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Summary of My Post-CPI Tweets

September 16, 2016 5 comments

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments. Plus…buy my book about money and inflation, published in March 2016. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • OK, 8 minutes to CPI. Street forecast is 0.14-0.15%, so a “soft” 0.2% or a “firm” 0.2% on core.
  • y/y core wouldn’t fall with that b/c last August’s core CPI was 0.12%. In fact, a clean 0.2% would cause the y/y to round up to 2.3%.
  • Either way, Fed is at #inflation target based on historical CPI/PCE spread. And arguably above it if you rely (as we do) on median.
  • Quick commercial message: our crowdfunder site for the capital raise for Enduring Investments closes in 2 weeks.
  • Commercial message #2: sign up for my articles at https://mikeashton.wordpress.com! And #3: my book!
  • Fed’s job just got a lot harder, with weaker growth but a messy inflation print. 0.25% on core, y/y rises to 2.30%.
  • And looking forward BTW, for the balance of the year we’re rolling off 0.19, 0.20, 0.18, and 0.15 from last year.
  • …so it wouldn’t be hard to get a 2.4% or even 2.5% out of core by year-end.
  • Housing rose to 2.58% y/y from 2.45%. Medical Care to 4.92% from 3.99%. Yipe. The big stories get bigger.
  • checking the markets…whaddya know?! they don’t like it.
  • starting to drill down now. Core services 3.2% from 3.1%; core goods -0.5% from -0.6%.
  • Core goods should start to gradually rise here because the dollar has remained flat for a while.
  • also worth pointing out, reflecting on presidential race: protectionism is inflationary. Unwinding the globalization dividend=bad.
  • Take apparel. Globalizing production lowered prices for 15 years 1994-2009.

apparel

  • Drilling down. Primary rents were 3.78% from 3.77%, no big deal. OER 3.31% from 3.26%, Lodging away from home 3.31% from 1.57%.
  • Lodging away from home was partly to blame for last month’s miss low. Retraced all of that this month.
  • Motor vehicles was a drag, decelerating further to -0.95% from -0.75%.
  • Medical Care: Drugs 4.67% from 3.77%. Professional svcs 3.35% from 2.86%. Hospitals 5.81% from 4.41%. Insurance 9.13% vs 7.78%
  • Insert obvious comment about effect of ACA here.
  • y/y med care highest since spike end of 2007.

medcare

  • CPI Medical – professional services highest since 2008.

prof

  • On the good news side, CPI for Tuition declined to 2.53% from 2.67%. So there’s that.
  • Bottom line: can’t put lipstick on a pig and make it pretty. This is an ugly CPI report. It wasn’t one-offs.
  • I STILL think the Fed doesn’t raise rates next week. But this does make it a bit harder at the margin.
  • Core ex-housing was 1.52%. It was higher than that for one month earlier this year (Feb), but otherwise not since 2013.

coreexshelter

As I noted, this is an ugly report. The sticky components, the ones that have momentum, continue to push inexorably higher (in the case of housing), or aggressively higher (in the case of medical care). The rise in medical care is especially disturbing. While core was being elevated mainly by shelter, it was easier to dismiss. “Yes, it’s a heavily-weighted component but it’s just one component and home-owners don’t actually pay OER out of pocket.” But medical care accelerating (especially a broad-based rise in medical care inflation), makes the inflation case harder to ignore. It is also really hard to argue – since there is a clearly-identifiable cause, and a strong economic case for why medical care prices are rising faster – that medical care inflation is resulting from some seasonal quirk or one-off (like the sequester, which temporarily pushed medical inflation down).

What makes this even more amazing is that inflation markets are priced for core and headline inflation to compound at 1.5%-1.75% for basically the next decade. That’s simply not going to happen, and the chance of not only a miss but a big miss is nonzero. I continue to be flabbergasted at the low prices of TIPS relative to nominal bonds. Sure, a real return of 0% isn’t exciting…but your nominal  bonds are almost certainly going to do worse over the next decade. I can’t imagine why anyone owns nominal bonds at these levels when inflation-linked bonds are an option.

Now, about the Fed.

This report helps the hawks on the Committee. But there aren’t many of them, and the central power structure at the Federal Reserve and at pretty much every other central bank around the world is very, very dovish. Arguably, the Fed has never been led by a more dovish Chairman. I have long believed that Yellen will need to be dragged kicking and screaming to a rate hike. Recent growth data show what appears to be a downshift in growth in an expansion that is already pretty long in the tooth, so her position is strong…unless she cares about inflation. There is no evidence that Yellen cares very much about inflation. I think the Fed believes inflation is low; if it’s rising, it isn’t going to rise very far because “expectations are anchored,” and if it does rise very far they can easily push it lower later. I think they are wrong on all three counts, but I haven’t recently held a voting position on the Committee. Or, actually, ever. Ergo, a Fed hike in my view remains very unlikely, even with this data.

Looking forward, Core and Median inflation look set to continue to rise. PCE will continue to drag along behind them, but there is no question inflation is rising at this point unless everything except PCE is wrong. In the US, core inflation has not been above 3% for twenty years. That is going to change in 2017. And that is not good news for stocks or bonds.

allup

Reforming Priors and Re-Forming Europe

September 7, 2016 1 comment

By now, you have probably heard that the sun did not set on the British Empire as a result of BrExit. Here is one chart from Tuesday’s Daily Shot letter – and see that letter for others.

520c2c5b-1ca3-4afb-8524-2736a4f4dbae

This is not at all shocking. While in the long-term it is possible (though I think unlikely) that Germany and other major European trading partners may choose to reduce the business they do with the UK – business which is bilateral, by the way – the immediate short-term impact of a lower pound sterling was much easier to read. In the immediate aftermath of the vote, I made the bold prediction that “Britain Survived the Blitz and Will Survive Brexit,” and then later that week in a post called “Twits and Brits” I made the fairly out-of-consensus prediction that “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.”

Oh, I should also point out that in early July I asked the question whether UK property price declines were rational, or overdone and concluded that “I don’t believe the current drop in listed UK property funds is a rational response to correcting bubble pricing, and it’s probably a good opportunity for cool-headed investors…and, more to the point, cool-headed investors who aren’t expecting to liquidate investments overnight.” What has happened since? See the chart below (Source: Daily Shot).

dailyshot1

I only mention these items in back-patting fashion because (a) I am proud that I responded thoughtfully, rather than hysterically like many analysts, to the Brexit surprise, and (b) I want to promote my credibility when I make the following observation:

Good news for the UK is bad news for the Eurozone. Not for growth or inflation in the Eurozone, but for its very survival.

The audacity of Britain in leaving the EU was shocking to the establishment, but everyone carefully predicted disaster for the ancient empire. They did this not because the economics said it would be that way – as I pointed out, the economics pointed the other way – but because it was in the interest of the common-currency project that there be huge costs to breaking the covenant. The “marriage” of the countries in the Eurozone was difficult and painful, and the ongoing relationship has been difficult on some of the members. If “divorce” is easy – and even worse, if it is beneficial, then the marriage will not last. The experience of the UK so far – not only doing okay, but actually doing well – cannot be escaping notice in Athens or Rome (or Madrid or Lisbon…or Paris).

Now, that doesn’t mean the Euro is doomed to fail next week. But it means that in the next crisis, whether that is Greece redux or Italy or some other ground zero, the Eurozone bosses in Brussels will be lacking a major threat to use to force the recalcitrant nation to accept painful austerity. Remember that it was the threat of a generational depression that helped get Greece into line. How is Greece doing? The chart below (source: Bloomberg) shows that nation’s unemployment rate.

greekunemp

Admittedly it is not a statistically-valid sample, although to be sure it is a sample that matches the a priori arguments of those who suggested that Greece should leave the Euro: the country that exited the EU is doing fine, and better-than-expected, while the country that remained in the Eurozone is actually mired in a depression. Hmmm. So tell me again why my poor country needs to accept austerity to remain in the Eurozone?

So much about policy depends on one’s priors. If your prior expectation is that leaving the Eurozone is likely to be a disaster, then both sides in the negotiation are likely to reach agreement on a relatively smaller inducement to stay than if the prior expectation is that leaving the Eurozone might be a positive event for the leaver. The events to date should cause these priors to shift when the next crisis happens.

Speaking of priors, and changing countries: Friday’s employment report did not seem, to me, to be outside of the range of outcomes that would cause policymaker priors to change. That is, if the Fed Chairman was planning to raise rates later this month, prior to seeing the Employment report, then I wouldn’t expect the report was weak enough to change that course of action. Conversely, if the Chairman (as I believe) was not planning to hike rates, then it doesn’t seem to me that the report was strong enough to change that course of action.

Markets have decreased the implied probability of such a rate hike, compared to what it was before the report. That’s just Mr. Market’s bipolar nature. The 6-month moving average of payrolls was 189k last month; it is 175k now. The 12-month average is exactly unchanged at 204k. There’s nothing here that is out of the ordinary. But if your attitude was that rates should rise because they need to be returned to neutral, then a 151k monthly Non-Farm Payrolls shouldn’t affect that decision. And if your attitude was that the economy might be weakening, and can’t sustain a rate hike, the number doesn’t change your attitude either. So, while Mr. Market has changed the implied probability, I seriously doubt Dr. Yellen wavered at all.

The problem is that we don’t know what Dr. Yellen (and let’s be clear, hers is the only vote which matters) was thinking prior to the number. We don’t know her priors. But, unless the data appreciably strengthens or weakens between now and September 21st, we will know her priors after we see the results from the meeting. My guess continues to be that the Chairman’s operating assumption is that low rates do more good than harm, and that therefore a hike in rates is unlikely until inflation (already above the Fed’s target, and rising) gets quite a bit more above the Fed’s target, or market interest rates signal restlessness with the Fed’s course.

Categories: Euro, Europe, Federal Reserve, UK

Need a Jedi to Blow Up the R-Star

September 6, 2016 Leave a comment

I haven’t written an article for a couple of weeks. This is not entirely unusual: I have written this commentary, in some form, since about 1996 and there are occasional breaks in the series. It happens for several reasons. Sometimes it is simple ennui, as writing an analysis/opinion article for twenty years can occasionally get boring especially when markets are listless as they frequently are in August. Other times, it is because work – the real work, the stuff we get paid for – is too consuming and I have not time or energy left to write  a few hundred words of readable prose. Maybe that’s part of the reason here, since the number of inflation-investing-related inquiries has definitely increased recently, along with some new client flows (and not to mention that we are raising capital for Enduring Investments through a 506(c) offering – you can find details on Crowdfunder or contact me through our website). Finally, in recent years as the ability to track the number of clicks/eyeballs on my writing has improved, I’ve simply written less during those times…such as August…when I know that not many people will read the writing.

But this time is a little different. While some of those excuses apply in some measure, I’ve actually skipped writing over the last two weeks because there is too much to say. (Fortunately, I said some of it on two Bloomberg TV appearances, which you can see here and here.)

Well, my list of notes is not going to go away on its own so I am going to have to tackle some of them or throw them away. Unfortunately, a lot of them have to do with the inane nattering coming out of Federal Reserve mouthpieces. Let’s start today with the publication that gathered a lot of ink a couple of weeks ago: San Francisco Fed President John Williams’ FRBSF Economic Letter called “Monetary Policy in a Low R-star World.”

The conclusion that Williams reached was sensational, especially since it resonates with the “low return world” meme. Williams concluded that “The time has come to critically reassess prevailing policy frameworks and consider adjustments to handle new challenges, specifically those related to a low natural real rate of interest.” This article was grating from the first paragraph, where Williams casts the Federal Reserve as the explorer/hero:

“As nature abhors a vacuum, so monetary policy abhors stasis. Instead of being a rigid set of precepts, it follows the adage, that which survives is that which is most adaptive to change… In the wake of the global financial crisis, monetary policy has continued to evolve… As we move forward, economic conditions require that central banks and governments throughout the world carefully reexamine their policy frameworks and consider further adjustments in terms of monetary policy strategy—both in its own right and as it relates to other policy arenas—to successfully navigate these new seas.”

One might give the Federal Reserve more credit if subsequent evolutions of policy prescriptions were not getting progressively worse rather than better. Constructive change first requires critical evaluation of the shortcomings of current policy, doesn’t it?

Williams carries on to argue that the natural rate of interest (R-star) is lower now than it has been in the past. Now, Fed watchers should note that if true, this implies that current monetary policy is not as loose as has been believed. This is a useful conclusion for the Fed, since it would explain – within their existing model framework – why exceptionally low rates have not triggered better growth; it also would allow the Fed to raise rates more slowly than otherwise. I’ve pointed out before the frustrating tendency of groupthinking economists to attribute persistent poor model predictions to calibration issues rather than specification issues. This is exactly what Williams is doing. He’s saying “there’s nothing wrong with our model! If we had simply known that the natural rate was lower, we would have understood that we weren’t as stimulative as we thought.” Possible, but it might also be that the whole model sucks, and that the monetarists are right when they say that monetary policy doesn’t move real variables very well. That’s a hypothesis that at least bears examining, but I haven’t seen any fancy Fed papers on it.

What is really remarkable is that the rest of the paper is largely circular, and yet no one seems to mind. Williams attributes the current low r-star to several factors, including “a more general global savings glut.” Note that his estimates of r-star take a sharp turn lower in 2008-9 (see chart below, source FRBSF Economic Letter, figure 1).

williams

Wow, I wonder what could have caused an increase in the global savings glut starting in 2008? Could it be because the world’s central banks persistently added far more liquidity than was needed for the proper functioning of the economy, leading to huge excess reserves – aka a savings glut?

So, according to Williams, the neutral interest rate is lower at least in part because…central banks added a lot of liquidity. Kind of circular, ain’t it?

Since according to Williams this fact explains “uncomfortably low inflation and growth despite very low interest rates,” it must mean he is bravely taking responsibility – since, after all, quantitative easing caused the global savings glut which, in his construct, caused low growth and inflation. Except that I don’t think that’s what he wants us to conclude.

This isn’t research – it’s a recognition that what they did didn’t work, so they are backfilling to try and find an excuse for why their theories are still good. To the Fed, it is just that something happened they didn’t realize and take account of. Williams wants to be able to claim “see, we didn’t get growth because we weren’t as stimulative as we thought we were,” because then they can use their old theories to explain how moving rates around is really important…even though it didn’t work this time. But the problem is that low rates don’t cause growth. The model is wrong. And no amount of calibration can fix a mis-specified model.

Summary (and Extension) of My Post-CPI Tweets

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments. Plus…buy my book about money and inflation, published in March 2016. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • 5 minutes to CPI. Consensus is for core to barely round to 0.2%, and for y/y core to remain at a soft 2.3%
  • I have the “over” there, but the “under” against my friend who thinks it’s gonna be 0.24%.
  • Core CPI +0.09%, y/y drops to 2.20%.
  • Waiting for the breakdown to dig deeper. Housing accelerated y/y, as did Medical care, but Apparel, Rec, Educ/comm all lower.
  • …Housing and Medical care are the big longer-term concerns so the internals might not be as weak as the headline. Taking a look now.
  • Meanwhile Dudley on the tape saying “probably don’t have to do a lot of tightening over time.” Echoes Williams. When doves cry.
  • At the same time Dudley says rate hike is possible in September. Sure, anything is possible. But not with core printing 0.1% m/m.
  • ..in Housing, Primary Rents fell to 3.77% from 3.81% y/y. OER rose to 3.26% vs 3.25%, continuing flat patterns.
  • Those are the biggest parts of housing. Lodging away from home plunged y/y. Where did the rise in housing come from? Household energy.
  • HH energy -1.37% y/y vs -3.02%. That’s 3.8% of the CPI, but not in core obviously. So housing ex-energy was basically flat.
  • Overall Medical Care category rose to 3.99% from 3.65% and 3.17% the month before that. Jumps in every category:
  • Drugs 3.77% (vs 3.40%). Equipment/supplies 0.1% (-0.62%). Prof Svcs 2.86% (2.60%). Hospital 4.41% (4.12%). Health Ins 7.78% (7.10%)
  • Large jumps everywhere in Medical Care. *Discuss.*
  • Apparel still rising y/y, at 0.35%, but won’t really take off until the dollar declines.
  • Overall, core services +3.1% (was 3.2%) and core goods -0.6% (unch).
  • Popular number is core ex-housing. 1.36% y/y vs 1.37%.
  • So overall, despite the weak m/m core number, the big trends remain in place. Housing flat to higher. Medical Care starting to ramp up.
  • A broad array of volatile components dragged m/m CPI down. But 59% of the basket is still accelerating faster than 3%.
  • Biggest monthly falls: motor fuel, car and truck rental, public transp, lodging away from home, and misc pers goods. All <-20% m/m
  • Only category over 20% annualized m/m increase was Infants and toddler’s apparel.
  • These last few facts mean that MEDIAN inflation, a better measure of inflation, will be up 0.24% or so m/m. 2.48% y/y.
  • Ugly pic #1: Health Insurance y/y

insurance

  • Ugly picture #2: medicinal drugs y/y.

drugs

  • ugly picture the worst: Medical Care overall, y/y

medicaltot

  • Owners’ Equiv Rent, largest part of CPI. Certainly high and stable. Maybe tapering? But at 3.3%! Ugly or no?

oer

  • FWIW our forecast is for OER to rise a little bit further, but less dramatically unless core ex-housing starts to move.
  • I’m not sure it’s comforting to have rents up “only” 3-4% in context of rising med care. In any event: core ain’t falling soon.
  • note that in August 2015, core was +0.12% m/m. So we’ll see some re-acceleration (and possible catch-up) next month.
  • I actually think there’s a chance for an 0.3% print next month. which would make the FOMC more interesting.
  • Right now, it’s not interesting. With m/m core at 0.09% and 3 quarters of 1% GDP, Fed not tightening in Sept.
  • Thanks for all the new follows and the re-tweets. Good time to mention a couple of things:
  • I’m thrilled to be on “What’d You Miss?” on Bloomberg TV at 3:30ET today. With @scarletfu @thestalwart and @OJRenick
  • Here’s my book: What’s Wrong With Money? The Biggest Bubble of All
  • My company, Enduring Investments, is raising a small amount of capital in the management co. Details here: https://www.crowdfunder.com/enduring-investments-llc/

So, while PPI is not usually much of a predictor of CPI, in this case it gave early warning that we were about to see a weak print from the more-important indicator. But that weakness came from a couple of smaller categories. I have shown this chart a number of times before, but I think it’s especially instructive this time. Compare the distribution of price changes in categories (by the weight in the category) this month…

distrib

To the same distribution from last October.

cpidist

Note that the left tail, which holds the laggards, has more weight this time. There is not quite as much weight in the deep deflation tail, but there are more 0% and 0.5% categories. Yes, there is also one really big increase on the right although it still doesn’t add up to much. The biggest piece of the upper tail is Health Insurance – which as you can tell from the chart above is fairly persistent. In short, I think there’s a better chance of the lower tail reverting to the mode of the distribution than there is of the upper tail doing the same. (This is why Median CPI is a better measure).

The bottom line for markets in the near-term is that nothing about this number scares policymakers. While Dudley says that September is still on the table for an FOMC tightening, the reality is that the data will present them with no urgency – even if, as I think likely, next month’s core CPI corrects for this month’s weakness. And Williams’ ridiculous paper gives them academic cover to ignore the fact that median CPI is at 2.5% and likely will continue to rise. Moreover, LIBOR has been rising because of changes in money market regulations, so FOMC members can argue that financial conditions are tightening automatically. In short, it is very unlikely in my opinion that the Fed hikes rates in September. Or November. Or December.

Shooting Blanks

August 2, 2016 4 comments

Almost eight years after the bankruptcy filing of Lehman Brothers and the first of many central bank quantitative easing programs, it appears the expansion – the weakest on record by several measures – is petering out. The Q2 growth rate of GDP was 1.2% annualized, meaning that the last three quarters were +0.9%, +0.8%, +1.2%. That’s not a recession, but it’s also not an expansion to write home about.

But why? Why after all of the quantitative easing? Is the effectiveness waning? Is it time for more?

I read recently about how many economists are expecting the Bank of England to increase asset purchases (QE) this Thursday in an attempt to counteract the depressing effects of Brexit on growth. Some think the increase will be as much as £150 billion. That’s impressive, but will it help?

I also read recently about how the Bank of Japan “disappointed investors” by not increasing asset purchases except incrementally. The analysts said this was disappointing because the BOJ’s action was “not enough to cause growth.”

That’s because no amount of money printing is enough to cause growth. No amount.

It seems like people get confused with this concept, including many economists, because we use units of currency. So let’s try illustrating the point a different way. Suppose I pay you in candy bars for the widgets you produce. Suppose I pay you 10 candy bars, each of which is 10 ounces, for each widget. Now, if I start paying you 11 candy bars instead of 10, then the price has risen and you want to produce more widgets, right? This, indirectly, is what economists are thinking when they think about the effect of monetary policy.

But suppose that I pay you 11 candy bars, but now each candy bar is 9.1 ounces instead of 10 ounces? I suspect you will not be fooled into producing more widgets. You will realize that I am still paying you 100 ounces of candy per widget. You are not fooled by the fact that the unit of account changed in intrinsic value.

Now, when the central bank adds to the money supply, but doesn’t change the amount of stuff the economy produces (they don’t have the power to direct production!), then all that changes is the size of the unit of account – the candy bar, or in this case the dollar – and the number of dollars you need to buy a widget goes up. That’s called inflation. And the only way that printing more money can cause production to increase is if you don’t notice that the value of any given unit of currency has declined. That is, only if I say I’m paying you 11 candy bars – but you haven’t noticed they are smaller – will you respond to the change in terms. This is called “money illusion,” and it is why money printing does not cause growth in theory…and, as it turns out, in practice.[1]

There is nothing terribly strange or unpredictable about what is going on in global growth in terms of the response to monetary policy. The only thing strange is that eight years on, with numerous observations on which to evaluate the efficacy of quantitative easing, the conclusion appears to be that it might not be quite as effective as policymakers had thought. And therefore, we need to do lots more of it, the thought process seems to go. But anything times zero is zero. Central banks are not shooting an inaccurate, awkward weapon in the fight to stimulate growth, which just needs to be fired a lot more so that something eventually hits. They are shooting blanks. And no amount of shooting blanks will bring down the bad guy.

[1] I address this aspect of money, and other aspects that affect inflation, in my book What’s Wrong With Money: The Biggest Bubble of All.

August: More Esther, Less Mester

The last two weeks of July felt a lot like August typically does. Thin, lethargic trading; somewhat gappy but directionless. Ten-year Treasury note futures held a 1-point range except for a few minutes last Thursday. The S&P oscillated (and it really looks like a simple oscillation) between 2160 and 2175 for the most part (chart source Bloomberg):

dull

In thinking about what August holds, I’ll say this. What the stock market (and bond market) has had going for it is momentum. What these markets have had going against them is value. When value and momentum meet, the result is indeterminate. It often depends on whether carry is penalizing the longs, or penalizing the shorts. For the last few years, with very low financing rates across a wide variety of assets, carry has fairly favored the longs. In 2016, that advantage is lessening as short rates come up and long rates have declined. The chart below shows the spread between 10-year Treasury rates and 3-month LIBOR (a reasonable proxy for short-term funding rates) which gives you some idea of how the carry accruing to a financed long position has deteriorated.

carry

So now, dwelling on the last few weeks’ directionless trading, I think it’s fair to say that the markets’ value conditions haven’t much changed, but momentum generally has surely ebbed. In a situation where carry covers fewer trading sins, the markets surely are on more tenuous ground now than they have been for a bit. This doesn’t mean that we will see the bottom fall out in August, of course.

But add this to the consideration: markets completely ignored the Fed announcement yesterday, despite the fact that most observers thought the inserted language that “near-term risks to the economic outlook have diminished” made this a surprisingly hawkish statement. (For what it’s worth, I can’t imagine that any reasonable assessment of the change in risks from before the Brexit vote to after the Brexit vote could conclude anything else). Now, I certainly don’t think that this Fed, with its very dovish leadership, is going to tighten imminently even though prices and wages (see chart below of the Atlanta Fed Wage Tracker and the Cleveland Fed’s Median CPI, source Bloomberg) are so obviously trending higher that even the forecasting-impaired Federal Reserve can surely see it. But that’s not the point. The point is that the Fed cannot afford to be ignored.

wagesandprices

Accordingly, something else that I expect to see in August is more-hawkish Fed speakers. Kansas City Fed President Esther George dissented in favor of a rate hike at this meeting. So in August, I think we will hear more Esther and less Mester (Cleveland Fed President Loretta Mester famously mused about helicopter money a couple of weeks ago). The FOMC doesn’t want to crash the stock and bond markets. But it wants to be noticed.

The problem is that in thin August markets – there’s no escaping that, I am afraid – it might not take much, with ebbing momentum in these markets, to cause some decent retracements.

Categories: Federal Reserve, Trading, Wages

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.

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