The Farce Is With Us

By: Michael Ashton | Wed, Jan 12, 2011
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The stock market leapt anew today, breaking out of the tedious range that has frustrated bulls for a whole week and a half.

Ostensibly an important part of the rally was the success overnight of Portugal's €1.25bln debt flotation, but this has farce written all over it. Prior to the auction, the EU announced that it was readying a stabilization for Portugal in case its auction didn't go well. And then, not much later, the auction went okay. Coincidence or con game? We don't know who bought these bonds, and we don't know what enticements (such as a healthy rediscount policy) the ECB offered other banks to buy the debt. It was important for the auction to complete, and it completed, but that is hardly a strong endorsement (as Bill Gross, of auction non-participant PIMCO, explained well on Bloomberg TV later).

The stabilization package mentioned shortly before the auction was too small to be serious (€60bln), so the announcement shortly before an auction that was designed to go well was likely timed to be a strong-sounding promise that there was no chance of keeping. The EU has tried bluffs before with Greece and Ireland, and it didn't work, so they are trying to be more tactical and bluffing only when there's no chance the bluff will be called.

Practically speaking, it doesn't matter much to investors that Portugal is in trouble if everyone is willing to believe the con. At least, this is true for now. Tomorrow, Spain tries to sell €3bln and Italy is scheduled to sell "up to" €6bln. They're in better shape than Portugal (Spanish 10y yields are 5.43% and Italian 10y yields at 4.77% compared with Portugal's 6.58% and Germany's 3.05%), and there's little doubt that these auctions too will not be left to chance. One wonders how long this farce can go on, but while the farce goes on so does the dance. As former Citi CEO Chuck Prince famously said, "As long as the music is playing, you've got to get up and dance." And with the same attitude, one might also add "and if the music starts again, you've got to dance again." One wonders also how many investors and institutions are dancing again, so soon after the band stopped playing the last time. It strikes me that this isn't like a real bandstand. There is no guarantee the set will last any given amount of time.

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The "success" of the Portuguese auction caused the dollar to weaken sharply for the first time this year. Although the greenback remains comfortably within its recent consolidation range, I suspect we may shortly see a trip back down to the levels of October and November, or even below.

The chart below shows the historical relationship between the dollar index (white) and the S&P GSCI commodity index. When the relationship is behaving normally, they move inversely to each other because most commodities (at least, in this index) are measured in terms of "dollars per unit of stuff," and when the dollar buys less stuff that often (but not always) means that it also buys less of other currencies. In this explanation, the recent strength of the dollar is idiosyncratic flight-to-quality strength, and may be erased once the flight-to-quality has passed. The recent "risk-on" attitude in the markets seems to suggest this is on the verge of happening.

Dollar/Commodity divergence
For the last two months, the usual dollar/commodity relationship has been broken.

Of course, this isn't the only explanation for the commodity-dollar divergence of late. The divergence may be because all fiat currencies are declining in value compared to stuff (say, due to a huge increase in the supply of fiat money because of global QE), and if that is the case then the relative value of the dollar compared to another fiat currency is not germane to the value of commodities. In that case, the relationship will stay broken down, with commodities continuing to rise while the currencies fluctuate relative to one another. This is the definition, of course, of a global inflationary outcome. The fact that commodity indices put in a substantial low in late August, when Bernanke unveiled the notion of QE2 - and some commodity indices put in very significant lows then - is suggestive.

A more upbeat interpretation would be that strong and/or strengthening domestic economic growth is helping to support both the foreign exchange value of the dollar and commodities as global demand picks up. This seems less plausible since the fundamentals of the particular markets are not uniform, and yet just about all of them have been rallying for months. Corn, Cotton, Coffee, Copper, Cattle, Crude: all are up significantly. Since August 23rd through Tuesday's close, the current contracts (so we don't have seasonality issues with new crop/old crop, for example) are up for those commodities by these percentages: 36%, 79%, 28%, 31%, 11%, 21%. Even when the economy is booming, not all commodities go up from demand alone!

Let's look at one particular commodity of special interest: gasoline. Since the end of August, gasoline is up about 30% (see Chart). Using the "normal" pass-throughs, this suggests a ~1% rise in headline inflation from this effect alone. With core inflation stable or (I think) bottoming, this suggests recorded headline inflation is going to be going up.

Gasoline Chart
Keep topping off that tank!

But now the good news: if the upbeat interpretation is true and this is happening because the economy is belting back, then this is just an "automatic stabilizer." The Fed normally ignores movements in energy prices, as unpopular as this is, because higher energy prices are already exerting a natural dampening influence on activity and lower energy prices are already exerting a simulative influence. Thus, if the Fed responded to higher prices that were caused by higher energy prices, it would be tightening into energy spikes and easing into energy collapses, and this would tend to amplify, rather than dampen, the economic cycle.

A 30% rise in wholesale gasoline prices, even back to the $2.50 level, will not kill the recovery. But in 2008, a rise above these levels certainly seemed to affect the animal spirits of consumers, and it bears watching especially since it is occurring coincidently with rises in food prices.

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Initial Claims (Consensus: 410k) are the main economic datum on tap for Thursday, although some will obsess over PPI (Consensus: +0.8%, +0.2% ex-energy) and/or the Trade Balance (Consensus: -$40.5bln). I already mentioned the Spanish and Italian bond sales, although I doubt there will be any surprises there; also of note will be Chairman Bernanke's comments as part of a FDIC panel discussion on "Overcoming Obstacles to Small Business Lending." It's nice to know that someone out there still thinks there are obstacles! But it will be interesting to see how optimistic the Chairman is. This is one place where the Fed, in its direct conversations with bankers, has a lot more information than the private analyst does and ought to be able to add some value.

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By the way, by my count yesterday was merely the 30th Binary Day of this century. January 1st, 10th, and 11th, October 1st, 10th, and 11th, and November 1st, 10th, and 11th, of each year '00, '01, and '10 makes 27 occurrences; this year we add 1/1/11 and 1/10/11, so 1/11/11 becomes the 30th. However, November 11th 2001 has the highest decimal value, as 111101 in binary is 61 in decimal.

 


 

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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