Do As I Say, No Matter What I Do

By: Michael Ashton | Thu, Nov 4, 2010
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On Thursday, the markets acted as if they were surprised by the Fed's action yesterday. Stocks leapt higher, along with bonds and (especially) commodities as the dollar declined to an 11-month low. Oil rose to nearly a 2-year high in response, and I hardly need to tell you what happened to gold and silver.

But the Fed action was very close to what was expected by the majority of observers. A few well-known shops expected more (Goldman was looking for up to $2trillion). I point this out because today's action is either a further rebuke of the efficient market hypothesis (as if one was needed), the market is acting on what it perceives is new information, or there is manipulation going on. Let us stipulate that the Fed's actions were approximately as-expected: they declared they will buy around $500bln (actually $600bln, but over a longer period of time than was expected, and they included an "out" clause in the statement), that they will buy only Treasuries, and that Kansas City Fed President Hoenig dissents.

So what else is new that might explain the market reaction? Let's look around.

Well, in the last couple of days Australia and India both raised rates, while the UK did not add anything to its own quantitative easing program. If anything, this last point could be considered a disappointment, since one possibility was that central banks might ease in a coordinated fashion rather than simply letting the dollar go. The relative ease of central bank policy in the U.S. compared to the rest of the world might be considered a positive for domestic securities, but with the dollar also under pressure? Moreover, inflation swaps actually declined today (with the exception of the front end of the curve, where the rise in energy prices pushed 1y and 2y swaps higher), which is not exactly what you might expect if domestic central bank policy was easier than expected.

On the economic data front, Initial Claims were weaker than the majority of economists forecast. Claims rose to 457k. I suggested yesterday that this was likely, since the BLS last week stated that seasonal adjustment issues had led to the surprising decline in Claims. But economists can be very gullible in the direction of their pre-existing bias, and economists have been looking for a recovery in Claims for a long time. Maybe the job picture is improving some, but one week below 450k does not a trend make. We cannot reject my current null hypothesis that Claims continue to float along at a steady run-rate of 450-475k (see Chart). So Claims fails as an explanation because it is in the wrong direction to help equities, and it is one day in front of Employment anyway. The Productivity and Unit Labor Cost data fail as an explanation because those are pretty useless economic data until roughly the 25th revision. We don't know how to measure either of these quantities well, and they rarely move markets.

Initial Jobless Claims
Initial Claims continues to do nothing important.

Perhaps missed, because of our tendency to focus on domestic issues to the exclusion of others, until these other issues are thrust in our collective face, was the fact that some European bond markets did not echo the US market rally. Specifically, while most European bond markets did rally, the following ones declined: Italy, Spain, Greece, Portugal, and Ireland. (Norway also, and certainly the Norwegians hope that is a coincidence). You may recognize that group as being the PIIGS countries. The rumors today concerned Ireland and the EU, but when one of the PIIGS countries gets pressured they all seem to look suspect. Many people - and I am one of these people - believe that the European sovereign debt crisis was not solved with the EU's hollow pledge of support for Greece and the ECB's decision to buy bonds of PIIGS countries. Many of us feel there is a second act coming. Is that act hastened when the Euro strengthens against the dollar, thus weakening an export sector that absolutely depends on the 'States? Absolutely. A modest dollar retreat/Euro strengthening isn't very important, but since the crisis "ended" in early summer the Euro has gone from $1.23 to $1.40 and today moved up over $1.42. Fairly soon, the ECB will need to join the Fed or watch the European economy finish what it started.

Still, this didn't feel much like a flight-to-quality trade, and anyway it doesn't explain why equities launched.

I suspect that no small part of the rally is related to Chairman Bernanke's unprecedented op-ed in the Washington Post today. It is unprecedented because until a few years ago, Federal Reserve officials observed a silent period within a week or so of the meeting (both before and after). That policy has relaxed in recent years, but the spectacle of the Chairman himself writing a piece to explain what the Fed did and why it did it the day after the FOMC issued an official statement that is supposed to explain what the Fed did and why it did it is embarrassing and, frankly, inexplicable.

In this op-ed, Bernanke explained the mechanism by which he believes QE2 works:

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

I specified "by which he believes," because if the Chairman is writing his own explanation without the imprimatur of the entire Committee, it implies that the Committee doesn't entirely agree with this explanation. Either they aren't unanimous in believing that all of those transmission mechanisms are operative, or they aren't generally in agreement in believing that all of these are necessarily good things or should be targets of the Fed. For example it isn't clear, and remains a topic of heated debate, whether the Federal Reserve ought to target asset prices. In this article, Bernanke makes clear that they think this is an important mechanism and certainly implied that pumping up the stock market isn't an unwanted effect.

And so perhaps the markets are not reacting to what the Fed did but to what the Chairman said. He came very close to declaring that the Bernanke Put is real. If higher stock prices are the mechanism by which the Fed encourages economic growth, and if the Fed is required to encourage economic growth, then et sequitur the Fed must support higher stock prices.

The argument is horribly flawed, of course. Lower corporate bond rates and higher equity prices encourage investment, true. They encourage mal-investment. They encourage companies and individuals to make decisions based on the availability of too-cheap capital. And that, as we have seen over and over for the last decade or two, means that ultimately a great deal of that capital must be destroyed.

If it were true that we could get all of the things that Bernanke promised without any costs - and he certainly didn't mention any costs - then why indeed doesn't the Fed pursue QE2 constantly? There must be something that the Chairman isn't telling us. That something concerns the importance of sound money and markets that clear at prices and yields which represent a fair exchange of risk for expected reward. He kinda left that part out. Maybe he meant to say that, but it was edited for length. But at some point, we need to stop giving this guy the benefit of the doubt. (He is, though, giving me a lot of material for the sequel to my book, Maestro, My Ass!)

I think, though, it is likely that today's rally resulted not from what the Fed did, but by the semi-promised reaction function implied by Bernanke's article.

If true, then what are the investing implications of this observation? If the Fed is pumping stocks, and intends to keep them from going down and inducing a negative wealth effect, shouldn't we jump on board? This is a difficult call, because of a couple of non-trivial facts. Fact #1: The work of the bear market was clearly never complete if people are more afraid of missing the next bubble than of avoiding the next bust. Fact #2: The Fed has shown that despite their best intentions, they are incapable of actually averting a crash, deferring a crash, or slowing a crash when a market crashed from an overvalued state. This should not be a surprise: for all the Fed's trillions, the market is bigger.

I think it makes little sense to buy bonds here. The fact that inflation expectations declined today makes me wonder if nominal yields haven't already fallen as much as the expected buying program should make them. I pointed out recently (link) that while nominal yields haven't budged since August, real yields have fallen and inflation expectations have risen. If nominal yields are falling further but real yields are not, then it implies the nominal market is merely marking up prices to sell to the greater fool (the Fed). I don't want to join them.

Stocks are a more difficult conundrum. If the Fed wants 'em higher, then they may well be able to push them higher for a while until they crack and collapse. But the time to crack and collapse is inherently unstable (for two excellent explorations of this phenomenon, see Why Stock Markets Crash: Critical Events in Complex Financial Systems and the more-accessible Ubiquity: Why Catastrophes Happen). I am naturally risk-averse, although even investors with a greater risk tolerance should also respond to uncertainty by decreasing bet size (see my discussion of the Kelly Criterion here). On the other hand, has Bernanke's Bid increased uncertainty, or decreased it? Arguably, the latter. So perhaps I ought to increase bet size, and protect against catastrophe with options that getting steadily cheaper (the VIX today declined to new post-April lows).

I believe, however, that I will wait a bit before doing that. Today's run by the S&P means that the market has just reached objectives from the breakout of the June-August consolidation period between 1040 and 1128 (projects to 1216 or so; if you think the pattern was an inverted head & shoulders - which I don't, since the pattern was bigger than the decline into the pattern - then the projection is 1246-ish) and met the April highs. This seems to me to be the wrong price-time to be putting on more risk. I'll buy a little higher, or a lot lower.

And, of course, I continue to invest in commodity indices and corporate inflation-linked bonds.

And with all of the foregoing, I have run out of much space to discuss the Employment figures tomorrow. The consensus is looking for an 80k gain in private payrolls (60k overall), with an Unemployment Rate stable at 9.6%. Remember, however, that last month the 'Rate almost declined, barely missing being rounded down, while economists had expected an uptick to 9.7%. Lots of quirky things have been happening with the labor force, but so far it certainly looks like there are no signs that a downtrend in the jobless rate is in place.

Last month's Employment data were dismal, but the market reacted positively because weak data promised a better chance of QE2. Another weak showing, however, is less likely to provoke a similar reaction with stocks at the highs for the year.



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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