Stoking The Engine With Paper

By: Michael Ashton | Wed, Jan 5, 2011
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The bond market was higher overnight, and the stock market lower, largely on news that the Swiss National Bank said they will no longer accept Irish government bonds as collateral (link to story here). This is fairly remarkable, and speaks to the determination of the Swiss body to stay a central bank rather than a thinly-disguised enabler of wastrel sovereign legislatures. Not surprisingly, the Swiss Franc leapt higher on the day. In the land of the blind, the one-eyed man is king, and the SNB today surely attracted some new capital to its land.

This introduces an interesting dynamic, when you think about it. Until now, the major central banks were apparently in a race to see who could be the most egregious enabler. The Fed is working on its second quantitative easing. The BOJ has gotten more serious with its QE. The ECB has been buying up any bonds that no one else wants (the biggest Danish pension fund today said they won't buy bonds issued by the periphery countries) and permitting banks to carry questionable sovereign credits with a prime risk weighting. The Old Lady of Threadneedle Street (aka the Bank of England) continues to act more like a young flapper, although she has recently made some noises about being more concerned about inflation down the road.

But now, the SNB - right in the heart of Europe! - has won a battle for responsible central banking, and been rewarded with a stronger currency and a stock market which led continental Europe with a +0.4% gain (the EuroStoxx 50 was -0.4%). Could others follow suit?


After all, most central banks these days want lower, not higher currencies to give a kick to domestic growth. Most are willing, even encouraging, of inflation to help grow out of large nominal debt burdens. How wide is the gate and broad is the road that these banks are taking? Many are entering through it. It seems much easier in the short run, and in the long run...

In the short term, the banks can affect the wiggles, a little, perhaps. But it feels oh so good to see an ADP report like today's. The number printed at +297k, the highest number ever recorded in this survey (which dates to 2001). As I wrote yesterday, there is something real happening here, but seriously? The economy doesn't seem to be booming, and that datum is inconsistent with lots of other readings of the employment situation (for example, while the Non-Manufacturing ISM released today was a little stronger-than-expected at 57.1 vs the 55.7 consensus, the Employment subindex fell, as it also did in the regular ISM report, to 50.5 from 52.7). I am more likely to believe that seasonal adjustment problems, always tricky but especially in December and especially for ADP, have something to do with the degree of strength.

But the markets were content to believe that the signs of strength in the U.S., as iffy as they are, outweigh the continuing issues abroad. Yes, we are parochial investors here in the 'States, but it's understandable that investors want to hope that if the American engine gets chugging it might pull the rest of the global train. Stocks managed to gain after the weak start, and bonds were smacked with the 10y yield back to 3.48% again.

It is understandable that investors want to hope that, but the engine is not being stoked with coal. Or wood. It is being stoked with paper, and the energy content of paper is probably not enough to get the engine up the hill with the entire train full of toys behind us.

I do understand, however, the desire to believe. I think I can, I think I can...

Inflation-linked bonds did very well again (compared to Treasuries), and inflation swaps continue to rise: to the tune of 7-9bps today. The 3y inflation swap is now at the highest level it has seen (over 2%) since September 8, 2008...and back then, oil was around $115/bbl and still coming down. Longer-term swaps have a little ways to go before they reach the highs of early last year: 10y inflation swaps are around 2.70% versus 2.88% highs early last year.

But it is easy to see the attraction right now of an asset class where there are two ways to win: if the engine makes it to the top of the hill and the global growth dynamic kicks into gear, then you might get demand-push inflation; if the engine coughs and slides back down to the bottom of the hill, then the central banks shovel more paper into the engine and you get incendiary results that way. (N.b. I am giving the argument, not my own view.) Result: congratulated if you do, congratulated if you don't, or so the thought process goes. I still think inflation-linked bonds are.

I don't know how any of this fits in with Kansas City Fed President Hoenig's unique view, expressed today, that a policy which is too expansionary can cause unemployment (link). The Fed certainly has the bases covered with theory. Kocherlakota thinks the Fed could force inflation higher by raising interest rates. Hoenig thinks that too much stimulus is contractionary. I think he is trying to convey a sense of the long-run tradeoffs compared to short-run tradeoffs of monetary stimulus, but it isn't exactly helping the discussion when you say it this way. (He generally scores points with me, though, when he says "Money is not wealth. The productive capacity of economy is wealth." Amen, brother.)


The Initial Claims (Consensus: 408k) data released between ADP and Employment is normally not particularly important. It ought to be even less important when the week in question is the last week of the year. But in this case, the context is dangerously suggestive. Last week's Claims figure surprised dramatically on the downside, plunging to 388k. This sharp improvement seems to have been echoed in the ADP report, although as I have noted it hasn't been echoed anywhere else yet! But if the bounce in 'Claims is smaller than anticipated, especially if it is actually below 400k, then we will essentially trade Friday's presumed upbeat Employment release tomorrow (and set up a much less risky counter-trade into Friday, by the way). A higher-than-expected number will be less significant but still might cool the ardor of the most bullish equity investors. So I would recommend paying attention to this one.



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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