Turbulent Flows

By: Michael Ashton | Tue, Nov 16, 2010
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With the holidays rapidly approaching, it seems the market is striving to get the volatility out of the way as soon as possible. Tuesday was one of those days when the under-the-water turbulence (that I recently referred to in these terms) comes boiling to the top.

At low rates, a fluid's flow may be laminar; at some point, as the fluid's rate of flow increases, it turns turbulent. The flow rate today managed to exceed the critical point, and suddenly things appeared to be growing less predictable.

Ireland was one obvious source of concern. Today, a subtle change took place as Irish 10-year yields rose 29bps. Until now, although there were clearly behind-the-scenes discussions about market conditions, Ireland staunchly denied that it had any need for additional funds before the middle of next year. Today, the Irish government conceded that these discussions were taking place, but Irish Prime Minister Cowen attributed these discussions to circumstances outside of Ireland:

"The turbulence in the markets over recent weeks has been about issues of wider concern than Ireland's situation. It is appropriate therefore that we discuss with our partners, as we are, how these issues should be addressed."

See, it isn't about Ireland but rather about the general turbulence in the markets...which just happens to come knocking at Ireland's door. EU Economic Minister Olli Rehn said the problem was in Ireland, but attributable (of course!) to those darn bankers. He said:

"The (European) Commission, together with the ECB, the IMF and the Irish authorities, are working in order to resolve the serious problems in the Irish banking sector."

Now, the fact that Ireland is running massive deficits and undertaking austerity measures that will probably make things worse in the short run is conveniently overlooked. After all, despite all of those problems, Ireland was funded through the middle of next year until it had to bail out its banks. The Irish government had painted itself into a corner and made it almost impossible to accept help without admitting defeat; this nuance change allows it to save face by pointing out that it would have been okay but for the problems with Irish banks.

The same basic process happened with Greece earlier this year: there is no problem. There is a problem but it isn't a bad one. There is a problem but it is not about us. There is a problem but we can solve it. Okay, we will accept some help just so that markets can calm down. Well, maybe we do have a little problem. Actually, the problem is somewhat worse than we said. Help. Now.

And speaking of Greece, that saga is not yet finished either. Greek bond yields rose 21bps (for the 10y) as Austria threatened to withhold payment of its next tranche payment (due in December). This is one reason that the "shock and awe" deal back in the early summer never seemed very credible to me even though the market loved it for a few months. Each country in the EU - and there are a couple of dozen - needs to write a check every time Greece needs another tranche. In this case, it is easy for Austria to put up a fight, because Greece is not meeting the targets they needed to with respect to cutting the deficit. Austrian Finance Minister Josef Proell said that the current progress "doesn't give us any reason to approve the December tranche."

So why didn't the EU just collect all of the money up-front when they passed the hat for Greece? The answer is obvious: if they had demanded that governments write checks back then, they couldn't have gotten the unanimous vote they required. Some governments went along, assuming that it would be politically more palatable to write checks later "once things calmed down." But what were the odds that all of the EU members would be able to write the checks later? Nearly nil, I would say, and now we are starting to see how rotten that deal was.

Pressure will be brought to bear on Austria. EU President Van Rompuy pulled out the superlatives today when he said "We are in a survival crisis. If we don't survive with the euro zone we will not survive with the European Union." This seems accurate, and scary considering that two or three weeks ago no one was worrying much about this.

Turbulent flows are inherently chaotic. They will form unpredictable vortices that impede and redirect the flow. In a laminar flow, the transit time of a given molecule of the fluid is highly predictable and distributed normally; in a turbulent flow, the transit time of a given molecule is highly unpredictable. We anthropomorphize such flow: we call the rapids "angry" waters. Right now, the waters are angry.

The dollar loves the EU turmoil, and strengthened again today. Stocks, not so much: the S&P dropped 1.6%. The decline of the indices from the highs is not yet very dramatic, but now all of the oscillators have turned and it will be much harder to rally back through the April highs now that momentum has flagged.

Bonds sold off, and then rallied to end modestly higher into the close. There were dueling Fed speakers today, with one (Bullard) implying that there was no guarantee the Fed would use the full $600bln they have allotted and another (Rosengren) that he "fully anticipate(s)" the Fed will use the full charge. In fact, they both said almost the same thing: if the economy booms, they won't need to spend all the money. They merely accented the statement differently.

But the bigger news Fed-wise was that there is a strengthening move afoot to change the Fed's mandate. A group of former Fed and Congressional officials, plus the brilliant Cliff Asness of AQR, wrote a letter to Chairman Bernanke imploring him to stop QE2 before it blows up into serious inflation. The story is here.

At the same time, Congressmen Corker and Pence introduced a bill that would replace the Fed's "dual mandate" with one that focused only on inflation. Helping the bill is the fact that Rep. Barney Frank, who routinely is on the dumb side of history despite being generally perceived as one of the smartest Congressmen in terms of raw IQ, said "The notion that the Fed should be indifferent to unemployment is a terrible idea, damaging to the economy." Since Mr. Frank is usually wrong, this is good for the bill.

Of course, saying the Fed shouldn't be indifferent to unemployment is like saying the Fed shouldn't be indifferent to the plight of the Giant Panda. Sure, but the Fed can't do anything about either. (Okay, so perhaps because of money illusion the Fed can do something about unemployment as a side-effect of monetary policy. But managing to the side-effect seems absurd).

This seems as good a time as any to state that I completely support the notion of narrowing the Fed's mandate to one it actually can do something about. In fact, in my book (by the way, have you considered buying an autographed copy as a holiday gift?) I devote the entirety of Chapter 4 to "Fed Problem 3: An Impossible Mandate."

"The multiple prongs of the Fed's mission are, unfortunately, significantly in conflict. No, that's not strong enough: as practiced, they're inherently inconsistent."

And, later in the chapter, I edit the first bullet point of the Fed's mandate statement this way:

Conducting the nation's monetary policy by influencing the money and credit conditions in the economy in pursuit of full employment and stable prices.
[Insert] Supervising the credit conditions in the economy and conducting monetary policy in pursuit of a stable monetary environment in which the natural economic cycle can play out.

So, needless to say, I am in support of the Corker/Pence efforts, although I cannot speak to the actual bill since I have not seen it.



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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