The Hypnosis Is Wearing Off

By: Michael Ashton | Thu, Jan 20, 2011
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Economic data today took a turn for the better, but should be placed properly in context. An important fact, though, is that for the first time in a very long time, the stock market didn't take the good data as another rallying excuse. Yes, prices rallied from the mid-morning low, but the fact that the market had declined after the data is interesting, as is the fact that even the late day rally could barely bring the S&P index back to unchanged before it sagged again, exhausted.

In other words, this is just the opposite effect we have recently seen, where bad news is shrugged off and turns into a rally. This is not the same thing as saying that we are in a bearish trend for equities! But at least, there is some sign that the hypnosis is wearing off, and that's a better condition for the market to be in. If you're an equity bull, you want the market to trade sideways in a choppy fashion for a little bit here, to relieve some of the possibility of a sharper pullback.

Sorting through the economic data, we come first to the strong Initial Claims figure of 404k, better than the expectation of 420k and a vast improvement from last week's 441k. However, like a broken record I will repeat my usual mantra that seasonal adjustments this part of the year, in particular for weekly data, are extremely difficult. From about the middle of December until the end of January, the week's numbers don't mean a lot. Yes, it still seems clear that the job prospects in the economy have improved in the last quarter, but it isn't at all clear how much. (And the market implications, even if the economy has improved quite a bit, are far from obvious with a cyclically-adjusted P/E ratio, or CAPE, above 23. The market, that is, is already pricing in a fairly aggressive improvement in earnings at a time when profit margins are already quite fat.)

The Philly Fed Index was essentially on-target at 19.3 versus 20.8 expected, but the components were stronger than the headline. There were big gains in New Orders (23.6 from 10.6) and Number of Employees (17.6 from 4.3). This is a jumpy number, but the "Number of Employees" figure is more consistent with the level of 2004 (when the average was 16.8). Again we should be careful to read too much into that, but for a different reason this time: this is a survey of relative perceptions, that is "do you see the number of employees increasing, decreasing, or staying the same" rather than "how many employees do you expect to add." Again, there is not much question that the labor situation is improving - the debate is whether it is improving sufficiently to move millions of people onto the rolls. That does not appear to be the case, but we're moving in the right direction.

Existing Home Sales was the best number of the day (5.28mm sales versus expectations for 4.87mm), but again some context is useful. The chart below (Source: Bloomberg) shows that the most consistent thing about this data recently has been its inconsistency. The real underlying pace of sales is probably 5mm units ±1mm units. That plus-or-minus means that forecasting it is a little more like throwing darts than doing econometric analysis.

US Existing Home Sales
Sure, try to draw some important conclusions from THIS chart!

More encouraging (because it is steadier) was the inventory of existing homes for sale, which fell to the lofty-but-improving level of 3.56mm units. This is a far cry from the "normal" levels of inventory around 2-2.5mm units, but this level of inventory is consistent with a change in CPI Shelter of about 1% over the subsequent year (see Chart, which I've shown before).

Existing Home Sales
3.5mm units of inventory is consistent with small increases in CPI Shelter one year hence.

Note that the recent bump upward in CPI Shelter, which I discussed in the context of the CPI release last week, is consistent with the dip in inventory we saw a year ago...but that this positive price effect should wane over the next six months or so in response to the higher inventory levels into last summer.

All of this was good economic news, but as I noted the stock market didn't really respond with the enthusiasm to which we have all become accustomed...some may say "addicted." A rally which began in the late morning managed to ensure stocks closed with only small losses. Bonds, on the other hand, were shellacked and some technicians will want to see a "flag" on the chart of the daily 10y yield (see Chart, source Bloomberg).

Chart 3
Technicians will worry if the 10y yield breaks out of the top of this flag-like formation. As will I.

It didn't help that the TIPS auction was surprisingly miserable. With real yields around 1.11% going into the auction, with TIPS investors holding the cash from the recent maturity of the Jan-11s and lots of coupons paid this month, and with the Fed buying back enough TIPS that the net supply of TIPS is essentially zero for the first half of this year, I figure the underlying fundamental demand is strong. That isn't to say that I expected all customers to show up at the auction itself; many customers prefer to let the dealers take down the paper and then buy it closer to the end of the month when the index reflects the new bonds. But with those fundamentals I thought dealers would have no problem buying the inventory. I was wrong! The direct and indirect bids were weak, with a bid-to-cover ratio of only 2.37:1, leaving dealers with a bunch of paper to buy. The median yield of the auction was 1.04%, which was well through the market and suggests a somewhat smaller auction would have been well-received, but to persuade dealers to take the last bits of the supply the Treasury needed to pay 1.17% (and since it's a Dutch auction, that's the yield at which the whole auction is settled).

To me, this says that dealers didn't have the guts to take all $7bln of the supply they needed to take. This isn't too surprising, I guess, especially when the Financial Reform law discourages dealers from taking proprietary risks with their capital. Imagine if that starts to happen with nominal Treasuries?

This auction will probably clean up all right, though not without some scars on the Street. That's the second weak 10y TIPS auction in a row, which means dealers will be more timid the next time (which incidentally sets them up to get couped, but that's another story for another time).


The New York Society of Security Analysts sent a link in an email today to a snippet of a speech from St. Louis Fed President James Bullard. It is worth the 2 minutes it takes to listen to it. He says that it is "most likely" that the effects of QE2 on the real economy will be conventional monetary-policy-like effects. That's his opinion, but the key to me is that unlike Bernanke's assertion on "60 Minutes" that he is "one hundred percent" confident that the Fed is in control (see my written primal scream here), Bullard acknowledges that this is not entirely certain. I would add to this the observation that the effects of conventional monetary policy are not entirely certain, for if they were, then we need to ask what is the Fed's excuse for getting us into the credit mess and the housing bubble and the equity bubble and ...

This lack of certainty, if it were taken to be the operating assumption, has huge ramifications for monetary policy if it is administered rationally. A policymaker who recognizes that he is operating in a condition of uncertainty should tend to minimize interventions into the economy (unless, I suppose, he believes that free market capitalism simply doesn't work at all and needs to be helped along by wise men). It continues to be the case in my opinion that the most dangerous aspect of this policy regime is not necessarily the actions that are being taken, but the utter certainty with which they are being taken. If they were traders, we would never let them near a phone because we would know we are gonna be "carrying them out" in short order. Let's hope they don't take us down with them.

There is no economic data due tomorrow, and another storm is supposed to hit the NY metropolitan area, so I would expect another day of thin conditions. I will be slogging around in the snow myself, so my next comment will probably not be posted until the weekend.



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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