% on a CPI basis. But at least on appearances, investors seem to be adjusting to the reality that inflation is headed higher.
Unfortunately, appearances can be deceiving. And in this case, they are. The headline inflation rate is of course the combination of core inflation plus food inflation and energy inflation; as a practical matter most of the volatility in the headline rate comes from the volatility endemic in energy markets. I’ve observed before that this leads to unreasonable volatility in long-term inflation expectations, but in short-term inflation expectations it makes perfect sense that they ought to be significantly driven by expectations for energy prices. The market recognizes that energy is the source of inflation volatility over the near-term, which is why the volatility curve for inflation options looks strikingly like the volatility curve for crude oil options and not at all like the volatility curve for LIBOR (see chart, source Enduring Investments).
The shape of the energy futures curves themselves also tell us what amount of energy price change we should include in our estimate of future headline inflation (or, alternatively, what energy price change we can hedge out to arrive at the market’s implied bet on core inflation). I am illustrating this next point with the crude oil futures curve because it doesn’t have the wild oscillations that the gasoline futures curve has, but in practice we use the gasoline futures since that is closer to the actual consumption item that drives the core-headline difference. Here is the contract chart for crude oil (Source: Bloomberg):
So, coarsely, the futures curve implies that crude oil is expected to rise about $4, or about 9%, over the next year. This will add a little bit to core inflation to give us a higher headline rate than the core inflation rate. Obviously, that might not happen, but the point is that it is (coarsely) arbitrageable so we can use this argument to back into what the market’s perception of forward core inflation is.
And the upshot is that even though 1-year CPI swaps are at the highest level since 2014, the implied core inflation rate has been steadily falling. Put another way, the rise in short inflation swaps has been less than the rally in energy would suggest it should have been. The chart below shows both of these series (source: Enduring Investments).
So – while breakevens and inflation swaps have been rallying, in fact this rally is actually weaker than it should have been, given what has been happening in energy markets. Investors, in short, are still irrationally lugubrious about the outlook for price pressures in the US over the next few years. Remember, core CPI right now is 2.2%. How likely is it to decelerate 1.5% or more over the next twelve months?
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Here is an interesting chart that might suggest flows into oil markets.
Or perhaps it suggests something else. But I put together the chart below (data sourced from Bloomberg) because it seemed to me as if recently crude oil – and other energy markets, but I am focusing on Crude – has been having a nice little spike in the middle of the morning. Often, these have seemed inexplicable to me; other times (like yesterday) there was ostensibly news but it was not immediately obvious that the news was oil-supportive.
This chart shows a composite trading day for June NYMEX Crude Oil futures for the last 20 days. You can see that it appears I am not imagining it: on average, Crude has been rallying about 30 cents per day, beginning about 9:00ET.
I thought this might be flattered by the DOE weekly release, which is at 10:30ET on Wednesdays. So I removed those days and the relationship is still clear (although it makes the rise from 3am to 9am look relatively more important).
I don’t know exactly what this means, but it has “felt” to the old trader in me that the market was tending to gap in that time frame and this seems to confirm the visceral sense. It doesn’t necessarily mean my other gut feeling, that this might represent systematic daily allocations – perhaps to energy or broad commodity ETFs? Or OTC products? Or both? – is correct, however.
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.
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.
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.
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.
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The big story of the weekend was that a meeting of OPEC and non-OPEC producers, at which an agreement was supposed to be signed to freeze oil production at recent levels, ended without an agreement being signed. This was not an enormous surprise, since Iran didn’t even attend the conference and the Saudis had said they wouldn’t sign unless Iran agreed, but oil prices initially took a significant hit before recovering some later in the day.
The economic significance of the lack of agreement is fairly small; most producers are producing near their maximum output, except for important non-attendees like the United States and Iran. (The Saudis claim to be able to put 1mm barrels per day online in short order, too). But the psychological significance was thought to be important.
I’m not so sure about the importance of mind-games in an efficient global market for a commodity product. The market is oversupplied, by a significant amount, and no amount of posturing will change that. However, basic economics may.
Overlooked by many is the fact that OPEC’s problem is one that automatically diminishes over time even if OPEC does nothing. This is because the demand for oil is short-term inelastic, but long-term elastic.
The elasticity of demand describes how quickly the quantity demanded responds to price. If demand is very elastic, then changes in price cause large changes on the quantity demanded. On the other hand, inelastic demand curves indicate that the quantity demanded changes very little when the price on offer changes.
The elasticity of demand has a very significant consequence for the question of how revenues change when prices change. Revenue is simply price times quantity. So, if a small change in price causes a large change in quantity (that is, an elastic demand curve), it is a good strategy (for example, as an individual company) to cut one’s price: the company will sell lots more product and give up only a little revenue on each one, so that total revenues rise with price declines if a producer faces an elastic demand curve. On the other hand, if demand is inelastic, then a price cut doesn’t change the quantity sold very much, but decreases revenue on each unit. If a producer faces an inelastic supply curve, total revenues decline with price decreases. And, conversely, total revenues increase with price increases in such a case. This is the reason that cartelization of the oil industry is an apparently attractive strategy: oil demand is, at least in the short-run, price inelastic. If gasoline prices rise $1 per gallon next week, you will still drive almost as much as before.
But static equilibria cannot fully describe dynamic markets! It turns out that for most products, demand elasticity in the long-run is higher, and often much higher, than in the short run. Consumers adjust to changing prices by adjusting their consumption mix! This is also true with energy markets: while you won’t drive a lot less next week if gasoline prices are much higher, if they stay higher you will start to carpool, buy more energy-efficient vehicles, and so on. This is one reason that cartelization ends up failing. In the short run, it makes sense to band together and hike prices, raising overall revenue, but this has deleterious effects on long-run revenue and creates incentives to cheat to grab more of the (diminishing) demand.
Analysis of the energy markets tends to focus on supply, but as prices increase and decrease over extended periods of time, it is important to remember that demand eventually responds. From 2011 until mid-2014, retail gasoline averaged about $3.50 per gallon (see chart, source Bloomberg). But it has been below that level for almost two years, and averaged more like $2.30 per gallon since then.
Similarly, WTI crude oil averaged around $100/bbl in 2011-mid2014, but only about $60 since then. And most of that was well below $60. The picture for Brent is of course very similar.
In the short run, with inelastic demand, these large declines represent a very large drop in OPEC producer revenues. But in the long run – and after two years, we are much closer to the long run – demand will increase even if the global economy doesn’t grow at all because there is a demand response to lower prices. OPEC, in other words, initially sold the same amount of oil at lower prices, but as time passes they will sell larger amounts of oil at these lower prices. While that’s not as good as selling those larger amounts of oil at higher prices, it is better than what it had been after the initial, sharp decline.
So oil producers will have more total revenue over the next year, even if price doesn’t change and even if the global economy stops growing, than they did last year. The need for a production freeze becomes less urgent all the time.
Of course, the supply overhang is huge, and it won’t go away overnight and probably won’t go away from demand response alone. But, as we are dealing with the long run, we shouldn’t neglect the demand response, either.
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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.
It is amazing to reflect on the fact that the stock market last week experienced its worst 5-day span to open the year ever. I haven’t independently confirmed that; it seems incredible to me that in a hundred and whatever years we have never started with a 6% loss – but that is what is being widely reported. In any event, it has been a bad start and the market is back to the levels it last saw in August, before the inexplicable Q4 blast-off. Easy come, easy go.
Why is the market down? The harder question is the question of why it was up in the first place. Stocks have been persistently far above fair value measured by CAPE, Tobin’s Q, or any other traditional value metric. The argument that stocks were high because bond yields were low is perhaps the best explanation; this is after all part of the whole “portfolio balance channel” effect that the Fed has been trying to create with QE – raise the price of a good (bonds) and the prices of substitutes (corporate bonds, stocks) should also rise. (Left unsaid, of course, is why it is a good thing to move asset prices away from fair value. The ‘wealth effect’ is small, and zero-sum at best unless prices can permanently be moved away from fair value.)
But if this is the explanation for sky-high stocks, it doesn’t explain why commodity indices – which are obviously also a substitute for stocks and bonds – are at multi-decade lows. Why should the price of that substitute move in the opposite direction? Before you say “weak global growth,” or “overproduction” (as this article has it) remember that not only is oil low, but so is Corn. And Hogs. And Sugar. And Cocoa. What, are we overproducing everything? Is China not eating, either?
I actually really like that article. When oil was at $120, everyone (including fancy Wall Street dealers) published breathless articles about $200 oil. Today I saw an article saying oil is going to $10 – which would be the lowest real price, I think, since oil was discovered. This article could have been written any time in the last 20 years and pointed to some new mine, or crop production technique, or oil field, or railroad, or the development of horizontal drilling, etcetera. It’s just when prices are very low that this is suddenly viewed as an epiphany that Aha! This must be why prices are low! There are big mines opening!
There are, of course, some problems of overcapacity in some commodities because cheap money made possible, for example, the massive draws from Baaken shale. But overcapacity in every commodity? Overcapacity in gold?
And global growth is, indeed, weakening. I would caution any analyst that wants to read into the surprising strength of Friday’s Payrolls report. It is a December measurement of the employment picture: notoriously difficult to seasonally adjust. Some have argued that exceptionally warm weather in December may have increased payrolls beyond what the seasonal adjustment calls for. I am not sure that argument works, since most of the seasonal adjustment is due to seasonal workers and I am not sure why you need more seasonal workers if it is warm. More in construction, perhaps…but the important point is that the error bars on the December are so large that you are supposed to ignore it in almost all circumstances. You simply cannot reject virtually any null hypothesis. What you believed before the number was released, in other words, you should still believe. And as for me, I believed that global growth was weakening – not collapsing, but weakening and probably headed for a recession.
And what a shame. What a shame that central bankers didn’t re-load when they had the chance, and let markets and economies get back to normal. What a shame that the federal deficit wasn’t pushed close to balance when the economy was growing over the last few years.
As David Bowie almost said, [What a] shame [they]’ve left us up to our necks in it.
But if in reaching that conclusion you have come to hate commodities along with stocks, you have come too late. Commodities were worth hating four years ago. But it is hard to see the upside of their downside, now.
This is not true, however, with equities.
An uneducated fellow was laid up in bed with a broken leg. The vicar’s wife, visiting him, asked what he did to pass the time, since he was unable to read and couldn’t leave the bed. His answer was “sometimes I sits and thinks, and sometimes I just sits.”
The reason I haven’t written a column since the CPI report is similar. Sometimes I sits and writes, and sometimes I just sits.
That isn’t to say that I haven’t been busy; far from it. It is merely that since the CPI report there really aren’t many acts left in the drama that we call 2015. We know that inflation is at 6-year highs; we know that commodities are at 16-year lows (trivia question: exactly one commodity of the 27 in the Goldman Sachs Commodity Index is higher, on the basis of the rolling front contract, from last year. Which one?)
More importantly, we know that, at least to this point, the Fed has maintained a fairly consistent vector in terms of its plan to raise interest rates this month. I maintained after the CPI report that the Chairman of the Federal Reserve, and at least a plurality of its voting members, are either nervous about a rate hike or outright negative on the desirability of one at this point. I still think that is true, but I also listen. If the Fed is not going to hike rates later this month, then it would need to telegraph that reticence well in advance of the meeting. So far, we haven’t heard much along those lines although Yellen is testifying on Thursday before the Congressional Joint Economic Committee; that is probably the last good chance to temper expectations for a rate hike although if the Employment data on Friday are especially weak then we should listen attentively for any scraps thereafter.
The case for raising rates is virtually non-existent, unless it is part of a policy of removing excess reserves from the financial system. Raising rates without removing excess reserves will only serve to accelerate inflation by causing money velocity to rise; it will also add volatility to financial markets during a period of the year that is already light on market liquidity, and with banks providing less market liquidity than ever. It will not depress growth very much, just as cutting rates didn’t help growth very much. So most of all, it is just a symbolic gesture.
I do think that the Fed should be withdrawing the emergency liquidity that it provided, even though the best time to do that was several years ago. Yes, we know that Chinese growth is slowing, and US manufacturing growth is slowing – the chart below, source Bloomberg, shows the ISM Manufacturing index at a new post-crisis low and at levels that are often associated with recession.
To be fair, we should observe that a lot of this is related to the energy sector, where companies are simply blowing up, but even if the global manufacturing sector is heading towards recession, there is no need for emergency liquidity provision. Actually, as the chart below illustrates, banks have less debt as a proportion of GDP than they have in about 15 years.
Households have about as much debt as they did in 2007, but the economy is larger now so the burden is lower. But businesses have more debt than they have ever had, in GDP terms, other than in the teeth of the crisis when GDP was contracting. In raw terms, there is 17% more corporate debt outstanding than there was in December 2008. Banks have de-levered, but businesses are papering over operational and financial weakness with low-cost debt. Raising interest rates will cause interest coverage ratios to decline, credit spreads to widen, and net earnings to contract – and with the tide going out we will also find out who has been swimming naked.
In 2016, if the Fed goes forward with tightening, we will see:
- Lower corporate earnings
- Rising corporate default rates
- Rising inflation
- Lower equity prices; higher commodity prices
- Banks vilified. I am not sure why, but it seems this always happens so there will be something.
All of that, and raising rates the way the Fed wants to do it – by fiat – does not reduce any of the emergency liquidity operations.
To be clear, I don’t see growth collapsing like it did in the global financial crisis. Banks are in much better shape, and even though they cannot provide as much market liquidity as they used to – thanks to the Volcker rule and other misguided shackles on banking activities – they can still lend. Higher rates will help banks earn better spreads, and there will be plenty of distressed borrowers needing cash. Banks will be there with plenty of reserves to go. And if the financial system is okay, then a credit crunch is unlikely (here; it may well happen in China). So, we will see corporate defaults and slower growth rates, but it should be a garden-variety recession but with a deeper-than-garden-variety bear market in stocks.
The recipe here is about right for something that rhymes with the 1970s – higher inflation (although probably not double digits!) and low average growth in the real economy over the next five years, but not disastrous real growth. However, that ends up looking something like stagflation, which will be disastrous for many asset markets (but not commodities!) but doesn’t threaten financial collapse.
 This story is attributed variously to A.A. Milne and to Punch magazine, among others.
 Cotton is +3% or so versus 1 year ago.