How To Make $1bln And Not Pay Taxes

By: Michael Ashton | Fri, Oct 1, 2010
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I did not write a comment yesterday because I was attending a conference for inflation-linked markets geeks, co-sponsored by Credit Suisse, BNP, Deutsche Bank, Morgan Stanley, Nomura, and UBS. It was very well-done, one of the better inflation conferences I have been to in a while, and it was nice to catch up with former colleagues and counterparties. I will have a little more to say about the conference later, but in case you missed me...

Speaking of inflation, today we got an interesting reading on one indicator that I rarely pay much attention to. The ISM Prices Paid subindex, which jumped this month to 70.5 from 59.0, is ordinarily just a lagged expression of the price of oil (or gasoline) relative to recent averages. The first chart below shows a 10-year time-series of the response to the "prices paid" subindex of the ISM (formerly NAPM) survey.

ISM subindex - 10 years

There is clearly some relationship between oil and Prices Paid!

Not surprisingly, most manufacturing purchasing managers react to changes in energy prices with great speed. The strength of the relationship is illustrated further in the next chart, showing a scatterplot of Prices Paid as a function of the deviation of oil from its recent average level.

Energy Price Chart

Latest point is definitely high.

The latest point is not without precedent, but it is somewhat unusual to be sure. Oil has basically been doing nothing important for the last year, and yet purchasing managers are suddenly saying that the prices they are paying have been rising.

There are several possible explanations for this. The simplest is that this may simply be spurious, and not indicative of anything important. Or it could be that commodity inputs other than energy have been rising... however, it is hard to find another commodity input that is as important to manufacturing and might cause such a spike.

Could this be the result of increases in rents, which some surveys show as increasing lately? Doubtful; again, many manufacturers don't explicitly pay rent... or, anyway, not enough of them do to cause such a move. A final candidate which sounds to me plausible is that insurance costs may have risen recently as insurance companies anticipate the new costs of the health care bill. However, I do not know where to find current data on insurance rates and cannot verify this.

I will say again that I do not generally pay much attention to the ISM Prices Paid subindex. Today it just sort of jumped out at me because it seems at odds with recent price trends (which are, basically, trendless). I doubt the Fed looks at it either, but to the extent they do then it can't help the QE2 possibility. No deflation threat, no QE2, right?

The market didn't care about the Prices Paid figure, nor any other data released today; stocks ended the day with a small gain (+0.4%), probably still driven by the possibility of further quantitative easing (or Large Scale Asset Purchases, LSAP). The notion gained a bit more currency today (ironically) as both Chicago Fed President Evans and New York Fed President Dudley came down on the side of further purchases. I continue to be amazed that we aren't hearing about removing the interest paid on excess reserves. It would hurt the money fund industry; okay, I get that. But LSAP is not likely to have much of an impact on anything but asset prices unless the reserves are released, and they're not going to be released while it is advantageous for banks to hold them. Would you rather let money funds close or the economy go into deflation? If you really think the latter is possible - and Fed speakers seem to believe it firmly - then I don't think it's a contest. Sorry, money funds, but I am sure you'll be back when rates rise again someday.

Now, perhaps monetary authorities are growing concerned about banks again, and want to make sure there are plenty of reserves sloshing about and not necessarily in the real economy. After all, the estimates of the costs of bailing out Anglo-Irish Bank continue to rise and the numbers are getting somewhat disturbing. But while I think the FOMC think of themselves as solid citizens of the world, I doubt they're bolstering our own banking sector because they are afraid of the fallout from Ireland. I could be wrong on this.

After all, in the U.S. we are making money on the bailouts! Well, sort of... the Treasury is booking a $1bln "profit" on the sale of 5% of Citigroup. They realized an average price of $3.93/share in selling the stake, and it was originally seized bought for $3.25/share. The other way to look at the sale - and the way a trader would look at it, from the prospects not the results - is that taxpayers risked $3.25/share to make $0.68/share. That's not a risk/reward trade you want to make very often. And let's remember, that $3.25 really was at risk. It isn't like they could have dumped the shares at $3.00 if it didn't work out.

But anyway, we all have parts of our portfolio we can point to and say "look at the great trade I made." Counting only the winners, as we all know, isn't quite fair. I seriously doubt that the government's aggregate ledger shows a gain when we ultimately include the accounting for the $1.7 trillion in securities bought previously by the Fed, the Maiden Lane structures acquired in the Bear Stearns shotgun wedding bailout, and other TARP investments whose performance no one has seen fit to tell us about. Never mind the value destroyed by the government when they intruded into private enterprise to tell companies how to run themselves (and by propping up GM, make no mistake, you hurt Ford and Chrysler!). However, at least Geithner has one great trade to boast about at cocktails.

I will write next week a little about the inflation conference I attended yesterday. On Monday, only Pending Home Sales and Factory Orders are due out - definitely low second-tier reports especially with Employment due on Friday - and Brian Sack, the head of the Fed's Markets Group (aka 'the Desk') is scheduled to speak at 11:30ET in California. Mr. Sack has given some very clearly-worded speeches in the past detailing the mechanics of withdrawing stimulus (I was never convinced in his assertion that the securities portfolio could be unwound into the market without significant impact, but they were very good speeches and information-packed), and since that's not exactly the concern today it will be interesting to see if he focuses more on the mechanics of increasing the securities portfolio through LSAP.



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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