Summary of My Post-CPI Tweets (August 2017)

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. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • about 15 mins to CPI. Consensus on core is 0.15% or 0.16% m/m, which would see y/y rise to ~1.74% vs 1.71%.
  • Few see upside risks to that forecast. Indeed, most pundits are braced for a lower print. 0.15% on core would have beaten last 4 mo.
  • Last 4 core CPI: -0.12%, 0.07%, 0.06%, 0.12%. But the 4 before that were 0.18%, 0.22%, 0.31%, and 0.21% so it’s a fair bet.
  • Though the NKor situation dominates market concerns, today’s CPI garnering more than normal interest. Potential for some volatility.
  • We’ve heard dovish Fed govs floating idea of pausing rate hikes (though continuing balance sheet reduction). That’s what doves do, but…
  • …but another weak CPI will be seen as “sealing the deal” for removing rate hikes from the calendar.
  • STRONG core CPI print is a much bigger surprise to most. Might be less mkt risk though – want to sell Tsys with NKor situation hot?
  • Core CPI 0.11%, y/y: 1.70%. Actually slightly down v 1.71% last mo. Think we can take rate hikes off table but will look @ breakdn.
  • Core goods steady at -0.6%, no dollar effect pushing it higher yet. Core services 2.4%, lowest in 2yrs.
  • Just quick glance I see new cars -1.1% y/y down from -0.3%. If this is autos I’d not be as worried.
  • Core ex-Shelter rose slightly, actually, to 0.63% from 0.60% y/y. But that’s obviously not alarming.
  • Dropping the full data set at the moment. Please hold.
  • In Housing, Primary Rents decelerated to 3.81% from 3.86%. OER slipped to 3.21% vs 3.23%. Small moved but big categories.
  • Lodging Away from Home -2.36% vs -0.07%. Big move, small category. But that category often has big moves.
  • Apparel went to -0.44% vs -0.67%. Again, not really seeing the dollar effect – apparel is one of the first places it would show up.
  • New cars -0.63% vs 0.01%, weight of 3.68% of CPI. Not only the lowest in 8 years but…recession leader? See chart.

  • Used cars -4.08% vs -4.30%, so the effect is in new.
  • That new cars decel is worth 3bps on core, so if was still at 0.01% we’d have had core right at expectations even w/ shelter slowdn.
  • Medical Care 2.58% vs 2.66% y/y. Pharma rose (3.84% vs 3.31%) but Prof Svcs dropped to 0.21% vs 0.58%
  • Medical – Professional Services starting to look like Telecommunications. What’s the one-off here?

  • Again with rents…decelerating but right about back on schedule.

  • For those playing at home: wireless telephone services -13.25% vs -13.19%. After the huge drop a few months ago, not much add’l.
  • Incidentally, Land Line Phone Services is 0.73% weight in CPI while Wireless is 1.74%. Gone is the ubiquitous creamcicle on the wall.
  • A little hard to guess at Median b/c median category looks like Midwest Urban OER, which gets a 2nd seasonal adj, but my est is 0.18%.
  • Here’s the inflation story over the last year, in two important chunks.

  • US #Inflation mkt pricing: 2017 1.3%;2018 1.8%;then 2.1%, 2.1%, 2.1%, 2.2%, 2.1%, 2.1%, 2.3%, 2.4%, & 2027:2.4%.
  • Here’s a little teaser from our quarterly. These are not forecasts, but entirely derived from mkt data.

  • Inflation in four pieces: Food & Energy

  • Piece 2: Core Goods, nothing to see here.

  • Core Services Less RoS – this is the core CPI story.

  • …though don’t forget piece 4. As noted earlier, this is just going back to model but some will forecast collapse.

  • This might be the bigger story – declining core CPI is all about the weight in the left tail, which is why median is still at 2.2%.

  • Despite core CPI slowdown, 44% of components are still inflating faster than 3%.

  • …this makes it more likely the recent CPI slowdown reverses, b/c it’s being caused by left-tail outcomes that probly mean-revert.

Coming into today the market thought the probability of a December rate hike was only 38%, which seemed very low to me. But there is nothing here that suggests the doves are going to lose the fight to slow down the already-timid pace of rate hikes. It isn’t surprising to see markets rally on this data.

However, it is also easy to get carried away with the story that inflation is decelerating. Those left-tail categories are what is driving core inflation lower (and it’s the reason I focus on median CPI, because it ignores the outliers). Shelter has come off the boil a bit, and if that rolled over I would be more concerned about seeing much lower CPI. But there is no sign of that happening, and it seems unlikely to given that home prices themselves continue to rise at a better-than-5% clip (see chart, source Bloomberg).

So, if shelter isn’t going to continue to decelerate much more, then the risk going forward is mean-reversion of those left-tail categories. I don’t think Physician Services are going to go into deflation. (To be sure, some of that is probably a measurement issue as the mode of hiring and paying for doctors is changing, and it is hard to predict mean reversion from measurement issues). Thus, if the market starts to price a near-zero chance of higher rates come December, I’d be interested in buying that option on the chance that one or two of these next four CPI prints (the December CPI report is out the day of the December FOMC meeting) is tilted the other way.

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Inflation Markets Showing a Pulse

We are two days away from the next electrifying CPI report (well, some of us consider it electrifying). The last few prints have been very low, causing great consternation among investors, economists, and other analysts who like to try and “play the carom” by picking turning points in the data.

As I have written before, there is nothing yet to suggest that inflation has abruptly turned and started to dive, and most of the shortfalls over the last few months have been caused by one-offs. (You can review my May, June, and July CPI summaries for the details, and also look at one of those one-offs in depth here.) Indeed, it would be odd if inflation suddenly turned tail and ran, since global money growth remains adequate to support the current level of inflation (see chart, source Enduring Investments).

This chart only shows the US and Europe, but if you add the UK and Japan and Switzerland and whatever else you like, the picture doesn’t change appreciably. In addition to the steady money growth (which, it should be remembered, no central bank is trying to restrain since most of them don’t believe it matters), housing prices continue to rise faster than inflation (see chart, source Enduring Investments) – which suggests that the cost of shelter is not about to suddenly go into retreat.

Finally, although it’s a minor effect, the dollar has recently weakened meaningfully. It isn’t a big deal but it changes the sign of that minor effect. Yes, there are pockets where I expect to see some coming or continuing weakness in pricing, such as in autos, but overall it would surprise me to see this three-month trend actually represent the top tick. Not to mention that such a thing would imply the casual inflation pundits were actually right, and not only right but timely. What are the odds?

Meanwhile, there are some interesting undercurrents that suggest I am not alone in thinking that inflation isn’t dead (again, or still, depending on your point of view). Against form, inflation swaps in the US have been rising anew; even more surprising, European inflation swaps are reaching towards new highs (see chart, sourced from our daily chart package) even though the Euro has been strong.

The market isn’t always…or even often…right. But there are flows into inflation product right now that, while hardly tsunamic, are causing moves unlike any we’ve seen recently. Also note that commodities are showing strength – the Bloomberg Commodity Index is up 6.5% since late June, and that isn’t all energy. The chart below (source: Bloomberg) shows the Bloomberg Commodity Index ex-energy.

With CPI on Friday, all I am saying now is that this is worth keeping in mind. Among all of the other negatives for stock and bond markets recently, a renewed rise in inflation would be an unwelcome addition.

Categories: CPI

The Gold Price is Not ‘Too Low’

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Before I start today’s article, let me say that I don’t like to write about gold. The people who are perennially gold bulls are crazy in a way that is unlike the people who are perennial equity bulls (Abby Joseph Cohen) or perennial bond bulls (Hoisington). They will cut you.

That being said, they are also pretty amusing.

To listen to a gold bull, you would think that no matter where gold is priced, it is a safe haven. Despite the copious evidence of history that says gold can go up and down, certain of the gold bulls believe that when “the Big One” hits, gold will be the most prized asset in the world. Of course, there are calmer gold bulls also but they are similarly dismissive of any notion that gold can be expensive.

The argument that gold is valuable simply because it is acceptable as money, and money that is not under control of a central bank, is vacuous. Lots of commodities are not under the control of a central bank. Moreover, like any other asset in the world gold can be expensive when it costs too much of other stuff to acquire it, and it can be cheap when it costs lots less to acquire.

I saw somewhere recently a chart that said “gold may be forming a major bottom,” which I thought was interesting because of some quantitative analysis that we do regularly (indeed, daily) on commodities. Here is one of the charts, approximately, that the analyst used to make this argument:

I guess, for context, I should back up a little bit and show that chart from a longer-term perspective. From this angle, it doesn’t look quite like a “major bottom,” but maybe that’s just me.

So which is it? Is gold cheap, or expensive? Erb and Harvey a few years ago noticed that the starting real price of gold (that is, gold deflated by the price index) turned out to be strikingly predictive of the future real return of holding (physical) gold. This should not be terribly shocking – although it is hard to persuade equity investors today that the price at which they buy stocks may affect their future returns – but it was a pretty amazing chart that they showed. Here is a current version of the chart (source: Enduring Investments LLC):

The vertical line represents the current price of gold (all historical gold prices are adjusted by the CPI relative to today’s CPI and the future 10-year real return calculated to derive this curve). It suggests that the future real return for gold over the next decade should be around -7% per annum. Now, that doesn’t mean the price of gold will fall – the real return could be this bad if gold prices have already adjusted for an inflationary future that now unfolds but leaves the gold price unaffected (since it is already impounded in current prices). Or, some of each.

Actually, that return is somewhat better than if you attempt to fit a curve to the data because the data to the left of the line is steeper than the data to the right of the line. Fitting a curve, you’d see more like -9% per annum. Ouch!

In case you don’t like scatterplots, here is the same data in a rolling-10-year form. In both cases, with this chart and the prior chart, be careful: the data is fit to the entire history, so there is nothing held ‘out of sample.’ In other words, “of course the curve fits, because we took pains to fit it.”

But that’s not necessarily a damning statement. The reason we tried to fit this curve in the first place is because it makes a priori sense that the starting price of an asset is related to its subsequent return. Whether the precise functional form of the relationship will hold in the future is uncertain – in fact, it almost certainly will not hold exactly. But I’m comfortable, looking at this data, in making the more modest statement that the price of gold is more likely to be too high to offer promising future returns than it is too low and likely to provide robust real returns in the future.

Two Disturbing Trends

July 27, 2017 2 comments

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Today I want to mention two disturbing trends – one of which may have some minor implications for inflation.

The first is the six-month downtrend in the US Dollar (see chart, source Bloomberg).

I’ve included the last several years’ worth of pricing for the broad trade-weighted dollar so as to help avoid any alarmist conclusions. While the trade-weighted dollar is down more than 7% since the beginning of 2017, it is unchanged on a trailing-two-year basis and still quite a bit above the level of three years ago. Moreover, as I’ve mentioned before – when the question concerned the effect of the dollar’s rise on inflation – the dollar doesn’t have a huge impact on US inflation. The US economy is much more closed than, for example, the economies of the Eurozone, the UK, or Switzerland – while the US is a major trade partner for virtually every country in the world, exports and imports as a percentage of GDP are less important than they are for most other countries in the world. Consequently, while movements in currency pairs will cause the declining currency to absorb more of the joint inflationary impulse of the two countries, the effect is fairly small in the US. A 15% dollar appreciation over a two-year period is associated with roughly a 1% deflation in core goods, nine months later, which is close to where core goods inflation has been (actually between 0 and -0.8% for the last few years). Core goods themselves are only about ¼ of core inflation overall. Since the dollar’s appreciation or depreciation has almost no discernable effect on core services a 15% dollar appreciation over two years only nudges core CPI down 0.25%.

So the effect is not large. However, it’s worth noting when the two-year rate of change goes from +16% (which it was one year ago) to 0%. This should start to add incrementally to core goods inflation, and provide a small upward lift to core inflation over the next year or so. But that assumes the dollar does not continue to slide. Continued dollar weakness might be attributed to the US political situation, but it isn’t as if most of our major trading partners are experiencing striking political stability (UK? Europe?). But dollar weakness could also be associated with a reversal in the relative hawkishness of the US Fed compared to other global central banks.

The run-up in the dollar corresponded with the end of Quantitative Easing in the US in 2014, combined with the continuation of QE (and more to the point, LSAP) in Europe and Japan. As hard as it is to think of Janet Yellen as being a hawk, on a global, relative basis her Fed was comparatively hawkish and this helped push the dollar higher.

Which brings us to the second disturbing trend, which may help to explain why the dollar is weakening: commercial bank credit growth has slowed markedly over the last year. The chart below (Source: Enduring Investments) shows the year-over-year change in commercial bank credit, based on data reported by the Federal Reserve.

The current y/y rate of credit growth, at 3.4%, is a number much more consistent with recession than with expansion as the chart above illustrates. To be sure, it is hard to see many overt signs of weakness in the domestic economy, although auto sales have been weakening (see chart, source Bloomberg) and they can sometimes be an early harbinger of economic difficulties.

It is also worth noting that credit growth hasn’t translated into slower money growth – M2 is still rising at 6% per year – so there is not an implication of slower inflation from the deceleration in corporate credit (at least, so far). But, between the suggestion the dollar is making that Federal Reserve policy may not be as hawkish going forward as the market had assumed, and the interesting and possibly disturbing sign from slowing growth in corporate credit, I’m starting to become alert for other early signs of recession.

Of course, the dollar’s slide might instead indicate that the ECB and/or BOJ are about to become less dovish, more rapidly than the market had expected. While core Euro inflation has been a little more buoyant than many had expected (1.1% in the last release), it seems unlikely to drastically change Draghi’s course. However, I will keep an open mind on that point. I’m not saying a recession is imminent; I’m just saying that I’m starting to watch more carefully.

Reversing the “Portfolio Balance Channel”

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Today I want to write about something that’s been bothering me a bit recently. It’s about the Fed’s impending decision to start drawing down its balance sheet over some number of years (whether or not we have an announcement about that at tomorrow’s meeting, it seems likely that “balance sheet reduction” is on tap for later this year). Something had been gnawing at me about that, and until now I haven’t been able to put my finger on it.

It concerns the ‘portfolio balance channel.’ This bit of Fed arcana is part of how the central bank explained the importance of the practice of buying trillions in Treasury bonds. Remember that back when the Fed first started doing Large-Scale Asset Purchases (LSAP), they were concerned that a lack of ‘animal spirits’ were causing investors to shy away from taking risk in the aftermath of the credit crisis. Although this is entirely normal, to the FOMC it was something to be corrected – if people and firms aren’t willing to take risk, then it is difficult for the economy to grow.

So, as the Fed explained it, part of the reason that they were buying Treasuries is that by removing enough safe securities from the market, people would be forced to buy riskier securities. When QE1 started, 10-year TIPS were yielding 2.5%, and that’s a pretty reasonable alternative to equities in a high-risk environment. But the Fed’s ministrations eventually pushed TIPS yields (along with other yields, but by focusing on real rates we can abstract from the part of that decline that came from declining inflation expectations rather than the forced decline in real yields) down to zero in 2011, and eventually deeply negative. As expected, despite the risk aversion being experienced by investors they began to move into equities as the “only game in town” – think about how many times you’ve heard people lament they own equities because ‘there’s nothing else worth owning’? The eventual result, of course, was that expected returns to equities began to fall in line with the (manipulated) expected returns to other securities, until we got the current situation where, according to our calculations, TIPS now have a higher expected real return than equities again (but at a much lower level).

What was bothering me, of course, was that shrinking the balance sheet also implies reversing the “portfolio balance channel.” Via QE, the Fed forced investors into stocks because there were fewer Treasury securities outstanding; every time the Fed bought $1 of bonds, some fraction of that went into stocks. The reverse must also be true – for every $1 of bonds the Fed sells, some fraction of that money must come out of stocks.

I’m not the first person to note that reducing the balance sheet should be a negative for equities since it “reduces liquidity.” But I was always uncomfortable with the vagueness of the “liquidity” mechanism…after all, lots of people predicted cataclysm when the Fed “tapered” QE. The reversal of the portfolio balance channel, though, is a real effect. The money to buy the extra bonds that will be on the market – bonds not held by the Fed must be held by someone, after all – will come from somewhere. And some of that “somewhere” will be from equities, some from real estate, some from cash, etc. I don’t know how big an effect it will be, but I know the sign.

Hard to Sugar-Coat Nonsense Like This

July 20, 2017 3 comments

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One of the things that fascinates me about markets – and one of the reasons I think “Irrational Exuberance”, now in its third edition, is one of the best books on markets that there is – is how ‘storytelling’ takes the place of rational analysis so easily. Moreover, almost as fascinating is how easily those stories are received uncritically. Consider this blurb on Bloomberg from Wednesday (name of the consultant removed so as not to embarrass him):

Sugar: Talk in market is that climate change has pushed back arrival of winter in Brazil and extended the high-risk period for frost beyond July, [name removed], risk management consultant for [company name removed] in Miami, says by telephone.

Sugar futures have recently been bouncing after a long decline. From February through June, October Sugar dropped from 20.40 cents/lb to 12.74¢; since the end of June, that contract has rallied back to 14.50¢ (as of Wednesday), a 14% rally after a 38% decline. There are all sorts of reasons this is happening, or may be happening. So let’s think about ‘climate change’ as an explanation.

There are several layers here but it boils down to this: the consultant is saying (attributing it to “talk in the market,” but even relaying this gem seems like gross negligence) that the rally in the last few weeks is due to a change in the timing of the arrival of winter…a change which, even if you believe the craziest global warming scaremongers, could not possibly have been large enough over the last decade to be measurable against the backdrop of other natural oscillations. Put another way, in late June “the market” thought the price of sugar ought to be about 12.74¢/lb. Then, “the market” suddenly realized that global warming is increasing the risk to the sugar crop. Despite the fact that this change – if it is happening at all – is occurring over a time frame of decades and centuries, and isn’t exactly suffering from a lack of media coverage, the sugar traders just heard the news this month.

Obviously, that’s ridiculous. What is fascinating is that, as I said, in this story there are at least 4 credulous parties: the consultant, the author of the blurb, the editor of the story, and at least part of the readership. Surely, it is a sign of the absolute death of critical thinking that only habitual skeptics are likely to notice and object to such nonsense?

Behavioral economists attribute these stories to the need to make sense of seemingly-random occurrences in our universe. In ancient times, primitive peoples told stories about how one god stole the sun every night and hid it away until the morning, to explain what “night” is. Attributing the daily light/dark cycle to a deity doesn’t really help explain the phenomenon in any way that is likely to be useful, but it is comforting. Similarly, traders who are short sugar (as the chart below, source Floating Path, shows based on June 27th data) may be comforted to believe that it is global warming, and not unusually short positioning, that is causing the rally in sugar.

As all parents know, too much sugar (or at least, being short it) isn’t good for your sleep. But perhaps a nice story will help…

 

Bitcoin Versus Tesla

July 18, 2017 3 comments

Last night, over drinks – a detail that will gain more salience when I describe the discussion – several friends and I were talking about lots of market-related items (as well as, of course, many non-market items).

The topics were as diverse as bitcoin, New Jersey Transit, and Tesla. However…and here’s where the drinks may have played a role…we also explored intersections of the elements of this set. For example, one of our party pointed out that fifteen Teslas would produce about the same power as a diesel locomotive, but at a fraction of the price. Given the recent record of New Jersey Transit’s locomotive fleet (among other problems), perhaps this is worth considering. Not only that, going to work in a train pulled by 15 Teslas would be much more stylish.[1]

A more interesting connection is between Bitcoin and Tesla.

In my book, I reflect at length about the significance of having money which is backed by something concrete (no matter what that is) compared to something backed only by faith – faith that other people will accept our money as a medium of exchange, in exchange for goods or services at rates reasonably predictable and not terribly volatile. Inflation is caused by too much money in the system; hyperinflation is what happens when a currency loses its anchor of confidence and people lose faith that these things will be true in the future. I talk a bit about how high rates of inflation, by eroding confidence, can lead to hyperinflation – but that’s only true of fiat currencies. If money is backed by something tangible, whether it is a precious metal or a bushel of rice, there are limits to how much it can depreciate in real terms and hyperinflation is difficult to come by in these circumstances.

In this context, consider Bitcoin or any of its crypto-currency brethren. Bitcoin is not backed by anything; indeed, it is backed by even less than the “classic” fiat currencies that issuing governments at least promise to accept in payment of citizen obligations to the government. This is not a critique – it simply is. Evidently, the inflation issue is not currently a problem with Bitcoin…as the chart below (source: Bloomberg) suggests, everything in the world is deflating in Bitcoin-equivalents.

But the fact remains that if something were to happen – such as the MtGox scandal a few years ago, at the left side of that chart – that affected people’s confidence that someone else would take Bitcoin in payment, then the value of Bitcoin could (and did) drop precipitously. At the extreme, Bitcoin could go to zero if no one was willing to accept it in exchange – for example, if for some reason it became impossible to confirm that the contents of your Bitcoin wallet was really yours.[2] There is no one you can turn to who is guaranteed to give you something real in exchange.

Now, no one thinks of Tesla as a currency. But, actually, equity securities representing ownership in Tesla could be considered a form of currency – you can exchange them for other items of value, although the usual way is to exchange them for dollars which can then be used to buy other items of value. I am not sure I would call  its price in exchange reasonably stable…but it’s certainly more stable than Bitcoin. Here’s the salient commonality, however: at the current price, representing a 11x price-to-book ratio, 6x price to sales ratio, and undefinable price to free cash flow (-$9.74/share free cash flow) or earnings, on a stock with negative net margins, ROA, ROE, and ROC, the price of Tesla is almost entirely faith-based. It is based on a quasi-religious belief by the equity owners that the CEO will manage to produce cars at a positive margin and maintain a large market share, which it will be able to maintain even once large auto manufacturers start to compete.

Far be it from me to question whether investors’ faith will prove well- or ill-founded. I will leave that to my friend @markbspiegel. I don’t own Tesla and have no plans to be long it or short it. My point, though, is that it is remarkably like Bitcoin in that it is backed primarily by faith and, as with any faith-based currency, is entirely based on that faith remaining unshaken. For the implications of having that faith shaken, see Enron in 2001 (chart below, source Bloomberg).

Interestingly, in the battle of Bitcoin versus Tesla it is the former that is winning. A share of Tesla in 2015 was worth 1 Bitcoin. Today, that share is only worth 0.14 Bitcoins (see chart, showing the ratio of Tesla to Bitcoin).[3]

All of which goes mainly to show – be careful when you go out for drinks with quant finance friends!

[1] We thought perhaps Elon Musk is just being coy, playing the long game before he springs this brilliant idea on the public. But today another friend of mine pointed out that it isn’t just the power you’re paying for but the sustainability of that power, and he estimated that 15 Teslas could only pull the train for about 8 miles. Oh well.

[2] “Preposterous!” shout the supporters of Bitcoin. Relax, I’m not saying this is something that will or could happen. It’s not a prediction. It’s merely a thought experiment.

[3] This is a ridiculous chart and it means nothing. But it’s fun. You should see what it looks like if you go back farther. In 2010, one share of Tesla was worth 300 Bitcoins!

Categories: Analogy, Bitcoin, Silly
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