This week, I am participating in a school-style debate at the Global Fixed Income Institute’s conferences in Madrid where the question before the house is whether or not inflation will resurface in major world economies in the next five years. As you might imagine, I feel that my part of the debate is the easy part, especially as inflation is pointing higher in the US and core inflation just surprised higher in Europe. However, I am sure the other side feels the same way.
The Institute is interested in this discussion partly to illuminate the question of whether the substantial rise in yields over the last three months or so in all developed bond markets (see chart, source Bloomberg, showing 10y yields in US, UK, Germany and Japan) is indicative of a return of fears of inflation.
The ironic part of this is that I do not believe that the rise in yields has much if anything to do with the expectation for higher inflation. Partly, it is due to a subtle sea change in the way investors are thinking about the prospects for central bank policy – to wit, the possibility (which I see as slim) that the Fed chooses to raise rates meaningfully above zero in the next year, starting in September. But to some degree, the market has been discounting higher forward rates for a very long time. It has been consistently wrong on that point, but the steeply sloped yield curve (the 2y/10y spread hasn’t been flatter than 120bps since early 2008 – see chart, source Bloomberg) implies higher forward rates.
The rise in yields, in my view, is partly related to the prospect for changes in central bank policy, but also partly (and more sinisterly) related to the continuing intentional destruction by policymakers of the ability of large banks and dealers to make markets. We see worse liquidity in more and more markets almost by the day (as predicted five years ago in this space, for example here and here, as well as by many other observers). Less liquid markets tend to trade with more volatility, as it gets harder to move institutional size, and at lower prices since holders of assets need to factor in the difficulty of selling a position. Higher yields are going to happen in any event, and when institutional holders of bonds decide to diversify into commodities or into other real assets, interest rates could rise quickly depending how quickly that meme spreads. Of course, the same is true of equities, and commodities. Asset-allocation shifts will get messier.
I actually think this isn’t a bad time tactically to enter long positions in fixed-income. The Fed isn’t going to be as aggressive as people expect; also, bonds will get some support from investors fleeing fading momentum in stocks. The chart below (source: Bloomberg; Enduring Investments calculations) shows the 52-week price change in stocks. This is one measure of momentum, and a very important one as lots of investors look at their returns in annual chunks. Incredibly, since the latter part of 2012 investors have always been able to see double-digit returns from stocks when they looked in the rear-view mirror. Today, that number is 7.5%.
That’s still a terrific real return of more than 5%, but (a) many investors have very screwy return expectations, (b) many investors are well aware that they’ve been living on borrowed time with a liquidity-inspired rally, and (c) certain quantitative investors place significant weight to momentum, over value, in their investment models.
It’s just another red flag for stocks, but it has become passé to point them out. From the standpoint of a bond investor, though, this is good news because all of those equity owners, when they decide to take their chips off the table, will become bond buyers.
And when that happens, the liquidity issues in fixed-income might cut the other way for a while.
I hadn’t meant to do a ‘part 2’ on the dollar, but I wanted to clear something up.
Some comments on yesterday’s article have suggested that a strong dollar is a global deflationary event, and vice-versa. But this is incorrect.
The global level of prices is determined by the amount of money, globally, compared to global GDP. But the movements of currencies will determine how that inflation or deflation is divvied up. Let us look at a simplified (economist-style) example; I apologize in advance to those who get college flashbacks when reading this.
Consider a world in which there are two countries of interest: country “Responsible” (R), and country “Irresponsible” (I). They have different currencies, r in country R and i in country I (the currencies will be boldface, lowercase).
Country R and I both produce widgets, which retail in country R for 10 r and in country I for 10 i. Suppose that R and I both produce 10 widgets per year, and that represents the total global supply of widgets. In this first year, the money supply is 1000r, and 1000i. The exchange rate is 1:1 of r for i.
In year two, country I decides to address its serious debt issues by printing lots of i. That country triples its money supply. FX traders respond by weakening the i currency so that the exchange rate is now 1:2 of r to i.
What happens to the price of widgets? Well, consumers in country R are still willing to pay 10 r. But consumers in country I find they have (on average) three times as much money in their wallets, so they would be willing to pay 30 i for a widget (or, equivalently, 15 r). Widget manufacturers in country R find they can raise their prices from 10 r, while widget manufacturers in country I find they need to lower their price from 30 i in order to be competitive with widget manufacturers in R. Perhaps the price in R ends up at 26r, and 13i in I (and notice that at this price, it doesn’t matter if you buy a widget in country R, or exchange your currency at 1:2 and buy the widget in country I).
Now, what has happened to prices? The increase in global money supply – in this case, caused exclusively by country I – has caused the price of widgets everywhere to rise. Prices are up 30% in country R, and by 160% in country I. But this division is entirely due to the fact that the currency exchange rate did not fully reflect the increased money supply in country I. If it had, then the exchange rate would have gone to 1:3, and prices would have gone up 0% in country R and 200% in country I. If the exchange rate had overreacted, and gone to 1:4, then the price of a widget in country R would have likely fallen while it would have risen even further in country I.
No matter how you slice it, though – no matter how extreme or how placid the currency movements are, the total amount of currency exchanged for widgets went up (that is, there was inflation in the price of widgets in terms of the average global price paid – or if you like, the average price in some third, independent currency). Depending on the exchange rate fluctuations, country R might see deflation, stable prices, or inflation; technically, that is also true of country I although it is far more likely that, since there is a lot more i in circulation, country I saw inflation. But overall, the “global” price of a widget has risen. More money means higher prices. Period.
In short, currency movements don’t determine the size of the cake. They merely cut the cake.
In a fully efficient market, the currency movement would fully offset the relative scarcity or plenty of a currency, so that only domestic monetary policy would matter to domestic prices. In practice, currency markets do a pretty decent job but they don’t exactly discount the relative changes in currency supplies. But as a first approximation, MV≡PQ in one’s own home currency is not a bad way to understand the movements in prices.
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.
Here 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.
- CPI Day! Exciting. The y/y for core will “drop off” +0.20% m/m from last yr, so to get core to 1.9% y/y takes +0.29 m/m this yr.
- Consensus looks for a downtick in core to 1.7% y/y (rounding down) instead of the rounded-up 1.8% (actually 1.754%) last mo.
- oohoooooo! Core +0.3% m/m. y/y stays at 1.8%. Checking rounding.
- +0.256% m/m on core, so the 0.3% is mostly shock value. But y/y goes to 1.81%, no round-assist needed.
- Headline was in line with expectations, -0.2% y/y. Big sigh of relief from dealers holding TIPS inventory left from the auction.
- Core ex-shelter was +0.24%, biggest rise since Jan 2013. That’s important.
- This really helps my speaking engagement next mo – a debate between pro & con inflation positions at Global Fixed Income Institute. :-)
- More analysis coming. But Excel really hates it when you focus on another program while a big sheet is calculating…
- It’s still core services doing all the heavy lifting. Core goods was -0.2% y/y (unch) while core services rose to 2.5% y/y.
- Core services has been 2.4%-2.5% since August.
- Owners’ Equivalent Rent rose to 2.77% y/y, highest since…well, a long time.
- Thanks Excel for giving me my data back. As I said, OER was 2.77%, up from 2.69%. Primary rents frll to 3.47% from 3.53%.
- Housing as a whole went to 2.20% y/y from 1.93%, which is huge. Some of that was household energy but ex-energy shelter was 2.67 vs 2.56
- Or housing ex-shelter, ex-energy was 1.14% from 0.67%. Seems I am drilling a bit deep but getting housing right is very important.
- Medical Care +2.91% from 2.46%. Big jump, but mostly repaying the inexplicable dip from Q1. Lot of this is new O’care seasonality.
- Median is a bit of a wildcard this month. Looks like median category will be OER (South Urban), so it will depend on seasonal adj.
- But best guess for median has been 0.2% for a while. Underlying inflation is and has been 2.0%-2.4% since 2011.
- And reminder: it’s median that matters. Core will continue to converge upwards to it, (and I think median will go higher.)
- None of this changes the Fed. They’re not going to hike rates for a long while. Growth is too weak and that’s all they care about.
- For all the noise about the dual mandate, the Fed acts as if it only has one mandate: employment (which they can’t do anything about).
- The next few monthly core figures to drop off are 0.23%, 0.14%, 0.10%, and 0.05%.
- So, if we keep printing 0.22% on core, on the day of the Sep FOMC meeting core CPI will be 2.2% y/y, putting core PCE basically at tgt.
- I think this is why FOMC doves have been musing about “symmetrical misses” and letting infl scoot a little higher.
- US #Inflation mkt pricing: 2015 1.1%;2016 1.8%;then 1.8%, 2.0%, 2.0%, 2.1%, 2.2%, 2.3%, 2.4%, 2.5%, & 2025:2.4%.
- For the record, that is the highest m/m print in core CPI since January 2008. It hasn’t printed a pure 0.3% or above since 2006.
There is no doubt that this is a stronger inflation print than the market expected. Although the 0.3% print was due to rounding (the first such print, though, since January 2013), the month/month core increase hasn’t been above 0.26% since January 2008 and it has been nearly a decade since 0.3% prints weren’t an oddity (see chart, source Bloomberg).
You can think of the CPI as being four roughly-equal pieces: Core goods, Core services ex-rents, Rents, and Food & Energy. Obviously, the first three represent Core CPI. The breakdown (source: BLS and Enduring Investments calculations) is shown below.
Note that in the tweet-stream, I referred to core services being 2.4%-2.5% since August. With the chart above, you can see that this was because both pieces were pretty flat, but that the tame performance overall of core services was because services outside of rents was declining while rents were rising. But core services ex-rents appear to have flattened out, while housing indicators suggest higher rents are still ahead (Owners’ Equivalent Rent, the bigger piece, went to 2.77%, the highest since January 2008). Core goods, too, look to have flattened out and have probably bottomed.
So the basic story is getting simpler. Housing inflation continues apace, and the moderating effects on consumers’ pocketbooks (one-time medical care effects, e.g., which are now being erased with big premium hikes) are ebbing. This merely puts Core on a course to re-converge with Median. If core inflation were to stop when it got to median, the Fed would be very happy. The chart below (Source: Bloomberg) supports the statement I made above, that median inflation has been between 2% and 2.4% since 2011. Incidentally, the chart is through March, but Median CPI was just released as I type this, at 2.2% y/y again.
But that gentle convergence at the Fed target won’t happen. Unless the Federal Reserve acts rapidly and decisively, not to raise rates but to remove excess reserves from the banking system (and indeed, to keep rates and thereby velocity low while doing so, a mean trick indeed), inflation has but one way to go. Up. And there appears little risk that the Fed will act decisively in a hawkish fashion.
Yesterday, Chicago Fed President Charles Evans gave a speech in which he said that he probably leaned towards making the first tightening early next year, as there is “no compelling reason for us to be in a hurry to tighten financial conditions.” The Fed, he said, probably shouldn’t raise rates until there’s a “greater confidence” that inflation one-to-two years ahead will be at or above 2%. This isn’t a surprising view, as Evans is the progenitor of the “Evans Rule” that says rates should stay near zero until unemployment has fallen below 6.5% (it has) or inflation has risen above 2.5%. Yes, those bounds have been walked about; in particular the 6.5% unemployment rate is obviously no longer binding (he sees the “natural rate” as being 5% again). But the very fact that he promoted a rule that set restraints on a mere return to normal policy means that he is a dove, through and through. So, it should not be surprising that he isn’t in a hurry to tighten.
What I found amusing is the sop he threw to the bears. Fed speakers often try to do the “on the one hand, on the other hand” maneuver, but in Evans’ case his heart clearly isn’t in it. He said that “you could imagine a case being made for a rate increase in June.” Notice that he doesn’t say he could imagine a case being made! I am also unclear about which June he means. Does he mean…
|(thru Apr)||(thru May)|
|Q1 GDP||Q2 GDP||Median CPI||M2 growth|
|June 2015?||0.2%||1.0% (e)||2.2%||5.4%|
I am not sure exactly what he thinks those darn hawks are looking at, but it seems to me the case for tightening in June is getting worse every year.
Eagle-eyed readers will notice that I didn’t include the Unemployment Rate in the table above. That particular metric has been improving each year, but we know that the labor situation tends to lag the economic situation. The Unemployment Rate is a big political football, but it isn’t particularly useful for policy unless you believe in the concept of a “natural rate” with respect to accelerating unemployment in the overall economy. I don’t: low unemployment tends to increase wages, but has no discernible effect on consumer inflation. Moreover, it appears that the “natural rate” shifts quite a bit over time (6.5% down to 5% in Evans’ formulation, in only a few years’ time), making it look to me like a fairly useless concept.
Yes, of course it makes it more difficult politically to tighten when people are out of work, but since monetary policy is quite useful for affecting prices and not particularly useful for affecting growth, this should be a secondary effect at best. The Fed simply can’t help the unemployed worker, except by holding down inflation for him. In the real world, of course, the Fed Chair is not going to countenance an uptick in rates when unemployment is above 5% or so.
Let me be clear: I think the Fed ought to have tightened in 2012, 2013, or 2014, and they ought to tighten now. I don’t necessarily mean they should guide rates higher, but they should reduce the size of the mountain of reserves via any means a their disposal. But if you are going to argue one year over another year, I think it is hardest to argue that now is the time unless you are merely being guided by the old James Carville adage that the best time to plant a tree was twenty years ago, but the second-best time is right now.
One thing that Evans said that quickens my heart, as an inflation-watcher, is that the Fed “ought to allow” a chance that inflation overshoots 2% that is symmetrical to its chance of falling below it. While he is quintessentially unclear about how he would establish these probabilities – as I have just shown, he seems blissfully unaware that consumer price inflation is already above 2% – the mere fact of treating the costs of inflation misses as symmetrical is dangerous territory. The costs are not symmetrical. The costs of an inflation rate around 0% are very low; some frictions, perhaps, created by wage “stickiness” (even this possibility hasn’t been conclusively established until inflation gets convincingly below zero). The costs of an inflation rate of 4% are much higher, since inflation has historically had long “tails.” That is, once inflation goes up a little, it not infrequently rises a lot. Over the last 100 years, if you take the set of all year-on-year inflation rates above 4%, you find that about one-third of them are also above 10%. This means the costs of a loss of inflation vigilance is must greater than the costs of a loss of deflation vigilance.
To be sure, it looks like growth slowed over the course of the difficult winter. The cause of this malaise doesn’t appear to me to be weather-related, but rather dollar-related; while currency movements don’t have large effects on inflation, they have reasonably significant effects on top-line sales when economies are sufficiently open. It is less clear that we will have similar sequential effects and that growth will be as punk in Q2 as it was in Q1. While I do think that the economy has passed its zenith for this expansion and is at increasing risk for a recession later this year into next, I don’t have much concern that we are slipping into a recession now.
Given how close the Atlanta Fed’s GDPNow tracker was to the actual Q1 GDP figure, the current forecast of that tool of 0.8% for Q2 – which would be especially disappointing following the 0.2% in Q1 that was reported last week – has drawn a lot of attention. However Tom Kenny, a senior economist at ANZ, points out that the indicator tends to start its estimate for the following quarter at something close to the prior quarter’s result, because in the absence of any hard data the best guess is that the prior trend is maintained. I am paraphrasing his remark, published in today’s “Daily Shot” (see the full comment at the end of the column here). It is a good point, and (while I think recession risks are increasing) a good reminder that it is probably too early to jump off a building about US growth.
That being said, it does not help matters that gasoline prices are rising once again. While national gasoline prices are only back up to $2.628 per gallon (see chart, source Bloomberg), that figure compares to an average of roughly $2.31 in Q1 (with a low near $2/gallon).
It isn’t clear how much lower gasoline prices helped Q1 growth. Since lower energy prices also caused a fairly dramatic downshift in the energy production sector of the US economy, lower prices may have even been a net drag in the first quarter. Unfortunately, that doesn’t mean that higher gasoline prices now will be a net boost to the second quarter; while energy consumption responds quite rapidly to price changes, energy producers will likely prove to be much more hesitant to turn the taps back on after the serious crunch just experienced. I doubt $0.30/gallon will matter much, but if gasoline prices continue to creep higher then take note.
Inflation traders have certainly taken note of the improvement in gasoline prices, but although inflation swaps have retraced much of what they had lost late last year (see chart of 5y inflation swaps, quoted in basis points, source Bloomberg) expectations for core inflation have not recovered. Stripping out energy, swap quotes for 5-year inflation imply a core rate of around 1.65% compounded – approximately the same as it was in January.
And that brings us to the most interesting chart of all. The chart below (source: Bloomberg) shows the year/year change in the Employment Cost Index (wages), in white, versus median inflation.
Repeat to yourself again that wages do not lead inflation; they follow inflation. I would argue this chart shows wages are catching up for the steady inflation over the last couple of years, and for the increased health care costs that are now falling on individuals and families but are not captured terribly well by the CPI. But either way, wages are now rising at a faster rate than prices, which will not make it easy for inflation to sink lower.
Let me also show you another chart from a data release last week. This is the Case-Shiller 20-city composite year/year change. Curiously (maybe), housing prices may be in the process of re-accelerating higher after cooling off a bit last year – although home price inflation as measured by the CS-20 never fell anywhere near to where overall inflation was.
Inflation risks are clearly now moving into the danger zone. I showed a chart of a lagging inflation indicator (wages), a coincident indicator (energy), and a leading indicator (housing). All three of these are now rising at something faster than the current rate of core inflation. In my view, there is not much chance that core inflation over the next 5 years will average only 1.65%.
I am not one of those people who believe that if the Fed is dramatically easing, you simply must own equities. I must admit, charts like the one below (source: Bloomberg), showing the S&P versus the monetary base, seem awfully persuasive.
But there are plenty of counter-examples. The easiest one is the 1970s, shown below (source: FRED, Bloomberg). Not only did stocks not rise on the geyser of liquidity – M2 growth averaged 9.6% per annum for the entire decade – but the real value of stocks was utterly crushed as the nominal price barely moved and inflation eroded the value of the currency.
If you do believe that the Fed’s loose reins are the main reason for equities’ great run over the last few years, then you might be concerned that the end of the Fed’s QE could spell trouble for stocks. For the monetary base is flattening out, as it has each of the prior times QE has been stopped (or, as it turns out, paused).
But for you bulls, I have happy news. The monetary base is not the right metric to be watching in this case. Indeed, it isn’t the right metric to be watching in virtually any case. The Fed’s balance sheet and the monetary base both consist significantly of sterile reserves. These reserves affect nothing, except (perhaps) the future money supply. But they affect nothing currently. The vast majority of this monetary base is as inert as if it was actually money sitting in an unopened crate in a bank vault.
What does matter liquidity-wise is transactional balances, such as M2. And as I have long pointed out, the end of QE does nothing to slow the growth of M2. There are plenty of reserves to support continued rapid growth of M2, which is still growing at 6% – roughly where it has been for the last 2.5 years. And those haven’t been a particularly bad couple of years for stocks.
So, if liquidity is the only story that matters, then the picture below of M2 versus stocks (source: Bloomberg) is more soothing to bulls.
Again, I think this is too simplistic. If ample liquidity is good today, why wasn’t it good back in the 1970s? You will say “it isn’t that simple.” And that’s exactly my point. It can’t be as easy as buying stocks because the Fed is adding liquidity. I believe one big difference is the presence of financial media transmitted to the mass affluent, and the fact that there is tremendous confidence in the Fed to arrest downward momentum in securities markets.
What central bankers have done to the general economy has not been successful. But, if you are one of the mass affluent, you may have a view of monetary policy as nearly omnipotent in terms of its effect on securities and on certain real assets such as residential real estate. What is different this time? The cult.
I am no equity bull. But if you are, because of the following wind the Fed has been providing, then the good news is: nothing important has changed.