Archive

Posts Tagged ‘economy’

Japanese Inflation is Rising – Of Course!

August 30, 2013 2 comments

The Financial Times today carried an article entitled “Japan Inflation Rises to Highest in Nearly Five Years.” Core inflation in Japan reached -0.1%, which is actually the highest since early 2009, so not quite five years (see chart, source Enduring Investments, below). More importantly, however, the year-on-year figures are near the highest in the last decade-plus, with base effects likely to push core inflation above zero in the near future.

japancoreThis should be shocking to no one, since Japanese M2 growth recently reached the highest year-on-year growth level since … wait for it … 1999, and is now actually growing slightly faster than European money supply for the first time in a long, long time. Because, you see, money growth is intimately related to inflation. News flash!!

But the Japanese have only just begun to increase their money supply, and it is going to go a lot higher. As will inflation in Japan.

Now, here’s the conundrum of the day. If the Japanese pat themselves on the back because they are near to exorcising the deflation demon with quantitative easing, then how can Bernanke, Yellen, Summers, et. al. be so confident that our QE will not increase inflation? It can’t be the case that QE is effective at ending deflation (which was one benefit that Bernanke trumpeted in the past, too), but doesn’t tend to increase inflation. Well, I suppose it can be the case, but it would be quite weird.

The difference between the US and Japanese response to money growth over the last few years is that money velocity in the US has been declining with interest rates, while the Japanese already had rates so low that velocity had nowhere to go but up. As I have noted previously, even if velocity in the US merely levels out, 7% money growth will produce an uncomfortable rise in inflation.

So before settling into the belief, as Summers has expressed, that quantitative easing has “few harmful side effects,” it seems to me that we ought to reflect on the Japanese QE example.

 

It’s Risk Parity, Not Risk Party

August 15, 2013 6 comments

I am disinclined to take victory laps when most people are losing money, but the recovery in commodities prices over the last week at the same time that bond and equity prices are both declining is a taste of success for my view that has been rare enough lately. That is, of course, the burden that a contrarian investor bears: to be wrong when everyone else is having fun, and to be right when no one wants to go out and celebrate. In fact, if you find yourself sharing your successes too often with other people who are having the same successes, I would submit you should be wary.

It is worth noting that the commodities rally has not been led by energy, despite the terrible violence in Egypt which threatens, again, to ignite a spark in the region. Today, the rise in commodities was led by gold and grains; yesterday by cows and copper (well, livestock and industrials).

I don’t think that this is because of a sudden epiphany about inflation. In fact, although breakevens have been recovering from the oversold condition in June (more on that in a moment), the inflation data today did nothing to persuade inflation investors that more protection is needed. I gave some thoughts about the CPI report earlier today in this post, but suffice it to say that it was not an upside surprise. (And yet, there are starting to appear more-frequent smart articles on inflation risks. I commend this article by Allan Meltzer to you as being unusually clear-eyed.)

And commodities are not moving higher because of renewed enthusiasm about growth, I don’t think. Today economic bell cow Wal-Mart cut its profit forecast because higher taxes are causing shoppers to be more conservative (perhaps in more ways that one). And, while today’s Initial Claims figure was good news (320k versus expectations for 335k), weakness was seen in Industrial Production (flat, with downward revisions, versus expectations for +0.3%) and both Empire Manufacturing and Philly Fed came in slightly weaker than expectations. None of this is apocalyptic, but neither is it cause for elation about domestic or global growth prospects.

While the nascent commodity rally makes me personally feel warm and fuzzy, the more-momentous move is in what is happening to interest rates. And here I need to recognize that until very recently, I thought that bonds would follow the typical pattern of a convexity-exacerbated selloff: after a rapid decline, the market would consolidate for a few weeks and then recover once the overhang had cleared. I’ve seen it aplenty in the past, and that was the model I was operating on.

But I believe rates are heading higher. Although the overhang from the prior convexity selloff has probably been distributed, there is a new problem as illustrated by the news today about Bridgewater’s “All Weather” fund. The All-Weather Fund is an example of a “risk parity” strategy in which, in simplified form, “low-volatility” strategies are levered up to have the same natural volatility as “high volatility” strategies. The problem is that levering up an asset class with a poor risk-adjusted return, as fixed-income is now, doesn’t improve returns or risks of the portfolio at large. The -8% return of the AWF in Q2 illustrates that point, and makes clear to anyone who bought the great marketing of “risk parity” strategies that they probably have much more rate risk than they want (although according to the Bloomberg article linked to above, Bridgewater “hadn’t fully grasped the interest-rate sensitivity” of being long 70% of net assets in inflation-linked bonds and another 48% in nominal bonds. I do hope that’s a mis-quote).

The unwinding of some of that rate risk (Bloomberg called the panicky dumping of a relatively cheap asset class, TIPS, into the teeth of a retail and convexity-led selloff “patching” the risk) helped TIPS bellyflop in May and June, and to the extent that institutional investors wake up and reduce their levered long bets on fixed income we might see lower prices much sooner than I expected across the entire spectrum of fixed-income. Indeed, without the Fed or highly levered buyers, it’s not entirely clear what the fair clearing price might be for the Treasury’s debt. I was at one time optimistic that we would get a bounce to lower yields after a period of consolidation, but this news is potentially a game-changer. Although the seasonal patterns favor buying bonds in August and early September, the potential downside is much worse than the potential upside.

A Summary of My Post-CPI Tweets

August 15, 2013 6 comments

Here are my post-CPI tweets from this morning. You can follow me @inflation_guy:

  • CPI #inflation +0.2% core. But here’s the thing: that’s with housing showing unexpected softness. And housing markets are bubbling.
  • Unrounded core inflation 1.698%. That’s the last we’ll see of 1.6% handles for years.
  • Core inflation actually barely rounded up, at +0.155% m/m. But, again, that’s with housing inexplicably weak.
  • Core services 2.4%. Core goods still plodding along at -0.2%, and holding overall core inflation down. That won’t persist.
  • CPI major groups accelerating: Food/bev, Housing, Apparel, Transp, Rec, Educ/Comm (89.5%). Decelerating: Medical and Other (10.5%).
  • …but housing only accelerated b/c household energy. OER was unch at 2.2% and primary rents 2.8% from 2.9%. That’s a quirk.
  • certainly nothing in today’s inflation data to scare the Fed into a faster taper.
  • bonds are breaking lower; although the convexity overhang has been worked off, we never got the expected bounce! Not sure why they’re weak.
  • higher rates->higher velocity->more inflation pressure, ironically. in this case, higher rates won’t affect money supply as offset to that

Of all of the places I expected to see a downside surprise, housing was not it. Of course, econometric lags aren’t the same as destiny, so the fact that the leading series all turned higher at the “right time” to cause a rise in Owners’ Equivalent Rent right about now is helpful information for investing, but not necessarily a timing tool!

At 2.2%, OER is still well above core inflation and primary rents at 2.8% are as well. But core goods continue to drag on the overall core inflation number (and to hold core inflation well below median inflation, which comes out later this morning).

I feel I should nudge lower my forecast for 2013 core inflation again, to a range of 2.4%-2.7% from 2.5%-2.8%. I am doing this for two practical reasons related to housing. One is that every month that passes without the expected acceleration is one less month over which inflation can accelerate to reach my year-end target. The other is that every month that passes without the expected acceleration increases the odds that I’m simply wrong, and something is holding down rents even though home prices are launching higher. I don’t think that’s true, but I want to be cognizant of overconfidence bias! However, at this point my nudging of the forecast is more about the former point: my 2014 forecast range remains 3.0%-3.6% for core.

 

Why Aren’t Delinquencies Falling Faster?

The great news today is that mortgage delinquencies dropped to their lowest level in five years. Look at the chart (source: Bloomberg)! Doesn’t it look great?

mortdelThis was actually a bit surprising to me. With the Unemployment Rate doing about what it usually does in recoveries, and the economy adding something a bit shy of 200,000 new jobs per month, and with interest rates low and housing prices rising, you would think that delinquencies would have improved much more than they have.

Pretty much all of the delinquency data looks the same way. Here is a chart of new foreclosure actions as a (seasonally-adjusted) percentage of total loans.

foreclosurestartedWhile well off its highs, this would have been a record level just a few years ago.

Is this a symptom of the “part-time America” phenomenon, in which all of these new jobs are being generated as part-time work, so that the improvement in the lot of the average worker is not paralleling the improvement in the jobs or unemployment rate numbers? (I’m not disputing that such a phenomenon exists; in fact I think it does. I am asking whether this is a symptom of that, or if there is another cause?) In any event, it isn’t a very good sign, and is one reason that even once QE ends, the Fed will endeavor to keep rates low for a very long time.

By the way, it also makes me wonder whether the celebrated move of institutional investors into the private residential real estate market is having a smaller effect than many people think it is. If there were big players looking to buy bank REO on the offered side, then wouldn’t you think banks would be accelerating foreclosures and that the delinquencies would be dropping faster (as homeowners either get into the foreclosure process, whereupon they aren’t in the delinquency stats, or get serious about becoming current)? I don’t know the answer.

.

Here is a technical point for institutional investors in inflation-indexed bonds and/or swaps – something worth watching for.

There has been much concern in some quarters recently about the coming increase in demand for high-quality collateral to back swaps under Dodd-Frank regulations.  One way this could manifest in the inflation markets is to narrow the spread between inflation “breakevens” and inflation swaps. As the chart below (Source: Enduring Investments) illustrates, the inflation swaps curve is always above the “breakeven” curve. In theory, both curves should be measuring the same thing: aggregate inflation expectations over some period.beivszcAnd, in fact, they do. But while the inflation swaps market is a relatively-pure measure of inflation expectations, breakevens have some idiosyncrasies that make them less useful for this purpose. Predominant among these idiosyncrasies is the fact that nominal Treasury bonds act in the market as if they are very, very good collateral and so often trade at “special” financing rates. That is, when you buy a Treasury bond you not only buy a stream of cash flows, but you pay a little extra for it since you can borrow against it at attractive rates sometimes (if you are an investor who does not utilize the bonds for collateral, then you are paying for this value for no reason). However, TIPS are much more likely to be “general” collateral, and to offer no special financing advantage. There is no fundamental reason for this: TIPS are Treasuries, and are just as valuable as collateral to post as margin as are nominal Treasuries. There just isn’t a deep short base, and the main owners of TIPS are inflation-linked bond funds that actively repo them out so that they are rarely in short supply. It is unusual, although no longer unprecedented, to see a TIPS issue trade special.

The consequence of this is that Treasury yields are lower than they would otherwise be, by the amount of the “specialness option,” and TIPS yields are not affected by the same phenomenon. Therefore, breakevens are lower than they would otherwise be.

If, in fact, there becomes a shortage of “good” collateral to use to post as swaps margin, one place I would expect that to show up would be in the TIPS market. I would expect that TIPS issues would begin to go on special more-frequently, and to start to behave like the good collateral they are. The consequence of that would be to cause TIPS yields to decline relative to nominal yields as they gain the “specialness option,”, and for breakevens to rise towards inflation swap levels. (As an aside, that would also cause TIPS asset swaps to richen of course).

A long time ago, I summarized this argument here,[1] and a slightly more-rigorous draft of a paper is here.[2]

As I said, this is a technical point and not something the non-institutional investor needs to worry about.


[1] I am bound to include this notice with any online use of the article: “This article was originally published in The Euromoney Derivatives & Risk Management Handbook 2008/09. For further information, please visit www.euromoney-yearbooks.com/handbooks.”

[2] Frankly, I need to update this paper and get it published, but the last time I submitted it I had one referee tell me “this is wrong” and the second referee said “this is obvious” so I decided in frustration to let it drift.

The Disturbing Evolution of Central Banking

August 7, 2013 7 comments

One of the more disturbing meta-trends in markets these days is the direction the evolution of central banking seems to be taking.

I have written before (and pointed to others, including within the Fed, who have written before[1] ) about the disturbing lack of attention being paid in the discussion and execution of monetary policy to anything that remotely resembles money. Whether we have to be concerned about money growth in the short- and medium-terms, ultimately, will depend on what happens to the velocity of money, and on how rapidly the central bank responds to any increase in money velocity. But there are trends that could be much more deleterious in the long run as the fundamental nature of central banking seems to be changing.

Today the Bank of England released its Quarterly Inflation Report, in which it introduced an “Evans Rule” construction to guide its monetary policy looking forward. Specifically, the BoE pledged not to reduce asset purchases until unemployment dropped below 7% (although Mark Carney in the news conference verbally confused reducing asset purchases with raising interest rates), unless:

“in the MPC’s view, CPI inflation 18 to 24 months ahead is more likely than not to be below 2.5 percent; secondly, if medium-term inflation expectations remain sufficiently well anchored; and, thirdly, the Financial Policy Committee has not judged the stance of monetary policy — has not judged — pardon me — the Financial Policy Committee has not judged that the stance of monetary policy poses a significant threat to financial stability, a threat that cannot otherwise be contained through the considerable supervisory and regulatory policy tools of various authorities.”

This is quite considerably parallel to the FOMC’s own rule, and seems to be the “current thinking” among central bankers. But in this particular case, the emperor’s nakedness is revealed: not only is inflation in the UK already above the 2.5% target, at 2.9% and rising from the lows around 2.2% last year, but the inflation swaps market doesn’t contemplate any decline in that inflation rate for the full length of the curve. Not that the swaps market is necessarily correct…but I’ll take a market-based forecast over an economist consensus, any day of the week.

So, for all intents and purposes, while the BOE is saying that inflation remains their primary target, Carney is saying (as my friend Andy the fxpoet put it today) “…the BOE’s inflation mandate was really quite flexible. In other words, he doesn’t really care about it at all.”

Along with this, consider that the candidates which have so far been mooted as possible replacements for Bernanke at the US Fed are all various shades of dovish.

Here, then, we see the possible long-term repercussions of the 2008 crisis and the weak recovery on the whole landscape of monetary policy going forward for many years. In some sense, perhaps it is a natural response to the failure or monetary policy to “get growth going,” although as I never tire of pointing out monetary policy isn’t supposed to have a big impact on growth. So, the institutions are evolving to be even more dovish.

At one time, I thought it would happen the other way. I figured that, since the ultimate outcome of this monetary policy experiment is clearly going to be higher inflation, the reaction would be to put hawkish central bankers in charge for many years. But as it turns out, the economic cycle actually exceeded the institutional cycle in duration. In other words, institutions usually evolve so slowly that they tend not to evolve in ways that truly hurt them, since the implications of their evolution become apparent more quickly than further evolution can kick in and compound the problem. In this case, the monetary response to the crisis, and the aftermath, has taken so long – it’s only half over, since rates have gone down but not returned to normal – that the institutions in question are evolving with only half of the episode complete. That’s pretty unusual!

And it is pretty bad. Not only are central banks evolving to become ever-more-dovish right exactly at the time when they need to be guarding ever-more-diligently against rising inflation as rates and hence money velocity turn higher, but they are also becoming less independent at the same time. A reader sent me a link to an article by Philadelphia Fed President Plosser, who points out that the boundaries between fiscal and monetary policy are becoming dangerously blurred. It is somewhat comforting that some policymakers perceive this and are on guard against it, but so far they seem ineffectual in preventing the disturbing evolution of central banking.


[1] Consider reading almost anything by Daniel L. Thornton at the St. Louis Fed; his perspective is summed up in the opening sentence of his 2012 paper entitled “Why Money Matters, and Interest Rates Don’t,”  which reads “Today ‘monetary policy’ should be more aptly named ‘interest rate policy’ because policymakers pay virtually no attention to money.”

Sweet And Sour

August 1, 2013 6 comments

Yes, I understand that it is an absolute blast to be long stocks when they are ripping higher. Everyone has fun, everyone feels wealthy, and all it took was for the Fed to defer a statement on the taper plan for at least a couple of months. For equity folks, that was equivalent to sounding the “all clear” signal to keep the party going for another couple of months. Add to that great news the fact that the ISM manufacturing index unexpectedly leapt today to two-year highs (see chart, source Bloomberg, below), and you have the possibility of good growth, with a supportive Fed. It isn’t that surprising that in the short term the equity folks are happy and the bond folks are a bit concerned.

ism

But the worst threat to stocks isn’t the taper, it isn’t an incipient slowdown in China, and it isn’t the fact that margins appear to be compressing. It’s that they will, some day, face competition for investment dollars from interest rates, commodities, real estate, and all of those other things that haven’t been exciting to invest in for a while.

Ten-year interest rates at 2.70% are not an exciting investment, but they are definitely more exciting than 1.60% rates were. However, you don’t really need to think about whether marginal investment dollars will flow to bonds since rates are 110bps higher now. You know that, no matter what the yield, more investment dollars are going to be flowing to fixed income going forward.

How do we know this? We know it because the Fed isn’t going to be buying $85bln per month, at some point in the not-too-distant future. So we know that, even if the Fed doesn’t sell, the bond market will be soaking up another $85bln of investment dollars compared to what it has been doing during QE3. And those dollars will need to come from somewhere. After all, this is just the ‘portfolio balance channel’ in reverse. The Fed pushed risky markets higher by buying all the safe stuff, so as to force investors to move out the risk spectrum. By taking away the “safe” alternatives, in other words, the Fed substituted for “animal spirits” in the market. (I discussed and illustrated this back in January.)

The opposite also occurs, though. When the Fed steps out, some investors will buy those “safer” investments at the higher yields where those markets clear. Those investors will be coming out of stocks, mainly. By substituting for animal spirits, the Fed pushed the stock market higher when investors didn’t feel much like pushing it there. And, once they start to taper that policy, they need investors with real animal spirits to step in and take risky positions in stocks because they want to.

The head-scratcher for me is, why would I want to take a risky position in stocks now, when interest rates and in particular real interest rates, are higher…if I didn’t want to take that position before? Does growth suddenly look that much better?

I ought to reiterate here that I still think a bond rally is due, despite today’s shellacking in a fairly illiquid-seeming market. I will change that view if 10-year yields rise another 5-10bps, however. I frankly think that while Bernanke likely wants to take the first step towards tapering while he is still Chairman – since it’s the polite thing to do to take the riskiest step of unwinding his policy before the next Chairman is forced to do it – I doubt he wants to get so far down the tapering road that the next Chairman feels locked in to a certain course of policy. So I suspect we will not see as much tapering this year as the market expects. Investors clearly thought we would get some indication about tapering at this meeting, and we didn’t. Bond folks know we will, eventually. Equity folks also know we will, but they all think they can get out as soon as the Fed gives the signal.

The problem, of course, is that some investors won’t wait for the explicit signal. To be fair, it has been a losing trade to be early on the Fed taper story, but that just means the ultimate comeuppance is going to be worse.

There is a ton of data due out on Friday, but my attention will not be on the Payrolls figure (Consensus: 185k). It is perhaps frightening to think about this, but Payrolls in the neighborhood of 200k is about all that we can expect. The chart below (Source: Bloomberg) shows the BLS Nonfarm Payrolls statistics along with a 24-month moving average. Ignore the swings from month to month. Instead, notice that in the expansion in the mid-2000s the 2-year average never got above 200k, and even in the robust expansion of the late 1990s the average was only about 250k (and we’re not about to have a robust expansion any time soon!). So, whether you like it or not, 200k per month is about all you’re going to get.

payroll2y

The Unemployment Rate is expected to decline back to 7.5% after rising to 7.6% last month. And again, here, the rate of decline in the Unemployment Rate is about as fast as you’re going to get it (see chart below, source Bloomberg). In fact, if anything the decline in the ‘Rate is slightly faster than in recoveries past, although as has been well documented the unemployment rate is much higher if you discount the increased prevalence in this recovery of part-time work.

usurtotSo, on growth the sad truth is that we have been waiting for economic improvement, but none is coming. This is about as good as it is likely to get, economically speaking (at least, in terms of the pace of improvement, though with time this will pull the Unemployment Rate gradually lower).

Indeed, much faster growth would likely incline the Fed to taper faster, and even to consider additional tightening measures. And much slower growth would probably dampen the rather ebullient earnings estimates of the sell-side analysts. The dividend yield is less than 2% with inflation-linked bonds paying around 0.5%. So I won’t be looking at the numbers very closely. We are already in the sweet spot. What I am going to be looking for, tomorrow and going forward, is any sign that investors are getting a sour taste.

Is A Bond Rally Due?

July 29, 2013 1 comment

As we head into a very busy week of economic data, the bond market remains drippy with the 10-year yield up to 2.59%. (Just writing that makes me laugh. Who would have thought, only a few years ago, that 2.59% was a high-ish yield?)

How we got here, from the ultra-low levels of the last two years, is well-traveled territory. The Fed’s swing from “QE-infinity” to “someday, maybe, we might not buy as many bonds” helped trigger a run for the exits, and then negative convexity inflection points kept the rout going for a long time. Most lately, the threat of muni bond convexity has been looming as the next big concern.

But my message today is actually one of good cheer. The worst of the bond selloff was now more than three weeks ago, without a further low being established. In my experience, convexity-inspired selloffs typically end not with a sharp rebound but with a sideways trade as “trapped” long positions gradually work their way out and buyers start to nibble. But it remains a buyer’s market for several weeks, at least.

We are getting far enough along in that process that I suspect we have a rally due. This has nothing to do with any economic data coming up. There is enough data coming this week, from Consumer Confidence to Payrolls to GDP to the Fed statement, that both bulls and bears will be able to find something to point to. And I am not pointing to technicals, exactly. I am just saying that markets rarely move in a straight line, and even bear markets – such as the one I think we have now entered, in bonds – have nice rallies from time to time.

But here’s a reason to expect this to happen relatively soon. The chart below is a neat “seasonal heat map” chart from Bloomberg showing the monthly yield change for the last 10 years and the average monthly change on the top line.

heatmapFor a long time, I have been following the rule of thumb I learned as a mere babe in the bond market, and that’s that the best time of the year to buy bonds is the first few days of September. From at least the late 1970s until today, September until mid-October has been the strongest seasonal period of the year (not every year, but with enough consistency that you wanted to avoid being short in September). But the heat map above shows that this tendency may have shifted. The month that has seen the best average bond market performance over the last decade has been August, with yields falling an average of 22bps with rallies in 8 of the last 10 years. If we were sitting with 10-year yields at 1.59%, I would be less interested in this observation, but at 2.59% I am looking for the counter-trade.

To be sure, yields in the big picture are headed higher, not lower. But I am looking for signs that the recent selloff has over-discounted the immediate threat of ebbing Federal Reserve purchases. And I don’t expect growth to suddenly leap forward here, either.

As an aside, 10-year TIPS yields have also experienced one of their best months in August, with the other clear positive month being January. But, because nominal yields have been so strong, August has been the worst month for breakevens, with 10-year breakevens falling 10bps on average over the last ten years. No other month has seen breakevens decline as much as 6bps, on average.

Now, although I am a bond bear in the big picture, I don’t think that the housing market is doomed because interest rates will go up one or two or three percent. I am fascinated by how many analysts seem to think that unless 10-year rates are below 3%, the housing market will collapse. I argued about six weeks ago that higher mortgage rates should not impact sales of homes very much as long as the interest rate is less than the expected capital gain the homeowner expects to make on the home. (Higher rates will, however, cut fairly quickly into speculative building activity, which is much more rates-sensitive). And here is another reason not to worry too much about the housing market. A story in Bloomberg last week says that adjustable-rate mortgages are booming again, with mortgagees taking them out at the highest pace since 2008. Faced with higher rates, and a Fed with is not likely to raise short rates for a long while – as they have taken pains to keep reminding us – homebuyers have rationally decided to take the cheaper money and let the future refinancing take care of itself.

Whether that is sowing the seeds of a future debacle I will leave to other pundits to debate. From my perspective, the important point is that higher rates are not likely to slow home sales, or the recent rise in home prices, very much…unless they get a lot higher.

You Can’t Jawbone a Bungee Jump

July 12, 2013 4 comments

Incredible to me, as well as to many others I am sure, is the fact that the words of one guy, Chairman Bernanke, who is leaving office soon, carries more weight in the market than all of the actual news that we see from day to day.

Today, France’s sovereign rating was lowered by S&P to AA+ from AAA. This is more significant than it sounds, since it means that none of the European “bailout” institutions can feasibly carry a AAA rating any more unless Germany and the Netherlands want to guarantee the whole thing. (They don’t.) In a humorous note, the French Finance Minister said that the country remains committed to restoring growth, lowering deficits, and adding jobs. Hmmm. One of these three doesn’t seem to belong in a statement about restoring the credit of the nation. How does adding jobs – stimulus, that is – help the situation? It was a strange statement.

Portugal’s situation is worsening again as President Silva is insisting on a broader “unity” government in which all parties participate in the government (and take the heat for austerity measures). Not all of the other parties agree; in particular the Socialists are demanding new elections, while declaring “we must abandon the politics of austerity, and renegotiate the terms of our adjustment programme.” In this dust-up, the more extreme elements of the political sphere in Portugal are calling for debt repudiation. Portuguese bond yields (10y) are back up to 7.35%, which is well above the 5.20% lows from May although also a far cry from the 16% levels in the teeth of the crisis early last year (see chart, source Bloomberg).

porto10

Philadelphia Fed President Plosser today said in a speech that the Fed should start exiting from the asset purchase program in September, and completely cease buying bonds by the end of the year. He is concerned about causing another housing boom (too late!), and thinks the costs outweigh the further benefits. He is right, and bonds took some brief grief before investors remembered that (a) he’s not the Chairman, who has the only vote that matters, and (b) he’s not even an FOMC voter this year.

None of this – not France, not Portugal, not Plosser – rattled the U.S. equity market in the slightest, because Bernanke has pledged to keep the taps running as long as possible, tapering slowly, and then maintaining easy policy for a long time. So investors are delighted to see stocks at all-time (nominal) price highs with nearly a 24 Shiller P/E. At these levels, the expected real total return for the next decade from the stock market is less than 1.75% per annum…with 10-year TIPS yielding 0.50%.

So does the continued presence of easy money from the Fed warrant exceptional risk-taking and valuation in equities? It seems to me that it does not. Removing QE is, of course, tightening relative to the baseline of current policy. Policy may remain absolutely easy, but it is going to be relatively tighter…and the direction of interest rates, not merely their level, matters to investors. Of course, Fed mouthpieces clearly want to suggest that “policy will remain accommodative.” Indeed it will, and it will also remain accommodative when the Fed Funds rate rises to 1%…and 2%…and 3% someday. But it will be less accommodative, or in other words: more restrictive.

The word-smithing by the Chairman in this regard is understandable, because the jawboning is an important part of policy for a central bank that is nearly impotent due to prior decisions. But it is absurd. Previously, investors were asked to stomach the “Perpetual Motion Machine” interpretation of policy: that buying bonds would push interest rates lower and increase economic activity, while selling them wouldn’t push rates higher or decrease activity (or prices in related markets). This latest tweak to the argument asks us to believe also that buying fewer bonds has the same (positive) effect as buying a lot of bonds!

Again, I completely understand why the Fed is trying to jawbone the markets to their way of thinking. But you can’t jawbone a bungee jump, and the inflection of policy here is the start of a bungee jump.

The risk here is that investors decide that the Fed is really going to be slow at removing accommodation (which I think is correct), but inflation is going to start to be problematic sooner than that. That sort of attitude adjustment may be closer than you think, for two reasons. First of all, the CPI report is due on Tuesday. Market expectations are for a figure lower than last month’s +0.17% rise in core inflation, and a decline in the year/year core inflation rate to +1.6% (from 1.7%) as last June’s +0.21% rolls out of the 12-month comparison. I believe there is a good chance that core comes in better than that, although it is unlikely to push the year-on-year change higher. But it could, since housing continues to accelerate and these low figures require ever-increasing drag from core goods prices. In any event, though, inflation will accelerate on a year-on-year basis in August, because the easy comparisons begin: +0.10%, +0.06%, +0.15%, +0.17%, +0.12%, and +0.12% are the monthly changes in core prices for the last six months of 2012: a 1.4% pace in aggregate. And the underlying inflation dynamics are accelerating at the same time.

The second reason that inflation expectations may begin to rise among investors soon is more pedestrian (in more ways than one): gasoline prices have recent spiked 40 cents in the futures markets, from near the lows of the year to near the highs of the year. This will pass through to retail gasoline prices over the next few weeks. If gasoline prices do not rise further from here, then no important shift in inflation perceptions will likely happen. But keep an eye on this. Enduring Investments’ sophisticated measure of “consumer inflation angst” has been at multi-decade lows for some time (see chart), but a fairly reasonable shortcut way to evaluate how consumers are feeling about inflation is to look at prices at the gas pump.

aggadjYou should note that there are two spikes on this chart. One covers the move higher from March 2001 to February 2003, a period during which stocks fell 28%. The second covers May 2007 to July 2009, covering a 35% slump in prices. (There is also a minor blip from November 2010 to September 2011, a period during which the S&P only dropped 4%.)

Of course, increasing consumer inflation angst wasn’t the only thing that was happening during those periods that helped to drive stocks down. Among other things, valuations were high. Indeed, valuations were high partly because inflation angst was so low. And one ought to consider this: if stocks decline from here in concert with rising inflation expectations, we would be able to say the same thing looking back: it isn’t only rising inflation expectations, but also high valuations and plenty of bad news to go around.

Moderate Monetary Policy: Vice Or Virtue?

July 10, 2013 4 comments

Barry Goldwater once said “Extremism in the defense of liberty is no vice. And moderation in the pursuit of justice is no virtue.” It is one of the great quotes of the 20th century, and so I feel moderately guilty to convert it to my own selfish uses by saying that “Extremism in the defense of bad monetary policy is no virtue. And neither is moderation in the attack on inflation.”

And that, for the most part, is the story of the day.

Much of the day’s trading session was as languorous as the Bermuda-shorted walkers on Lexington Avenue in the wilting, moist heat of the New York summer. But, late in the day, the release of the minutes from the last FOMC meeting and the subsequent question-and-answer session from Chairman Bernanke roused traders and rattled markets.

The minutes themselves were filled with comments on inflation that are likely to be held up as articles of ridicule in only a few months.

The extremism of St. Louis Fed President Bullard, in defense of bad policy, summed it up: “Mr. Bullard dissented because he believed that, in light of recent low readings on inflation, the Committee should signal more strongly its willingness to defend its goal of 2 percent inflation. He pointed out that inflation had trended down since the beginning of 2012 and was now well below target.” He was not alone, as “…most participants…anticipated that [inflation] would remain below the Committee’s 2 percent objective for some time.”

If by “some time” they mean “several months,” then I suppose this will end up being right. But there is very little doubt that core inflation will be over 2% very quickly, unless some interesting data quirk provides an encore to the Medicare-induced decline in core CPI over the last six months. This is where good analysis is supposed to play a role. The chart below (Source: Bloomberg) shows core CPI, along with another measure of the central tendency of inflation: the Cleveland Fed’s Median CPI.

medianandcoreNow, in this column I have written quite a bit previously about what exactly is happening to core CPI, and why we shouldn’t pay too much attention to its recent decline (in summary: it is all in core commodities and especially pharmaceutical prices, while the biggest chunk of CPI, housing, is in the process of turning higher). But the point of this chart is that the deviation in core CPI compared to median CPI should be a clue to the thoughtful analyst to look more closely at what is going on, since the median is barely moving – and remains above 2% – while the average is declining. What this tells you, statistically, is that there are a few big outliers to the downside that are skewing the core reading lower. It is upon further investigation that the observation about housing-versus-pharmaceuticals (which cause core PCE to be even lower, since core PCE exaggerates the effect of medical care while understating the importance of housing) ought to be crystal clear. You don’t have to be an inflation expert to figure that out. You just need to look at the data carefully. It takes a bit more expertise, but not a ton, to observe that the second half of the year should see core inflation rise because of easy comparisons to the year-ago period, if for no other reason.

And the Fed came to the right conclusion…

“Several transitory factors, including a one-time reduction in Medicare costs, contributed to the recent very low inflation readings. In addition, energy prices declined, and nonfuel commodity prices were soft…”

…and then butchered the forecast for higher core inflation by incorrectly attributing it:

“Most participants expected inflation to begin to move up over the coming year as economic activity strengthened…”

It’s a simple forecast (although the rise will be more than they expect it to be), and they at least got the sign of the movement in inflation right. Maybe they even got the causes right, privately, but just felt it was too hard to explain in the minutes.

But, I doubt it.

The FOMC participants are not expecting, as it also says, inflation to move above 2% (on core PCE, which would be somewhat higher on core CPI). It’s a very marginal forecast they are making here. More extremism, though, was provided by the IMF’s Chief Economist Olivier Blanchard, who said in an interview that he is “not at all worried about inflation” in the U.S., because in his view (although stated as fact) inflation can rise because of an overheated economy or people’s expectations of cost increases. People, said Blanchard, who fear a jump in prices are “plain wrong.”

What is plain wrong is that they picked a guy to be chief economist who doesn’t understand the first thing about inflation. Virtually no one who has studied the matter believes that inflation expectations cause inflation. This is because there is nothing remotely suggestive of that in the data (and, moreover, no one can figure out how having customers who are afraid of cost increases can cause a vendor in a competitive marketplace to jack up prices with no other reason). Many people believe that an “overheated economy” can cause inflation to rise, so that’s at least a more common error, but consider that that core inflation fell in the U.S. from 1995-1999, and then rose from 2000 to 2002. Consider that it fell from 2006 to 2008 with unemployment below 5% and then rose sharply in 2011 with unemployment around 9%. Given that, is it unreasonable to ask that a chief economist at least be less strident in his statement about how plain wrong everyone else is?[1]

There was some volatility on the release of the FOMC minutes, with inflation markets getting pressured modestly on the theory that the minutes were not quite as dovish as was hoped, and there was at least some fair discussion about the importance of holding down inflation. Eventually, that is. But inflation breakevens as well as commodities prices (and stocks, and bonds, etc) rallied when Chairman Bernanke took some questions after his speech in Boston. In his responses, he backed off the recent tapering signals further – really, they’ve been backpedaling so fast on this that they’re behind where they started – by saying that inflation and the state of the jobs market indicates that more Fed stimulus is needed. The fact that this comment, myopically focused on the very short run followed a speech with the grand title of “The First 100 Years of the Federal Reserve: The Policy Record, Lessons Learned, and Prospects for the Future” was an irony apparently lost on the Chairman.

But, hey, let’s face it. He’s going to be gone when the important work of policy normalization gets started. As the President said recently, he’s stayed far longer than he wanted to. Is it unreasonable to expect him to just be ‘phoning it in’ at this point? Yet his moderation is no virtue, especially if you own fixed-rate bonds or other assets that will perform poorly when inflation rises.


[1] I, on the other hand, am free to do so since I am not the Chief Economist of the IMF nor the Chairman of the Federal Reserve, and moreover because no one much cares what I think. Ah, the freedom of irrelevance!

Bond Beatings Continue

June 25, 2013 4 comments

The beatings are continuing, and apparently morale really does improve with such treatment. Consumer Confidence for June vaulted to the highest level since early 2008, at 81.4 handily beating the 75.1 consensus. Both “present situation” and “expectations” advanced markedly, although the “Jobs Hard to Get” subindex barely budged. It is unclear what caused the sharp increase, since gasoline prices (one of the key drivers, along with employment) also didn’t move much and equity prices had been steadily gaining for some time. It may be that the rise in home prices is finally lifting the spirits of consumers, or it may be that credit is finally trickling down to the average consumer.

Whatever the cause, it is not likely to prevent the rise in money velocity that is likely under way, driven by the rise in interest rates. Between the rise in home prices – the Case-Shiller home price index rose a bubble-like 12.05% over the year ended April, and Existing Home Sales median prices have advanced a remarkable 14.1% faster than core inflation (a near record, as the chart below shows) over the year ended in May. (Lagged 18 months, such a performance suggests about a 3.9% rise in Owners’ Equivalent Rent for 2014).

wowpricesBut of course, we must fear deflation more than ever!

The nonsense about deflation is incredible to me. Euro M2 growth hasn’t been this high (4.73% for year ended April) since August of 2009. Japanese M2 growth hasn’t been this rapid (3.4% for year ended May) since May 2002. US money supply is “only” growing at 6.5% or so, down from its highs but still far too fast for a sluggishly-growing economy to avoid inflation unless velocity continues to decline. But you don’t have to be a monetarist to be concerned about these things. You only need to be able to see home prices.

Core inflation in the US is being held down by core goods, as I have recently noted. In particular, CPI for Medical Care just recorded its lowest year-on-year rise since 1972, and Prescription Drugs (1.32% of CPI and an important part of core goods) declined on a y/y basis for the first time since 1973. The chart below (source: Bloomberg) illustrates that as recently as last August, that category was rising at a 4.0% pace.

cpiprescript

Now, I suspect that this has something to do with Obamacare, but no one seems to know the full impact of the law. Keep in mind that Medical Care in CPI excludes government spending on medical care. So, one possible narrative is that the really sick people are leaving for Obamacare while the healthy people are continuing to consume non-governmental health care services. This would be a composition effect and would imply that we should start looking at CPI ex-medical for a cleaner view of general price trends. I have no idea if this is what is happening, but I am skeptical that prescription meds are about to decline in price for an extended period of time!

But that’s the bet: either core inflation is going to go up, driven by things like housing, or it’s going to go down, driven by things like prescription medication. Place your bets.

Equity prices recovered today, but bond prices continued to slide into the long, dark night. For a really incredible picture, look at the chart below (source: Bloomberg), which shows the multi-decade decline in 10-year yields on a log scale, culminating in the celebrated breakout below that channel. Incredibly, the recent selloff has yields back to the midpoint of the channel and not outrageously far from a breakout on the other side!

logof10s

Incidentally, students of bond market history may be interested to know that the selloff has now reached the status of the worst ever bond market selloff (of 90 days or less) in percentage terms. Since May 2nd, 10-year yields have risen from 1.626% to 2.609%, a 98.3bp selloff which means that yields have risen 60.5% in less than two months.

And we are probably not done yet. I wrote about a month ago about the “convexity trade,” and I made the seemingly absurd remark that “This means the bond market is very vulnerable to a convexity trade to higher yields, especially once the ball gets rolling. The recent move to new high yields for the last 12 months could trigger such a phenomenon. If it does, then we will see 10-year note rates above 3% in fairly short order.”[emphasis in original] Incredibly, here we are with 10-year yields at 2.61%, up 60bps over the last month, and that statement doesn’t seem quite so crazy. As I said: I have seen it before! And indeed, the convexity trade is partly to blame for what we are seeing. I asked one old colleague today about convexity selling, and here was his response:

“massive – the REITs are forced deleveraging and there are other forced hands as well. The real money guys are too large and haven’t even sold yet – no liquidity for them. The muni market has basically crashed and at 5% yields in muni there is huge extension risk on a large amount of bonds: something like $750bln in bonds go from 10-year to 30-year maturities as you cross 5%.” (name withheld)

Now, I am not a muni expert so I have no idea what index it is I am waiting to see cross 5%. But the convexity trade is indeed happening.

Lots of bad things have happened to the market, but they really aren’t big bad things. In fact, I move that we stop using the term “perfect storm” to mean “modestly bad luck, but I had a lot of leverage.” The Fed was never going to be aggressively easy forever, and as various speakers have pointed out recently they didn’t exactly promise to be aggressively tightening any time soon. There is bad news on the inflation front, but the market is clearly not reacting to that. Some ETFs have had some liquidity issues, and emerging markets have tumbled, and there was a liquidity squeeze in China. But these are hardly end-of-the-world developments. What makes this a really bad month is the excess leverage, combined with the diminished risk appetite among primary dealers who have been warned against taking too much “proprietary risk.”

And markets are mispriced. Three-year inflation swaps imply that core inflation will be only 1.9% compounded for the next three years (the 1-year swap implied 1.6%; the 2y implies 1.75%). That is more than a little bit silly. While I have not been amazed that the convexity trade drove yields very high, and probably will drive them higher, it has surprised me that inflation swaps and inflation breakevens have continued to decline. Still, investors who paid heed to our admonition to be long breakevens rather than TIPS have done quite a bit better, as the chart below (source Bloomberg), normalized to February 25th (the date of one of our quarterly outlook pieces) illustrates.

breaksvstips

As the bond selloff extends, I don’t think TIPS will continue to underperform nominal bonds. I believe breakevens, already at low levels (the 10-year breakeven, at 1.97%, is lower than any actual 10-year inflation experience since 1958-1968), will be hard to push much lower, especially in a rising-yield environment.

%d bloggers like this: