Surely Bernanke is right, and all of this crazy price action is merely discounting rational outlooks. Today, the Chairman told Congress that “the fact that interest rates have gone up a bit is actually indicative of a stronger economy.”
Really? Do we really have any idea what it is indicative of, when the price being discovered isn’t a free market price? Where the heck did he learn economics, from correspondence school? You may as well say that since the price of bread in the former Soviet Union was very stable, it indicated that markets were in balance. Well, either that or it indicated that the State thought the price ought to be steady.
To be sure, the economic data over the last couple of days has been terrific (compared, as always, to what we’ve become accustomed. On Tuesday, New Home Sales hit the highest level since the summer of 2008, at 437k when economists were looking for 380k. Consumer Confidence printed 69.6, a huge jump from 58.4 in January and a well above the 62.0 expected (yes, this is strange with higher gasoline prices and higher taxes, but it is still below November’s level so perhaps it just reflects relief that Congress is in gridlock – interestingly, the “Jobs Hard to Get” subindex rose).
On Wednesday, Durable Goods ex-Transportation orders rose 1.9%, easily beating the +0.2% consensus. And Italy managed to sell debt, although one is never sure these days if the buyers are buying it because they believe in Italy, or because they’re banks who get good accounting treatment.
So life is good, and stocks rose 1.3%, erasing what was left of Monday’s downdraft.
And, obviously, because growth is so good Gasoline was crushed, with its worst 1-day drop since November. Industrial metals also declined. But inflation breakevens and inflation swaps, despite that, widened.
Bonds sold off slightly, although for most of the day – with the immediate Italy crisis already fading and the economy evidently feeling better – they were higher.
The dollar fell, and precious metals fell as well.
But clearly, this all makes sense to Bernanke, who is at peace with the world at the moment. There are no signs of anything wrong to the Chairman.
“Although a long period of low rates could encourage excessive risk-taking, and continued close attention to such developments is certainly warranted, to this point we do not see the potential costs of the increased risk-taking in some financial markets as outweighing the benefits of promoting a stronger economic recovery and more-rapid job creation.”
But you know, here’s the REAL problem – why does he, or any of the smart people on the FRB, or any of the smart people at the Fed as a whole, get to decide how to “weigh the benefits of economic recovery” compared to the “potential costs of increased risk-taking in some financial markets?” This is something that the market is supposed to do. Right, Comrade?
It is one thing to believe that the government or Federal Reserve should step in when there is a market failure. It was arguably (although I am one who would argue against it) the right thing to do for the Fed to guarantee commercial paper issuance during the crisis so that businesses could continue to fund themselves in the dysfunctional, poorly-planned, but nevertheless critical-at-that-moment way they had become accustomed to. But the Fed simply shouldn’t be in the business of weighing “potential costs of increased risk-taking” versus the “benefits of…more-rapid job creation.”
We are all investors and traders here. What is the first thing you learn as a trader? The market is bigger than you are. Not that the market is always right – far from it – but if you lose to the market then you need to ask whether the millions of other traders collectively know something you don’t. And the point is writ even larger when you’re talking about the economy as a whole. If the bread is too expensive, then the baker won’t be able to sell all of it and he’ll have to lower his price tomorrow. There is no way that the Central Committee can set the price of bread more intelligently than can the market. And that goes double for the price of risk.
So, while we’re talking about Fed overreaching, take a moment to read this one-page summary by Brian Wesbury about how the Fed will make excuses about inflation when inflation begins. People often ask me, “won’t the Fed simply start to tighten once inflation makes them uncomfortable,” and the discussion then revolves around how long it will take the Fed, once they move, to have an impact on the inflation dynamic. But Wesbury gets to the behavioral dynamic of the Fed and proceeds to detail – I think with absolute plausibility – how the Fed will excuse rises in inflation once it heads higher. In sequence, the excuses will be:
- Higher inflation is due to commodities, and core inflation remains tame.
- Higher core inflation due to housing is just due to housing prices bouncing back to normal, and that’s temporary.
- It’s not actual inflation that matters, but what the Fed projects it to be.
- It’s okay for inflation to run a little above 2% for a while because it was under that level for so long.
- Increasing price pressures are due to something temporary like a weaker dollar or a temporary increase in money velocity or the multiplier.
- Well, 3-4% inflation isn’t that bad for the economy, anyway.
Wesbury gives a little more color about how the transition from excuse to excuse will happen so smoothly – it’s worth it reading the short summary in his own prose.
When everything from the price of 10-year notes to the price of risk as a whole is being controlled by the Fed, any kind of forecasting or trading is almost a fool’s game. It’s like trading a random number generator because deviations from fair value are not followed, necessarily, by an eventual return to fair value. I believe that in this environment, it is as important as ever to focus not on reaching for better returns, but in nailing down your risks as best as you can (especially when the price of such hedges is low, ironically for the same reason that the price of risky strategies is low). Right now, I believe that one of the biggest risks is that of an inflationary outcome. I hope each person out there is thinking carefully about how well his or her portfolio is protected against such an outcome, because there will be no excuses when it happens…except from the Fed.
Like everyone else, I want to believe that the Greek bailout this time really is ‘done.’ Of course, my main reason for wanting that outcome is that I am weary of writing about all of the deals, which turn out not to be deals, which get trumpeted as deals again, and so on.
Over the weekend, we were assured that there was finally a solution to the Greek crisis. The ECB (and it turns out today, other European central banks) will swap their bonds for new Greek bonds that will not be subject to haircuts. Meanwhile, private bondholders will take a haircut and get new bonds worth a lot less, although this afternoon the head of the IIF (the group responsible for the PSI negotiations) told the BBC that this will only work if CDS owners don’t choose to trigger their payouts. So, as long as private-sector bondholders choose to take less money, this is all good. The IMF is also reportedly contributing less to the deal than had previously been expected. And all of this is subject to approval by a number of legislatures.
So the problems of subprime sovereign Europe have not yet been put wholly to rest. The markets seem unsure on this point. Stocks ended essentially unchanged after hitting new highs in the morning, on continued low volume. Bond yields rose, with the 10-year nominal bond up 5bps to yield 2.06% and 10-year TIPS 2bps higher to yield -0.24%. That would seem to indicate some marginal lessening of tensions, but with volumes thin and equities near-unchanged I think such a read would be premature. The VIX was higher on the day, although it remains lower than it was last week.
Commodities had a banner day, relative to equities, with the DJ-UBS index +1.35%. Precious Metals led the way with a 2.75% gain and Industrial Metals rose 1.6%. Energy, however, will get the headlines. Although Nat Gas blunted the performance of the group, NYMEX Crude rose to $105.50, the highest level since May and 40% above the October lows; Brent reached $121. Gasoline jumped a nickel to $3.0661/gallon, the highest since driving season and the highest print ever for the March 2012 contract.
This seems like the first time in a while that commodities have simply smoked equities, but since the beginning of the year they have kept pace…if you leave out Nat Gas. Our preferred ETF, USCI, is up 8.98% year-to-date compared with 8.32% for the S&P. The correlation has been far too high for our tastes, suggesting that both markets are trading QE3 rather than inflation expectations. But they too are higher: the INFL Deutsche-issued ETN is +5.0% year-to-date.
While all markets move in lock-step, it is hard for me to believe that the earthquake has happened. Whether it’s the earthquake of Greece failing and banks coming clean about their losses therefrom (and a potential unzipping of other subprime sovereigns), or it’s the earthquake of Greece getting bailed out successfully and causing the line of sovereign supplicants to extend around the block, there’s some kind of resolution coming that should fracture, at least for a while, these high correlations. I believe that in such a circumstance, commodity indices are the best-valued and most likely to come on top…but we will see.
However, Bloomberg claims that the S&P is the cheapest relative to bonds it has ever been, since 1962. I enjoy the presumably-unintended bias in construction. Why not say, “Bonds are the most-expensive, relative to stocks, that they have been since 1962?” Both would be true, if the metric they’re pushing (the spread of the ‘earnings yield’ to the 10-year Treasury rate) is the right metric, but one headline implies that stocks are cheap on an absolute basis while the other headline doesn’t imply that. Our equity culture is alive and well, sadly; but there are many more arguments to be made that both bond and stock prices are too high than there are to be made that both are too low. And of course, as I’ve pointed out before, saying that stocks are cheap relative to something else is not the same as saying they are cheap, in the sense they will have better-than-average returns. By the same token, TIPS are extremely cheap relative to nominal bonds, but I would not suggest owning them outright at a -0.25% real yield. So if you want to buy stocks and sell bonds, or you want to buy TIPS and sell bonds, you may have a winning trade…if you weight the trade right. Be assured that the correct weight is not equal notional amounts. That is, if you sell your short-term bond portfolio to buy an equity portfolio dollar-for-dollar, you probably have more risk to markets returning to fair value even though bonds are expensive to stocks.
On Wednesday, after an overnight session filled with updates, clarifications, exceptions, and corrections to the so-called Greece deal, we will get to enjoy the happy news about January Existing Home Sales (Consensus: 4.66mm from 4.61mm). Since the weather in January was better-than-average, it is fair to expect a strong number, which means the market ought to react more to any downside surprise than to an upside surprise. But the magic number is 5 million. Existing Home sales haven’t been there, except for a brief spike in late 2009, since 2007. But prior to 2002, a pace of 5-5.5mm Existing Home Sales was a fairly typical level (see Chart, source Bloomberg), and would imply that properties are finally starting to clear at something like normal rates. The data may be a little messy for a few months as bank REO property gets put back on the market (potentially driving up both inventory and sales numbers), but 5mm is the level to hope for.
After buying stocks ‘with both hands’ on Tuesday, investors went with a distinctly one-handed approach as stock indices ended mixed on even lighter volume. It is far too early to be deeply concerned about the lack of volume, but…it’s not too early to be a little concerned. Volume the first two trading days of 2012 is down 25% from the first two trading days of 2011, which itself was the lowest total in at least 5-10 years.
To be sure, there is little new information to warrant a shift of position in the new year if you were happy with your position in the old year. And the indices are still at the top of the ranges of the last five months, so perhaps investors are waiting for resolution before jumping on board. The more sinister interpretation is that Volcker rule restrictions are continuing to erode market makers’ ability to provide liquidity, as many of us have warned is a likely consequence of limiting market makers’ ability to ‘intermediate temporally’ by taking a position.
However, I suspect the quiescence is at least partly for the former reason. Website hits for my comment are down as well from the same period a year ago, which suggests fewer people are tuned in so far this year.
Commodities markets have enjoyed the beginning to 2012. Energy markets and industrial metals rallied today. Crude was only up a little, although there was a development that threatens to change the calculus for Iran. In Brussels, EU members agreed in principle on economic sanctions against Iran, crucially including an embargo on importing oil from that nation. If enacted, this significantly changes the balance of risks for Iran associated with closing the Straits of Hormuz. If they are not going to be exporting through the Straits, then there is much less economic cost to Iran to close the Straits. If they aren’t selling much oil anyway, then the actual act of closing the Straits carries only military risks – and perhaps not even that, if the regime doubts the determination of the White House. The EU still hasn’t put an embargo into place, and it may be implemented ‘gradually,’ but in my mind the probability of a conflict just went up meaningfully.
But again, it wasn’t just energy markets that rallied. And today, the dollar was stronger rather than weaker. Nominal interest rates rose again (10-year Treasuries now yield 1.99%), but TIPS rallied and inflation swaps increased as well. Moreover, it wasn’t just short-term inflation swaps, as would be the case if the market was pricing in a potential oil spike. 10-year inflation swaps are up about 10bps over 2 days to 2.365%. That’s still terribly low in the grand scheme of things, as the chart below (Source: Bloomberg) shows. Indeed, Fed officials cannot be blind to the fact that 10-year inflation expectations have only been appreciably lower in the 2008 crisis and in 2010 right before QE2 was ‘announced’ by Chairman Bernanke.
It is incredible to me that with monetary conditions as accommodative, globally, as they have been in decades, inflation swaps are still nearly as cheap as they have ever been. That’s truly striking. What is the 10-year downside to a long inflation position from these levels? One-half percent per annum? Seventy-five basis points per annum? How low can inflation be over the next 10 years, especially with central banks apparently willing (and even anxious) to produce as much liquidity as is needed?
On Thursday, the ADP report (Consensus: 178k from 206k) for December is the keynote release. Initial Claims (Consensus: 375k vs 381k) makes it a rare labor-market double, but Claims for the last week of the year isn’t a particularly useful figure and should be ignored. The Non-Manufacturing ISM (Consensus: -46.0 vs -47.5) rounds out the pre-Employment data. Of these, ADP is clearly the most important, but traders will prefer to be conservative in interpretation of any outlier points. This is partly because there is some evidence that ADP suffers seasonal-adjustment problems in December and partly because just last month ADP significantly exceeded estimates and Employment was right on target. In still-thin trading conditions, and only one day to wait to get the ‘real’ data, traders will prefer to avoid making bets on ADP.
I have a favor to ask readers. Would you be so kind as to take a single-question anonymous poll, about your interest and/or willingness to buy certain kinds of “different” inflation-linked bonds? It will take no more than two or three minutes. This is the link to the poll. Thanks in advance!