Cool The Engines

By: Michael Ashton | Wed, Nov 3, 2010
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It will take some time for investors to finish reading the huge volumes of analysis that will be and have been written about the events of the last 24 hours. In an attempt to add to this pile, I offer the following.

The election results were qualitatively as-expected. The Republicans won a much larger margin in the House than most observers expected, but failed to overtake Democrats in the Senate. In my mind, though, the biggest positive for investment conditions were the changes in the state houses and governors mansions, which in several cases swung decidedly towards the more conservative (which is not necessarily to say "conservative") party. There will be some shrinkage of government at the state and local level, regardless of what happens at the federal level; moreover, Republicans will tend to favor less spending and lower taxes - or, more realistically, lower taxes than would otherwise be the case. At the federal level, this is less likely to happen, because the Democrats can protest that Republicans are just being obstructionists who refuse to compromise (not that they themselves would ever do such a thing), while the party on the other side of the aisle has every incentive to push aggressively conservative plans that are wholly unpalatable to the Administration.

I found disheartening the President's speech today, because he seemed to dismiss those who think cutting taxes is the right way to stimulate the economy, and appeared to suggest that both cutting some taxes (but only for the "middle class") and increasing spending on some programs was the right approach. Assuredly, that way lies national bankruptcy. It is also hard to tell if the President truly understands the implications of the election; from his speech today it appeared that he did not. He said that his focus over the next couple of years is "making progress" on the economy, which he saw as the message from election night (I guess the focus over the last couple of years was creating grand new entitlements and sticking it to the wealthy). He got close to an epiphany when he said that the People "felt like government was getting much more intrusive into people's lives... but this was an emergency situation." He seems not to understand that one of the main reasons people are concerned about the government getting bigger and more intrusive - both of these, not just the intrusiveness, are causes for alarm for most people - is Obamacare, which (I don't think) had anything whatsoever to do with the "emergency situation" that triggered the stimulus bill and the bailouts. After all, at least some of the latter can be legitimately laid at the door of the prior Administration... but Obamacare is all his own, and a big impediment to making budgets rational over the next few years. I expect that Obama will be willing to "compromise" and "make progress" any time that legislators want to agree with him, but he certainly didn't seem to be very chastened by the election result.

Still, the change in representation at the local level, together with the implied threat to legislators who pursue aggressive Socialist agendas, are reasons for optimism.

One pundit last night raised an interesting point, though. I was beginning to be happy at the thought that the great increase in the quantity and variability of business regulation (the latter being more damaging to future growth) might be ebbing, and perhaps we may see more stability in the legislative and regulatory framework. That is the positive promise of "gridlock," after all - while inferior to positive legislation, the expectation of no legislation is probably the next-best thing. But this pundit observed that the Administration may see gridlock in Congress as his carte blanche to implement his programs through executive orders and additional regulation from his branch. I hope this is wrong.

All in all, though, the trajectory of government clearly changed last night. Because of the gains at the sub-federal level, I am more optimistic about the economy (at the margin); unfortunately, I think the equity market already over-discounts my optimism. Stocks are too dear, especially as interest rates begin to rise and profit margins retreat to historic norms. I think, in short, that the investing climate improved last night, but it still underwhelms me.

Turning to the Federal Reserve, the Committee announced this afternoon that the Fed will buy up to $600bln in Treasury securities, around 5-6yr duration, between now and June, in addition to reinvesting an estimated $250-300bln in maturing securities and coupon receipts. Where I was surprised was on the magnitude of the reinvestment requirements, actually. Combining those amounts, $850-900bln over the next 8 months is actually slightly more than the $100bln/month that is roughly what is perceived to be the operational speed limit of the Fed's LSAP program. In other words, in terms of the amount of money being promised, this is about the maximum possible over that time frame. The $600bln is what matters, not the $900bln, but the reinvestment requirements created limitations I hadn't realized were there.

Except, however, that the Fed was "crossing its fingers." In stating the goal for asset purchases, the FOMC also stated that "The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability." Since this is already at the maximum pace that can be handled by the Fed, this is essentially saying "we're going to buy bonds until we decide not to buy bonds." It is a promise, therefore, only to the extent of about $75-100bln that will be executed between now and the next FOMC meeting.

This means that there will be extra "convexity" around economic reports in fixed-income, and a dampening of convexity for equities. Strong data will push bonds down not only because it suggests real rates and inflation expectations should rise, but also because it increases the chance that the LSAP might be prematurely arrested. On the other hand, strong data that would otherwise be bullish for equities will have a counteracting effect to consider. In short, being long fixed-income volatility and being short equity volatility is probably the right trade (if you can figure out the weightings!). The VIX agreed with at least half of that, dropping from 21.8 right before the Fed announcement to 19.5 one hour later. (As I pointed out yesterday, though, that's partly because a couple of big events are now behind us).

None of this, in my view, gives any more reason to be long bonds or long stocks than we had yesterday. And we are now devoid of obvious catalysts for further gains in the equity bourses. While the S&P managed to end on the highs of the day and the month and the half-year, it looks to me like one booster stage just fell away, and the next one hasn't fired yet. And I'm not even sure there is a next one.

There was other news, too. In the Treasury's quarterly refunding statement, the department announced that there will be a TIPS auction each month in 2011, always on the Thursday prior to the end-of-month auctions (of 2y, 5y, and 7y securities). The schedule of auctions, by month, will be:

Jan: 10y (new)
Feb: 30y (new)
Mar: 10y (reopening)
Apr: 5y (new)
May: 10y (reopening)
June: 30y (reopening)
July: 10y (new)
Aug: 5y (reopening)
Sep: 10y (reopening)
Oct: 30y (reopening)
Nov: 10y (reopening)
Dec: 5y (reopening)

So there will be one 5y TIPS issue with two reopenings, one 30y TIPS issue with two reopening, and two 10y TIPS issues with two reopenings each. That's a lot of TIPS - around $120bln, depending whose projections you look at, but at least for the next eight months or so it isn't enough.

Remember that we have two TIPS maturing in 2011, in January and April. That represents something like $36bln in maturities, much of which will be rolled into other TIPS. Also, if the Fed adheres to its stated plan for QE2 it will be buying some $22bln itself between now and June. Using Credit Suisse's forecasts for the TIPS auctions, through June the Treasury ought to produce some $82bln in TIPS, of which $10bln comes tomorrow in a 10y reopening. So of the remaining $72bln, $58bln is already spoken for by the Fed and the money from the maturities. That leftover $14bln ought to be pretty popular, and so while I don't expect TIPS to rally dramatically further from here (I did recently sell the ones I owned) I would expect them to be reasonably well-supported for a while.

Also tomorrow, Initial Claims (Consensus: 442k from 434k) will be released, along with preliminary Q3 Productivity (Consensus: 1.0% vs -1.8% in Q2) and Unit Labor Cost (Consensus: +0.6% vs +1.1% in Q2) figures. Be forewarned that the BLS attributed the decline in Claims last week to seasonal adjustment issues having to do with the holiday, which to me suggests that Claims more like 450-460k might be produced this week. In any event, the Employment number is the following day and the ADP release today (about 23k stronger-than-expected) will have investors looking for good news on the job front, so a slightly-weaker Claims number may well be ignored.

 


 

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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