No Pleasing Some Folks

By: Michael Ashton | Tue, May 4, 2010
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There is just no pleasing some people!

Greece finally gets a package of a decent size...okay, so it's not very likely that the deal will be approved by the entire EU, and it depends on the U.S. contributing a whole lot of money via the IMF, but still: it's what investors wanted, as of yesterday...and today the market comes unglued again. The S&P ended -2.4%, at the lowest point since wayyy back in March. Considerably more starch was taken out of the FTSE and the EuroStoxx. Energy (and Silver) commodities fell hard, bringing the GSCI down about 3%.

Bonds rallied, with the 21/32nds rally in the June 10y Note contract bringing the 10y yield to 3.59%. The low closing yield for the year to date is 3.56%, by the way.

Inflation swaps dropped 4-8bps in the U.S., which is interesting because in Europe inflation was nearly unchanged. The Euro plunged 2 big figures, below 1.30 for the first time in a year, so what the inflation market may be telling us is that the rallying dollar will be disinflationary for the U.S., but the troubles in Europe increase the likelihood that the ECB starts adding liquidity in a serious way at some point. Maybe, but if the ECB adds liquidity then unless the Fed is working to drain it it will push prices higher. Money is fungible, so while increased ECB liquidity would tend to change relative prices between the Europe and US, it is an upward shock to prices globally.

As in 2008, the question of whether aggressive liquidity provision would be inflationary - and this is all speculative, anyway, since we have no idea what the ECB may do - is whether the velocity of money declines fast enough to counteract the rise in the quantity of money. I wonder if that trick can be played twice; surely the velocity of money hasn't yet recovered from the last thrashing or we would have inflation already.

But supposing all of these things are possibilities, I wonder why U.S. inflation is still expected to be so much higher than European inflation. I wrote last week (here) about the fact that 10y U.S. inflation swaps were projecting 2.80% compared to 2.15% on the Continent. As of today, it is 2.70% versus 2.16% but the same logic applies. If you want to be long inflation, then European inflation seems to be a better value to me.

Things seem to be unraveling a little bit, but it may be premature to say that. It is never too early to head for higher ground, of course, but we should remember that with Europe mostly closed yesterday for May Day this was the first opportunity that investors there had to express a view on the Greek rescue package. Perhaps this is a one day thing. However, as I said - it is never too early to head for higher ground, and there have been enough reasons to be cautious recently.

There are still lots of bullish economists, and they're very clever. If the economy survives this blow and continues to recover, they can say that they predicted as much; if Greece, or the oil spill in the Gulf, or some other event brings down the economy or just the market they can say "well, no one could have foreseen that." That is what they said in each of the last several recessions.

But an economist who is forecasting an economic trajectory without giving some sense of the risks to that forecast doesn't understand the economist's role, in my view. As an investor, I can't possibly invest only on the basis of the bullish case, even if that is the most likely case to a prognosticator. Investing is about managing uncertainty, and what I want to hear from the economist is, what are the error bars like? What things could derail your forecast? What are the known unknowns, and how much does it matter how they develop? And in the context of the state of the economy, what is the likelihood that the next "unknown unknown" will be a negative event, compared to a positive event? (That is: when everything is going right, the best bet is that the next bolt from the blue will be a bad thing; when everything is going poorly the best bet is that a bolt of the blue could make things better).

An honest economist who answers those questions right now would say, "heck, there are some positive things that could happen but most of the things that are most likely to occur that are not in my forecast are bad things: Greece defaulting, Greece leaving the EU, interest rates rise with or without Fed action, banks pull back credit again..." The economist doesn't need to forecast that Greece is going to default - that's where you bring in the guy who trades Greek bonds. The economist just needs to forecast that sh-t happens. The difference between a good economist and a bad economist is that the former forecasts that sh-t happens, while the latter uses the fact that sh-t happens to explain deviations from his forecast after the fact.

Speaking of economists, the bow-tied set is forecasting ADP tomorrow will rise from -23k last month to +28k. That is a lower forecast than they entered last month with (+40k), which is interesting. The ADP is in some sense a little less important this month and over the next couple of months simply because it doesn't include Census workers, and that's a big portion of what job growth will be. In another sense (the one that the market probably doesn't care about, but economists should), the ADP is perhaps more important than usual since it isn't polluted by one-time public-sector hires and so perhaps gives a truer reading of the underlying trend of private payrolls.

The Treasury also holds its quarterly refunding announcement. Be aware that some auction sizes may actually be cut at this refunding; while that is not likely to be a permanent improvement (unless the government suddenly stops running trillion-dollar surpluses) emphasis will probably be carefully placed to imply that this is a big deal. It's all marketing, of course, and with this many billions they better keep doing a darn good job of marketing.

 


 

Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
E-Piphany

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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