Reading The T-Leaves

By: Michael Ashton | Thu, Nov 18, 2010
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Some bounce for the equity market is certainly understandable, from a psychological perspective. The market had rallied, basically uninterrupted, for two months and 18% or so without a setback of more than a percent or two. Is it really surprising, then, that the first time there is a mild pullback, some performance-chasers are trying to plunge in? This is fairly routine behavior: "I have a second chance! I missed the rally, but now I don't have to endure the taunting of my friends at cocktail parties." This doesn't necessarily end well, since after all someone is selling securities to these buyers and it may well be the guy who wanted to get out a week and a half ago and then felt "trapped" by the Ireland news. I am also impressed by the chart in Barron's that shows the very high ratio of insider sales to buys. Why would insiders be selling just when aggregate demand is beginning to swell?

To be sure, there was decent economic news today and one can use that to justify the higher prices (and weaker bonds). The Philly Fed index had exactly the opposite message as the Empire Manufacturing index a couple of days ago. Empire went to 18-month lows; Philly Fed matched the highs of the last couple of years. The Employment subindex rose to 13.3 from 2.4; New Orders rose to 10.4 from -5.0. These subindices support the headline, which in the Philly Fed survey is a separate question about general business activity, rather than a composite of the subindices. Maybe this has something to do with the fact that the Philadelphia Eagles scored 59 points this weekend while the Giants were beaten by the Cowboys. (Just kidding, maybe).

Delinquencies and foreclosures both declined to early-2009 levels, and have likely seen their peaks. The declines, though, are not exactly rapid. Some improvement is rates of delinquency and foreclosure is natural, simply because the lowest-hanging fruit goes delinquent and then defaults first. You want to see a rapid improvement, not a slow improvement, in these figures before breaking out the bubbly.

Initial Claims was approximately as-expected, which is to say that it is at the low end of the year's range. It still has not broken decisively lower, but at least it is threatening to.

Now, the problem with all of this as an excuse for the market rally is that the rally happened predominantly overnight. Once the market opened, stocks went sideways and were mostly unaffected by the data. So this looks more like dip-buyers in Asian and European centers and perhaps a second round of excitement about the fact that Ireland is going to get some kind of bailout.

I said yesterday that I was going to be more focused, today and in future weeks, on development in the money supply (which the Fed reports at 4:30ET on Thursday afternoon). You can see why in the chart below, which shows M1. No special prizes if you are able to identify QE1 and QE2 on the chart.

In this edition of "Where's Waldo," you need to find QE1 and QE2.

Of course, M1 is not where the inflationary rubber meets the road. That is in the broader aggregates, which as has been repeatedly documented have not responded as sharply. With IOER in place they may not, but this week's data moves the 13-week annualized rate of change up to 7.66% (see Chart). It will take a few weeks to see any real impact here - the recent rise in the aggregate is actually the slow seepage from QE1.

M2 Rate of Change
M2 starting to look perky again.

Inflation-linked bonds have stabilized a bit after having been beaten badly for about a week. What happened to cause the selloff, which was largely complete before the low CPI printed yesterday?

The story of the bond market since May, seen through the lens allowed us when we separate the nominal interest rate into its constituent parts of a real rate and inflation compensation, is fairly interesting and the actually quite clearly told. Refer to the chart below, and follow along carefully as the chart is pretty busy. The yellow line is the 10y nominal Treasury rate, which dropped 140bps between April and August, flatlined for a couple of months, and then has risen in November. The white line is the 10y TIPS yield; the reddish line is the 10y breakeven (the difference between real yields and nominal yields, which is predominantly inflation expectations). Each has its own scale, which can be seen to the right. Because the scales cover different ranges, two parallel lines on the chart are not quite parallel in reality, but close enough that you can get the gist of what has happened.

Rising Rates
Confusing chart. Read the text closely.

From May until August, the decline in nominal rates was substantially about a decline in inflation expectations. You can see this by the fact that the yellow and red lines trace closely while real rates decline only slowly. From April 30th to August 27th, nominal 10-year yields declined from 3.66% to 2.65%, while 10-year breakevens dropped from 2.40% to 1.63% and10-year real yields fell from 1.26% to 1.02%. So, of the 101bp decline in nominal yields, 77bps came from the 10y breakeven (inflation expectations) and 24bps came from a decline in real yields.

As I have written elsewhere (link), from August 27th until QE2 on November 3rd, nominal rates didn't move much (2.65% to 2.57%, -8bps), but this masked a large decline in real yields (1.02% to 0.42%, -60bps) and a significant rise in inflation expectations (1.63% to 2.16%, +53bps). Clearly, this is what the Fed was trying to do: lower real yields by holding nominal rates down and increasing inflation expectations. They even said that was what they were trying to do.

Since November 3rd, what has happened? Nominal yields have risen 33bps from 2.57% to 2.90%. That is entirely accounted for by a rise in real yields from 0.42% to 0.75%, with inflation expectations unchanged. Put another way, just slightly more than 2 weeks out from the announcement of QE2, half of the decline in real yields that the Fed engineered has evaporated.

Now, if real yields have risen because investors expect growth to re-accelerate, then this isn't an indictment of the Fed. But I think the evidence is more consistent with the notion that investors are expecting the cost of money - which is what real rates are - to rise when inflation rises. Inflation-linked bonds were simply too rich when they were at 0.42% and nominal yields were at 2.57%. The Fed is buying right now, but everyone knows that eventually they will be competing with real borrowers to sell bonds back into the market. This isn't really the Fed's fault, but the consequence of having large fiscal deficits. Investors aren't willing to keep lending money to the G-men at 40bps real yield when the federal appetite seems insatiable.

The fact that nominal rates are rising despite the Fed's pledge to buy $600bln in Treasuries (plus rolling maturing bonds) is amazing. But perhaps it shouldn't be - while direct manipulation of government bond markets is fairly unusual, we have a lot of experience with FX market intervention. What FX traders will tell you is that when the central bank steps in to purchase the currency and stem its decline, or to sell the currency to arrest a rise, it only works if the market was already exhausted and looking for an excuse to pause or reverse. Otherwise, whatever pause the bank is able to create tends to be temporary and the dominant trend soon resumes.

I think the same thing is true with interest rates. Fed buying can hold interest rates down, or push them lower, only if the market was willing to go there anyway. The market is larger even than the Fed, and if the underlying trends call for higher rates, then higher rates we will eventually get - Fed or no Fed.

There is no economic data on Friday, and trading is likely to thin out early as some people will take the Thanksgiving week in its entirety as a holiday. I don't know what that means for market direction, though. On the one hand, trimming risk before the holiday season officially begins would argue for lower equity prices; on the other hand, I would think the EU will want to make a loud, generous announcement about Ireland sometime before markets open on Monday, so I wouldn't want to go home short either. Tough call.

Have a nice weekend. This comment will not be produced on Friday, as I am taking a partial day off myself. I will be writing on Monday, Tuesday, and possibly Wednesday next week, however. Thanks for reading.



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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