A Bridge To...Another Bridge

By: Michael Ashton | Wed, Nov 17, 2010
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One day on, one day off - the risk shuffle continues. Irish bonds rallied 17bps today, simply because the EU and the IMF have said they are working with Ireland on a rescue plan. Was there a doubt that they would work on a plan? Less comprehensible was the rally in Portuguese bonds. To the extent that Ireland, or Irish banks, or anyone else for that matter, actually gets bailed out, doesn't that mean that there is less money for Portugal? I suppose the fear was that the mechanism might completely break down; this would explain the correlation between these bonds when Ireland-specific news somehow lifts the other PIIGS boats.

Either way, Ireland for a day drifted to the background. This was fine for me, since it also happens to be CPI day. It was also Housing Starts day, and Housing Starts fell to the lowest level since April 2009 (519k); however, as I said yesterday the wiggles here hardly mean anything with the overall level so low.

The October CPI should be the trough print in the year-on-year numbers, as I have been saying for a while. The index certainly made the most of that trough, surprising on the downside for the second month in a row. Headline inflation clocked in at only +0.2% despite the rise in gasoline, but this miss was due to the (more important) fact that core CPI came in at -0.007%. CPI was pulled down by vehicles (-0.4%, echoing the weakness in PPI that I pooh-poohed yesterday) and apparel (-0.3%), which jointly constitute about 10% of the index and more like 12-13% of the core index. But there was broad softness outside of those categories as well. The year-on-year core CPI fell to only +0.6%, the lowest ever.

Yes, that core CPI number is exaggeratedly low because the Housing component of the index has fallen -0.2% over the last year, and Housing is around half of core CPI. But that still means that Core CPI-ex-Shelter dropped to 1.29%, the lowest level since late 2007 (see Chart). By itself, this would suggest the Fed is right to think inflation is a trifle low - although being at 1.3% when the target is 2.0% doesn't really warrant, to me, a $600bln injection of liquidity - except for the small detail that this is almost certainly also the cyclical low.

Core CPI
Core ex-Shelter is at recent lows, but this is also likely the cyclical low.
Source: Enduring Investments

Not only is this index, and y/y core CPI itself, likely to rise because of base effects (that is, the comparisons for the next couple of months will be against the very low prints of late 2009 and early 2010 rather than from the relatively high-and-declining prints of early 2009), but QE2 just kicked into gear and these effects may eventually be felt. Actually, I am reasonably confident that they will eventually be felt; the question is whether IOER slows the effect to a crawl or whether the effect of IOER in a non-crisis situation is different from IOER in a crisis situation. Do take the time to review my math about "what might happen" from last week (http://mikeashton.wordpress.com/2010/11/08/chairman-h-e-double-hockeysticks/).

Because we are at the inflection point, QE2 has begun and yet the CPI reflects the "old, pre-QE2 regime." In a very real way, today's CPI report is old news, and I am more interested in the near-term with...can you imagine?...the money supply figures that come out every Thursday afternoon. The 13-week and 26-week rates of change were already rising (at 7.3% and 6.2% annualized, respectively) prior to the implementation of quantitative easing. Of course, those rates jump around a lot, but I will be watching especially attentively over the next few weeks to see whether there is any sign of lift-off in the growth rates.

On Thursday, in addition to the post-close M2 figures, Initial Jobless Claims (Consensus: 441k from 435k) will be released in the morning. Recent economic data have been weak: Empire and Housing, PPI and CPI. Claims, on the other hand, has shown a modest strengthening although it seems too early to call it a trend. At 10:00ET, the Philly Fed index for November (Consensus +5.0 from +1.0) ought to be scrutinized carefully given the reading from the Empire survey. Also at that time, the Mortgage Bankers Association will release the Q3 statistics on delinquencies and foreclosures. In Q2, the rates were 9.85% and 4.57%, respectively. For all the talk about the improving credit picture, the evidence has yet to show up in a meaningful decline in either delinquencies or foreclosures. Flat is nice, but we must remember this is flat at depression-like levels (see Chart). Any meaningful economic recovery will be accompanied by a significant decline in these ratios, and such a decline is also a sine qua non for getting housing inventory under control and giving home prices a chance to rise in the future.

Deliquencies
Delinquencies haven't fallen despite the 'return to growth.'

A sideways move in stocks does not impress me. While I think it is fairly likely that "a rescue" gets announced for Ireland soon, it will be interesting to see what sort of credibility the market gives to such a package. After all, the Greek "rescue" package didn't work, and the "backstop" did not prevent a run on Ireland. It is an almost-certainty that a rescue will be announced at some point, with lots of smiling and cheerful predictions that the market can now calm down. The last such rescue calmed the market for about four months. How long will this one last? Or will the market go ahead and fast-forward to the next calamity, to save the four months?

I remember during all of the anthrax scares, the initial market reaction to a report of anthrax being found or suspected was dramatic. After several such reports, the market reaction grew markedly less, until after a while the market would immediately move in the opposite direction on the announcement, since everyone knew that if you bought on the rumor, you probably wouldn't be able to sell on the news in time. So investors skipped the whole "buy on the rumor" thing. It was remarkable to watch the market "learn," and I am curious to see how the market reacts to this "rescue" that we all know is just a temporary bridge to the next rescue.

 


 

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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