I want to talk today about some of the really important pieces of information that circulated this weekend. First, I am certain that everyone is familiar with the following chart, which made the rounds after the Brexit vote. It shows an enormous surge in the search term “What is the EU” after the Brexit vote was completed:
This chart, or something very much like it, was all over the place. Oh, wait! I just realized that I forgot to put the axes on the chart! Here it is with a few more relevant pieces of information – incidentally the same information that was left off the original chart. It turns out that it wasn’t the chart I thought it was. Sorry about that…they looked the same.
(For the record, after an extended period of indolence, on Thursday I went for a run; on Friday I went for a run before putting on any other shoes first; on Saturday I went for a run and then later put on different shoes to go to a cocktail party.)
Is it too much to ask that people seeking to insult the British voters at least put some effort into their attempt? Ignore for a moment the simple fact that we don’t know who was searching this – it might well have been the people who voted to Remain, after all – and so the story line that the people who voted Leave were just morons gets no support from this chart. It also turns out that this was the second-most-searched term only for one small time segment: early in the morning after the vote. By 5am it was eclipsed by questions about the weather. Oh my – it seems the Britons also don’t know what weather is! Also, as the Telegraph’s skeptical story (linked above) points out, the raw number of people asking the question was only on the order of 1,000 – it was just a massive increase since it hadn’t been previously asked very much. This is where not having axes matters…it turns out this is a non-story, and nonsense.
Another piece of nonsense I want to point out is more general. I have seen several Twitter polls and other polls in something like this form:
Q: What effect do you think that Brexit will have on the global economy?
a) Deeply contractionary
b) Moderately contractionary
c) Somewhat contractionary
Now this is nonsense because the actual result not only has nothing to do with opinion, it’s not even clear why we would care about people’s opinion in this case (unless we are trying to show how pervasive the negative news stories are, or something). Polls work comparatively well when there is not a lot of information inequality – for example, when each person is asked about his or her own vote. But the poll above is analogous to this poll:
I submit that only me, and my valet, have the information sought by this poll; all other respondents have zero information. Therefore…what’s the value of the poll? Unless I or my valet are respondents, precisely zero; if we are, then the value is inverse to the number of other respondents diluting the response of the people who know.
Similarly, there is likely some information asymmetry among respondents to the poll about the effect of Brexit on the global economy. I would respectfully suggest that most people who are responding are saying what they have heard, or what they fear, or what they hope, while some people – macroeconomists, for example – might have actual models. To be sure, those models are probably only slightly better than the fearful and hopeful assumptions put into them, but the point is that this poll is nonsense in the same way that polling people about what they expect inflation next year to be is nonsense. The vast majority of respondents have no way to evaluate the question in a structured way, so what you are capturing is no more and no less than what people are worried about, which is itself just a reflection of what they’re seeing and hearing…for example, on Twitter.
(For what it’s worth, I think that thanks to the weakening of sterling Brexit is likely to be mildly stimulative to the UK economy, as well as somewhat inflationary, and slightly contractionary and disinflationary to the rest of the world. But the question about global effects is a trick question. Obviously, global production and consumption are unlikely to change much in real terms just due to the arrangement of trade flows. More friction in the system to the extent that Europe puts up significant trade barriers against the UK – something I don’t view as terribly likely – will lower global output slightly and raise global prices.)
These flash polls and Google trends data are part and parcel of the Twitterization of discourse. They have in common the fact that they can be snapshot and draw eyeballs and clicks, whether or not there is any content to the observations. In these cases, and in many others, there isn’t.
Here’s a thought: why don’t we wait a few months, or better yet a few years, before we judge the impact of Brexit? Sometimes, having actual data is even better than a Twitter poll.
So I see today that former Fed Chairman Alan Greenspan says this is the worst crisis he has seen. Bigger than the 1987 Crash? Bigger than Long Term Capital? Bigger than the internet bubble collapse? Bigger than the Lehman (et. al.) collapse? Really?
As humans, we tend to have short memories and (ridiculously) short planning horizons. Greenspan, especially in his apparent dotage, has a shorter memory even than he had previously – maybe this is convenient given his record. I don’t want to comment on his planning horizon as that would seem uncharitable.
Why is Brexit bad? The trade arrangements and treaties do not suddenly become invalid simply because the UK has voted to throw off the shackles of her overlords and return to being governed by the same rules they’ve been governed by basically since the Magna Carta. But Jim Bianco crystallized the issue for me this week. He pointed out that while Brussels could let this be a mostly painless transition, it has every incentive to make it as painful as possible. In Jim’s words, “if it isn’t painful then hands shoot up all over Europe to be the next to leave.” That’s an astute political observation, and I think he’s right. The EU will work hard to punish Britain for having the temerity to demand sovereignty.
But Britain survived the Blitz; they will survive Brexit.
Indeed, Britain will survive longer than the Euro. The sun is beginning to set on that experiment. The first cracks happened a few years ago with Greece, but the implausibility of a union of political and economic interests when the national interests diverge was a problem from the first Maastricht vote. Who is next? Will it be Greece, Spain, Italy, or maybe France where the anti-EU sentiment is higher even than it is in the UK? The only questions now are the timing of the exits (is it months, or years?) and the order of the exits.
As I said, as humans we not only have short memories but short planning horizons. From a horizon of 5 or 10 years, is it going to turn out that Brexit was a total disaster, leading to a drastically different standard of living in the UK? I can’t imagine that is the case – the 2008 crisis has had an effect on lifestyles, but only because of the scale and scope of central bank policy errors. In Iceland, which addressed the imbalances head-on, life recovered surprisingly quickly.
These are all political questions. The financial questions are in some sense more fascinating, and moreover feed our tendency to focus on the short term.
A lot of money was wagered over the last few weeks on what was a 52-48 proposition the whole way. The betting markets were skewed because of assumptions about how undecideds would break, but it was never far from a tossup in actual polling (and now perhaps we will return to taking polling with the grain of salt it is usually served with). Markets are reacting modestly violently today – at this writing, the US stock market is only -2.5% or so, which is hardly a calamity, but bourses in Europe are in considerably worse shape of course – and this should maybe be surprising with a 52-48 outcome. I like to use the Kelly Criterion framework as a useful way to think about how much to tilt investments given a particular set of circumstances.
Kelly says that your bet size should depend on your edge (the chance of winning) and your odds (the payoff, given success or failure). Going into this vote, betting on Remain had a narrow edge (52-48) and awful odds (if Remain won, the payoff was pretty small since it was mostly priced in). Kelly would say this means you should have a very small bet on, if you want to bet that outcome. If you want to bet the Leave outcome, your edge was negative but your odds were much better, so perhaps somewhat larger of a bet on Brexit than on Bremain was warranted. But that’s not the way the money flowed, evidently.
Not to worry: this morning Janet Yellen said (with the market down 2.5%) that the Fed stood ready to add liquidity if needed. After 2.5%? In 1995 she would have had to come out and say that every week or two. A 2.5% decline takes us back to last week’s lows. Oh, the humanity!
Just stop. The purpose of markets is to move risk from people who have it to people who want it. If, all of a sudden, lots of people seem to have too much risk and to want less, then perhaps it is because they were encouraged into taking too much risk, or encouraged to think of the risk as being less than it was. I wonder how that happened? Oh, right: that’s what the Fed called the “portfolio balance channel” – by removing less-risky assets, they forced investors to hold more-risky assets since those assets now constitute a larger portion of the float. In my opinion (and this will not happen soon), central banks might consider letting markets allocate risk between the people who want it and the people who don’t want it, at fair prices. Just a suggestion.
One final point to be made today. I have seen people draw comparisons between this episode and other historical episodes. This is refreshing, since it reflects at least some thoughtful attempt to remember history. Not all of these are apt or useful comparisons; I saw one that this is the “Archduke Ferdinand” moment of this generation and that’s just nuts. Europe is not a military powderkeg at the moment and war in Europe is not about to begin. But, to the extent that trade barriers begin to rise again, the idea that this may be a “Smoot-Hawley” moment is worth consideration. The Smoot-Hawley tariff is generally thought to have added the “Great” to the phrase “Great Depression.” I think that’s probably overstating the importance of this event – especially if everybody decides to respect Britons’ decision and try to continue trade as usual – but it’s the right idea. What I want to point out is that while rising tariffs tend to produce lower growth and lower potential growth, they also tend to produce higher inflation. The fall of the Berlin Wall and the opening of Eastern Europe is one big reason that inflation outcomes over the last few decades have been lower than we would have expected for the amount of money growth we have had. The US has gone from producing all of its own apparel to producing almost none, for example, and this is a disinflationary influence. What would happen to apparel prices if the US changed its mind and started producing it all domestically again? Give that some thought, and realize that’s the protectionist part of the Brexit argument.
We can cheer for a victory for independence and freedom, while continuing to fight against any tendency towards economic isolationism. But I worry about the latter. It will mean higher inflation going forward, even if the doomsayers are right and we also get lower growth from Brexit and the knock-on effects of Brexit.
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?
The next chart shows a longer time scale. You can see that this is not a phenomenon unique to the last few years.
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)
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.
The ECB fired its “bazooka” today, cutting official rates more into negative territory, increasing QE by another €20bln per month, expanding the range of assets the central bank can buy to now include corporate bonds, and creating a new 4-year program whereby the ECB will loan long-term money to banks at rates that could be negative (based on bank credit extended to corporate and personal borrowers).
My point today is not to opine on the power or wisdom of these policy moves. The main thing I want to observe is this: the inflation market is pricing in what amounts to success for global central banks, with consumer inflation averaging something between 1 and 2 percent per year for the next decade (a bit lower in Japan; a bit higher in the UK). Not only are inflation swaps prices much lower than would be expected from a pure monetarists’ standpoint – but options prices are also very low. The chart below (source: Enduring Investments) shows normalized volatilities over the last five years for a 10-year, 2% year-over-year inflation cap. That is, every year you take a look and see if inflation was over 2%. If it was, then the owner of this option is paid the difference between actual inflation and 2%; if it was not, the owner gets zero. So you get to look ten times at whether inflation has gotten above 2%, and get paid each time it has.
The chart shows that whatever inflation is expected to be, the price to cover the risk that inflation is actually somewhat higher is very low. So, not only is inflation expected to be low, but it is expected to be not volatile either.
Look, we’re talking about bazookas, helicopters…does something not seem right about pricing in very little risk of screwing up?
Whether you believe my thesis in my freshly-released book What’s Wrong With Money? that the likely course of inflation over the next few years is higher and potentially much higher, or you agree with those who think deflation is imminent, shouldn’t we agree that bazookas introduce volatility?
Central banks are attempting to do something that has never been done. Shouldn’t we at least be a teensy bit nervous, as they line up to perform the first-ever quintuple-lutz, that no one has ever landed one before? That no one has ever landed a commercial passenger jet on an aircraft carrier?
Uncertainty is supposed to lower asset values, all else being equal. So even if you think stocks at these levels are “fair,” in an environment with earnings and interest rates where they are now and projected earnings following a certain path, an increase in the volatility of those outcomes should lower the clearing price of those assets since the buyer of the asset (which has positive value) is also assuming the volatility (which has a negative value).
But the market also says that uncertainty right now is low. Yes, the VIX is well off its lows and seems to suggest greater short-term uncertainty (see chart below, source Bloomberg) – but I would argue that the long-term volatility of the economic fundamentals has rarely been this high.
Supposedly you can’t roller skate in a buffalo herd, but we also have never tried to do it. There’s a reason we haven’t tried to do it!
But the Fed, and the rest of the world’s central banks, are not only roller skating in a buffalo herd – the world’s markets seem to be suggesting that investors are sure they’re going to succeed. Regardless of whether you’re optimistic about the outcome, I would argue it’s nearly impossible to be both optimistic and highly confident!
 This means something to options traders but can be glossed over by non-options traders. Essentially the point is that you can’t use a regular Black-Scholes model to price options if the strike and/or the forward can have a negative value!
 #1 on Amazon in “Economic Inflation,” thanks largely to all of you!
A reader pointed out to me today a piece by Amy Higgins and Randal Verbrugge on the Cleveland Fed’s website entitled “Is a Nonseasonally Adjusted Median CPI a Useful Signal of Trend Inflation?” I will let readers draw their own conclusions about the new measure that Higgins and Verbrugge are proposing, but I wanted to point out the research because I often cite Median CPI as the best way to look at the central tendency of inflation (what the researchers call “trend inflation”) and this article confirms and reinforces that point of view.
And it is worth looking, therefore, at the recent movements in Median CPI. Yes, I know you’ve seen this over and over from me, but take a look anyway (chart is sourced from Bloomberg).
I don’t believe for a second that the FOMC is unaware of this picture; nor, however, do I believe they really care equally about inflation and growth. The talk right now is moderately hawkish, and with growth fair and inflation heading higher it is time to withdraw reserves. Indeed, it is long past time. As I have said for a while, the time to withdraw reserves was roughly when the Fed was busy implementing their last QE. Also note that I am not saying “raise rates,” since raising rates is an effect of withdrawing reserves and it is the withdrawal of reserves, not the raising of rates, that matters.
Practically speaking, since growth is slowing, the Fed is now back in a pickle of its own making. Inflation is clearly heading higher; growth is probably heading lower. If the FOMC had a balanced mandate (inflation and employment equal) then they would probably be at a neutral rate right now, so that would argue for tightening. But the FOMC has nothing remotely close to a balanced mandate. Against all evidence that monetary policy can affect inflation but not growth, the Fed is totally biased to act to support growth. The bankers believe that slow growth solves the inflation problem, so they should fight recession and just worry about inflation when growth gets “too hot.” Therefore, I currently do not expect the Fed to tighten in December.
Moreover, this increase in core or median inflation is happening in most major economies (with the notable exception of the UK, where it was nearing 4% in 2011 but has gradually come back to around 1%). This is in contrast to the conventional wisdom being propagated that inflation is falling everywhere. Consider the chart below, which is of core Japanese CPI (with the effect of the one-off tax increase in 2014 smoothed out).
Core inflation in Japan is the highest it has been in more than 17 years. Seventeen years. Tell me again how the BOJ’s money printing is having no effect? It is having no effect on growth, but it is doing what we would expect it to do on inflation.
Eurozone inflation is rising less impressively (see chart), but still rising. But then, the ECB has been less aggressive on monetary policy than either the US or Japan. Still, Europe is not, as the popular press would have you believe, flirting with deflation.
All of these economies are only flirting with deflation if you include energy quotes (these pictures may be worse if we had median CPI rather than core CPI for these economies). Now, energy quotes matter, just as much when they are going down as when they are going up, but it is a separate question whether including energy is at all helpful for predicting future inflation. And the answer is, as the Higgins and Verbrugge point out: no, it really isn’t. We are entering a period with weakening growth and strengthening inflation.
This should be “fun.”
“When in the Course of human events it becomes necessary for one people to dissolve the political bands which have connected them with another and to assume among the powers of the earth, the separate and equal station to which the Laws of Nature and of Nature’s God entitle them, a decent respect to the opinions of mankind requires that they should declare the causes which impel them to the separation.
“We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness. — That to secure these rights, Governments are instituted among Men, deriving their just powers from the consent of the governed, — That whenever any Form of Government becomes destructive of these ends, it is the Right of the People to alter or to abolish it, and to institute new Government, laying its foundation on such principles and organizing its powers in such form, as to them shall seem most likely to effect their Safety and Happiness.”
Greece has voted ‘no.’ It should not surprise us that this has happened. The only surprise is that it took this long for “one people to dissolve the political bands which have connected them with another.”
Let us all grab the reins on the dollar. Yes, it is true: the buck is up some 25% from a year ago, and at the highest level in more than a decade. After retracing recently, the dollar index has been chugging higher again although it has yet to penetrate recent highs. But put this all into context. In the early 1980s, the dollar index exceeded 160 before dropping nearly by half. A subsequent rally into the early 2000s was a 50% rally from the lows and took the index to 120. This latest rally is a clear third place, but also a distant third place (see chart, source Bloomberg).
We can probably draw some instruction from reviewing these past circumstances. The rally of the early 1980s was launched by the aggressively hawkish monetary policy of Paul Volcker, who vowed to rein in inflation by restraining money growth. He succeeded, and took core inflation from nearly 14% in 1980 (with the dollar index at 85) down to 4.5% in 1985 (with the dollar index at 160). If you make a thing, in this case dollars, more scarce, its price rises. An optimistic press wrote about the “Superdollar” and the return of that signature American optimism.
Well, one out of two isn’t bad. The dollar soon slipped back, as other central banks instituted similar monetary restraint and the relative advantage to the greenback faded. It bounced around until the late 1990s, when Congress attacked the federal deficit – actually turning it into a surplus in the late 1990s. The dollar rallied fairly steadily from 1995 until topping out between late 2000 and early 2002, thanks to aggressive easing action from the Fed which took the Fed Funds target rate from 6.5% to 1.0%.
But it is important to remember that with currencies, it is all relative. If everyone is easing or everyone is tightening, then there shouldn’t be much in the way of relative currency movements. Thus, even though the Fed has spent most of the last seven years doing quantitative easing, the dollar hasn’t done much on net because everyone else is doing so as well. All currencies should be cheapening relative to real assets (and are, with respect to real estate, but not so much with commodities…for reasons that make little sense to me), but not relative to one another.
But recently, the dollar has outperformed because the investing community collectively perceived a divergence in monetary policies in the offing. While Japan and Europe have been ramping their QE higher, the Fed has ended its QE and at least some people expect them to raise rates soon. If it were to actually happen that money growth in Japan and Europe continued to accelerate while it slowed in the U.S., then it makes perfect sense that the dollar should appreciate. That is happening a little: the chart below (source: Bloomberg) shows that in the most recent data, European M2 money growth exceeded US M2 money growth (as well as UK and Japan M2 money growth) for the first time since 2008. Look at that spike on the red line in the chart below!
On the other hand, there doesn’t seem to be anything dramatic happening on that chart, with all growth rates between 3.5% and 6.1%. And, honestly, I think investors have it generally wrong in thinking that if the Fed hikes US interest rates, money growth should slow and overall monetary conditions should tighten. Quite the contrary: I believe that with enormous excess reserves in place, rising interest rates will only spur bank interest in lending, and money growth will not slow but may even increase. But in any event, dollars are not about to become more scarce. The Fed doesn’t need to do any more QE; the vast quantities of excess reserves act as a reservoir of future money.
I have been surprised by the dollar’s rally, but unless something changes in a more serious way I don’t expect the rally to end up resembling the two prior periods of extended dollar strength.