I Don't Know Why They Swallowed The Fly

By: Michael Ashton | Sun, Nov 14, 2010
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I waited to write my "Friday" comment until Sunday for a couple of reasons, the most important of which was that I wanted to see how the European drama played out over the weekend.

On Friday, the rumblings from the Continent were not the main cause of the stock market's 1.2% drop, or the reason that bonds fell and the 10y note yield rose to 2.79% (the highest in 2 months). Bloomberg said that these things happened because China might raise interest rates. Talk about the tail wagging the dog! The Chinese central bank gets more respect in U.S. markets than our own central bank!

Commodities set back hard on the fear that slower Chinese growth lowers the future demand for every sort of good. Oil fell below $85 from what had been 6-month highs near $89. Sugar fell 11.6%, and Corn, Beans, Silver, Nickel, and Zinc were all down more than 5%. Every commodity included in the S&P GSCI declined. That index had a bigger fall back in August when the weak skein of economic data showed up, but since QE2 had been proposed it hadn't seen a meaningful weekly setback (see Chart). This drop occurred just after the index reached a 50% retracement of the collapse seen in the financial crisis, and it should be noted that it happened with the dollar unchanged on the day!

Commodity Index Weekly
The commodity drop isn't that much in the grand scheme. Hard to believe we're only halfway back!

The recent pressure on Irish and Portuguese debt, in particular, started to percolate into something more on Friday, but it took until 6pm on Friday to erupt into a rolling boil. Earlier on Friday, European bonds rallied after the finance ministers of France, Germany, Italy, Spain, and Britain issued a joint press release. The market recently had become concerned because recent debate about the "future permanent crisis resolution mechanism" had suggested there ought to be some "sharing" of the risks by the private sector. Of course, when the government starts to talk about the private sector "sharing" the costs, the first reaction is to grab for one's wallet and make sure it is still there; the second reaction is to make sure you are not part of the "private sector" in the market being eyed.

All of this may be confusing to the reader who doesn't follow the European soap opera on a regular basis...like me. I thought the crisis was resolved six months ago, with the establishment of the European Financial Stability Facility (EFSF) backed by €750bln in guarantees by the member states and the IMF? Remember, the size of the facility was designed to be so large that its mere announcement would "shock and awe" the crisis into receding, and it seemed to work, for the extended period of six months (€750bln doesn't buy what it used to!). What has happened to that money that we now need private sector involvement? Could it be that member states are feeling a little bit queasy about the size of the commitment, since it looks like the facility may actually have to start disbursing more funds?

But, not to worry. The joint press release by these finance ministers declared:

Whatever the debate within the euro area about the future permanent crisis resolution mechanism, and the potential for private-sector involvement in that mechanism, we are clear that this does not apply to any outstanding debt and any program under current instruments. Any new mechanism would only come into effect after mid-2013 with no impact whatsoever on the current arrangements. The EFSF is already established and its activation does not require private sector involvement. We note that the role of the private sector in the future mechanism could include a range of different possibilities, such as a voluntary commitment of institutional investors to maintain exposures, a commitment of private lenders to roll-over existing debt or the inclusion of collective action clauses in future bond emissions of euro area member states.

You can see why bondholders might get the shivers. What exactly does it mean to have backing from the EU, if the holders of those bonds might someday be required to "share" the cost of a bailout? That sounds an awful like a default. The press release seeks to calm these concerns by reassuring investors that they are in fact protected by the EU crisis resolution mechanism...at least, until mid-2013. (You can see more about this story here.) It had its intended effect; Irish and Portuguese bonds rallied as some holders decided (I suppose) to wait until early 2013 to get out of their positions. Good luck, I say. If this whole debate doesn't make a bondholder wonder about the shifting definition of the "crisis resolution mechanism" and the quality of the support from the EU, then that bondholder is acting more like an equity holder and focusing on return, rather than focusing on the question of the return of principal.

This was the state of play on Friday afternoon, with stocks and bonds down, the dollar stable, commodities taking a licking, and periphery Eurozone bonds rallying.

Then, at 6pm on Friday, this headline crawled across the Bloomberg ticker: "Ireland said to be pressed by European officials to take aid."

Now, Ireland has said quite loudly that it doesn't need aid since it is funded through mid-2011. It appears, though, that those calculations do not incorporate the potential need to recapitalize the two large Irish banks that the government has now assumed responsibility for; Ireland may be hoping that those entities can raise money in their own names with the sovereign guarantee behind it, but realistically the sovereign guarantee isn't carrying much weight - so if those banks need money, it will have to come from the Irish government.

And if the Irish government therefore needs money, it will have to come from the EFSF.

And if the EFSF needs to disburse money it will need to come from the EU nations.

And I don't know why they swallowed the fly...perhaps they'll die. (And now, through the magic of YouTube, Mister Burl Ives: link)

The weekend has brought many headlines about what is going on behind the scenes at the moment. With the curtain still down, all of these reports are just speculation but everybody seems interested in getting ahead of this crisis before it simply melts down. On Sunday morning, the latest headline is that Germany is pushing Ireland to seek aid, while Ireland continues to declare it doesn't need aid (it should be recalled that the Greek crisis followed roughly this same script). Of course, Portugal asked just the other day about a clarification about the crisis mechanism, but seems to be second in line this weekend.

Pressure on the European Union continues to increase. It flabbergasted me back in May that investors were willing to take the EU's statement that "all is calm" as sufficient evidence that all was calm, but I wonder how much longer investors can be assumed to be gullible. The old maxim is that one's reputation doesn't behave like a boomerang: once thrown away, it doesn't come back. The bond markets have always acted like this rule didn't quite apply (see, for example, emerging markets née LDC debt, high yield née junk bonds, JM Advisors née JWM Partners née Long-Term Capital), but it seems to me dangerous to ignore. We will see, perhaps as early as Monday.

Also on Monday, Retail Sales for October (Consensus: +0.7%, +0.4% ex-auto) is supposed to put in another respectable showing, and the Empire Manufacturing report (Consensus: 14.00 vs 15.73 last month) is supposed to retain most of its surprising jump last month. None of this is important if Europe curdles.

In inflation-related news, I know that I will get questions regarding this story about how a "secret Wal-Mart survey" shows that inflation is already here so let me address it. I have noted for a very long time that ex-housing, prices of many classes of goods are already rising. I have also illustrated (see for example my paper here) why inflation feels higher even than that. So it isn't terribly surprising to me that if one takes a selection of small, frequently-purchased goods that one will find there is some inflation! It supports my main thesis. At the same time, it bears noting that the consumption basket in this study wasn't designed to look like the entire consumption basket (which would have to include other big things like housing, medical care, tuition, cars which are not available at WalMart...so far). So the survey is helpful in highlighting inflation in one part of the consumption basket but shouldn't be taken as having any more weight than the BLS measure. In fact, I suspect that if one took the item-level indices from the BLS and combined them in the same proportions as this researcher did, you would get a similar answer.

And this, I suppose, is the point I want to make. Careful observers will agree that in a broad sense inflation is already growing in a meaningful way if you take out shelter. But that doesn't mean the BLS is cooking the books and making up numbers as some people will claim. It should be noted that even this study, focusing on things that are commodity-sensitive and that we all agree have been inflating, computes much less inflation than the ShadowStats conspiracy theorists do. The main thing I want is to have the conversation about inflation while working from common, agreed-upon premises, and in this sense the Wal-Mart survey contributes to the discussion while the ShadowStats guys don't.

 


 

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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