Oh Rats

By: Michael Ashton | Wed, Aug 11, 2010
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Foreword: I need your help! Please read to the bottom of the post and participate in the poll: the bigger the sample, the better!

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Stocks did actually decline today. The decline started last night; the conventional explanation is that investors were discouraged by the Fed's dour outlook (the Bank of England also cut its growth outlook, today). Volumes were light (although Wednesday's volume was the highest of the month), but the vector was clear and the arrow pointed downward. Bounces were feeble, although that is doubtless due to the fact that it's August. The S&P index fell 2.8%, and the VIX rose to a level last seen in mid-July.

While I think the proper level for the indices, if the Fed is going to stoke inflation, is lower (the result of lower earnings from slower growth combined with lower multiples associated with higher inflation), I don't think investors were selling because of a fear of inflation. They sold because they're worried the Fed may be right about deflation. Look at the dollar: it rallied hard, despite a very weak Trade report (more on that in a monent) that would ordinarily cause the unit to sag. Look at the bond market, where yields on the 10y note fell to 2.69% despite a $24bln auction and the 30y yield fell to 3.93% as well. And of course, look at the inflation curve where inflation swaps dropped 4-5bps across the curve.

So the equity market had the "right" response, but for the wrong reason. Deflation isn't our problem, inflation is (or will be, if the Fed pursues QE as they seem bent on doing).

The Trade Balance was much worse than expected, and not just because imports were higher. If the deficit is expanding because we are importing more, that's not so bad because at least it signals domestic demand is okay. Imports rose 3%. But exports fell 1.3%, the worst performance in more than a year. Sputtering global growth is bad news for everyone. The big miss on the Trade Balance for June implies that the GDP figures for Q2 will need to be revised substantially lower (recall that GDP = C + I + G + (X-M)). I haven't seen the extent of the revisions yet, but I noticed that one shop lowered not only their Q2 figure but also their Q3-4 figures since it is harder to envision a strong second half if the first half was already fading.

There has been building a not-so-subtle tension between the bond guys, who apparently saw weak growth ahead and priced yields accordingly, and the equity guys, who saw sunny skies, kittens, and hugs. It looks like that disagreement is being resolved right now in favor of the bond guys, although it helps that the Fed is going to be buying about $18bln in Treasuries and TIPS (mostly the former) over the next month.

This is about more than just Fed buying, however. Nominal yields can be low either because inflation expectations are low or because real yields are low, or both of course: the Fisher equation says (1+n)=(1+r)(1+i), where n is the nominal yield, r is the real yield, and i is expected inflation over the horizon. In the teeth of the crisis, in late 2008, real yields were very high and implied inflation very low; when nominal yields plunged it was mostly because expected inflation was dropping as the market priced in deflation. Real yields remained fairly high, partly because deflation makes for pretty high real yields.

But now, real yields have fallen to within a whisker of the all-time lows at the 10-year point (see Chart, source Bloomberg). They reached those lows during the Bear Stearns crisis, when the extent of the housing slowdown was becoming apparent.

10-Year Real Yields near all-time lows
10-year real yields are near all-time lows

Real yields are not that low again because the Fed is restraining nominal yields. The Fisher equation implies that movements in nominal yields are an effect, not a cause, of movements in real yields and inflation. Real yields are low right now because there is slack demand for capital, and they are a symptom of economic malaise. Low real yields will also be part of the cure, of course, as an automatic stabilizer in the same way that low oil prices in a recession help stabilize growth. But the bond market is telling us that investors think real growth will be low not just for a year or two, but for a long time.

Thursday's Initial Claims data may recall this to mind. Remember that last week saw a wholly unexpected jump to 479k. The consensus expects a retracement to 465k, which strikes me as a little timid if economists still thought we were in an improving trend. Evidently, confidence in that fact is wavering.

Damage has been done technically to the stock market, and I expect a return to the 1040-1050 level on the S&P at least and perhaps a deeper pullback than that. Bonds may be getting a bit ahead of themselves, but it is hard to believe that we won't see a re-test of the 2008 lows near 2.05% on the 10y note. That is a change for me, incidentally. I still think the secular worm has turned, and we will ultimately see higher rates, but bond bears are on the run for now with the strongest seasonal period of the year (Sep-Oct) approaching quickly.

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I want to ask a favor of readers of this column. I have been working on a paper recently and I want to test a hypothesis I have. I'd like to take a (very unscientific) poll about your perceptions of what inflation is like for you. Below you will find a poll I've created, and I'd appreciate it if you'd take a few minutes to reflect on your answer and to record your perceptions. To quote Count Rugen in The Princess Bride as he begins to torture Wesley:"and remember, this is for posterity so be honest." I appreciate your time. If you'd like to help further, feel free to post the direct URL for this poll - http://poll.fm/25auj - to friends, family, and Facebook. Thanks a lot!

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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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