Never Happened!

By: Michael Ashton | Wed, May 12, 2010
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Well, the stock market is back to where it was pre-Thursday, with the S&P rallying some 1.4% today on again-lower volume. There was, for the first time in a while, almost no financial news about Greece (although the unions have called for a strike) and almost nothing about the rescue package, whether the ECB is still buying stuff, which legislatures are approving the measures, or anything else. It is as if the whole thing never happened.

But it did.

I suppose investors may just be waiting for next week, when Greece needs to roll a big maturity, but it is odd to have a "$1 trillion rescue package" (quotation marks used intentionally) fade into irrelevancy that quickly. I guess eventually the trillions lose their meaning.

Now, fixed-income hasn't completely forgotten. TYM0 was -7/32nds, with the 10y yield back to 3.58%, but that was with an auction today. Inflation swaps rose 5-6bps across the curve and gold rallied further. There is a little tension building between the markets on the true implications of the open checkbook.

One threat to the near-term possibility of inflation is the recent behavior of the monetary aggregates. Since the beginning of the crisis, commercial bank loan growth has been in the toilet, and it's still at -5% year-on-year; however, recently the growth rate of the broad aggregates has been declining as well. Over the last 52 weeks, M2 growth is only +1.4%, and M3 within the OECD is at -0.8%. This reining in of money growth would almost smack of hawkish central banking, if it were intentional.

Then why are markets around the world responding as if there is easy money sloshing around the streets? I believe it is because of what monetary authorities have done to reverse the plunge in money velocity.

What matters for inflation prospects is not, technically, the amount of money (M), but the quantity of money circulated in a period of time. We measure that by taking the raw amount of money M and multiplying by the number of times each unit changes hands; this latter is designated velocity (V).

When the crisis first hit, central banks released a gusher of liquidity to counteract the plunge in velocity that happened when risk budgets were being sharply curtailed and money was being hoarded. It was all they could do in the short-term, but if velocity had continued to decline the central banks would have been hard-pressed to keep up. If V declines 20%, then M must increase 25% to counteract that decline (0.8 * 1.25 = 1.0), but if V declines 40% then M must increase 67% (0.6 * 1.67 = 1.0); the further velocity falls, the more dramatic the money-printing needs to be. M2 velocity in 2008/2009 in fact fell 10-11%, which was a lot - and could have been much more - but it was a feasible amount by which the money supply could be goosed.

The fact that it fell only 10-11% is testimony to the aggressive moves by central banks not merely to reliquify banks but also to encourage re-leveraging. I'm not saying that is a good thing, but if you take as your major premise that recessions are bad and must be avoided at all costs (rather than natural cleansing occurrences, as I believe) then, well, it seems it was successful.

So which is better? To have booming growth in M and collapsing V? Or declining M and rising V? Don't answer right away. The advantage of the latter is that it is easier to reverse M than it is to reverse V, because policymakers actually can control the lever for M. Indeed, we can't even observe V in real-time; we know it is related to leverage but loosely. The disadvantage of the latter is that you're sucking away money at the same time that your system is getting levered up, and that would seem to me to risk a sudden breakdown...which would presumably be followed with more M. Does that oscillation - more M, less V, followed by less M, more V, then repeat - dampen over time, or amplify? I don't want to find out.

So what are the implications for inflation? They are complex. My models look at long-term (several year) changes in M because it is reported in something close to a timely fashion while V is not 'reported' at all. But right now, I am wary that the tepid growth in money is sending a false signal because V is coming back with a vengeance if recent bank earnings and returns of fixed-income relative value hedge funds are any indication.

My models had shown a bottom in core inflation to be coming in Q3, and they still do, followed by a sharp jump. Visibility much beyond Q4 is difficult for any model, though, and moreover my models do not strip out housing from core inflation so they are subject to even more uncertainty than usual. That said, they've been doing surprisingly well over the last couple of years. Anyway, if the decline in money growth globally is sustained, then the model will likely show that the Q4 -ish turn that I expect doesn't become a launch but merely an uptrend.

This does not mean that an investor should necessarily eschew inflation-linked assets. If, somehow, the Fed and ECB were to jointly steer core inflation gently back to the 1.5%-2.0% range, then it would be supportive for equities since the best environment for stocks is that of low, stable inflation. Stocks, however, already seem to incorporate this sunny possibility (as well as most other sunny possibilities).

But even if inflation might return to being low and stable, there are good reasons to include inflation-linked assets in a portfolio. Among them:

  1. The main investing goal is to maximize after-tax real returns; this implies that holding real assets tends to decrease a portfolio's real risk (whatever it does for the returns). As Zvi Bodie has pointed out persuasively, being low-risk with one part of the portfolio frees up an investor's "risk budget" to take more active risks with another part of the portfolio.
  2. Along similar lines, I think investors are well-served presently to tilt their portfolios to take relatively less risk since the range of potential outcomes over the next few years is unusually large.
  3. Even if you don't think that inflation is tactically a threat, it may be strategically a threat; in this case you should patiently add real assets when they are less expensive. I think there will be better opportunities to buy TIPS later this summer as weak inflation numbers scare some investors off and the added supply weighs on the market in real as well as nominal rates, and finally,
  4. It is bad practice to eschew purchasing insurance merely because the house isn't currently on fire.

I am not, in short, abandoning linkers. The transfer of debt from private entities to public ones greatly increases, in my view, the odds that monetary authorities will eventually be forced to monetize the debt. Of course, every central banker worth his/her salt will swear that will not happen, but a truly independent central bank does not exist. If the debt threatens to crush an economy, bankers will mix the cocktail they believe they know the hangover cure for: inflation.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

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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