Sputtering

By: Michael Ashton | Mon, Jan 24, 2011
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In Ireland, the government is collapsing (I am not a scholar of Irish politics; the correct verb tense may be "has collapsed") as Prime Minister Brian Cowen resigned as head of his party last week and the Greens party pulled out of the ruling coalition on Sunday.

The country is now scrambling to pull together a coalition that will be able to pass a budget before near-term elections (which CNN tells me are most likely going to be held on February 25th). The current estimate is that the austerity budget will be passed by the coming weekend, but that isn't really the important point. At this point, the government is just passing legislation to support the promises it made to the EU in exchange for a bailout. But this is very different from the decisions which will face the new government that takes shape after elections. It isn't at all clear that that government, freshly elected and not feeling as much ownership over the deal - and perhaps peopled with more populist members - will still favor accepting the aid from the EU with all of the onerous conditions (which more or less guarantee recession/depression in Ireland for years, as in Greece). And then the EU will have to decide whether it wants to slacken the conditions, or let Ireland fail.

Irish bonds dipped a tiny bit (5bps) in a generally rallying market, but it is hard to read very much into the behavior of that market when the ECB stands ready to scoop up lots of bonds when needed. Credit default swaps on Ireland widened 10bps while those for other periphery countries narrowed 5-10bps on the day (thanks to my friend AK for the update!). But in general, this is still a page 5 story, at best, here. If and when the budget fails (which it shouldn't), or if and when the new government repudiates the EU deal (which I think is somewhat likely) after the February elections, it will become a page 1 story again. And it won't just be a story about Ireland at that point, but also the other periphery nations and indeed the whole bailout structure, because as much as Europe wants to think of itself as one body, it still has a couple of dozen legislatures. Getting unanimity from a loose confederation of states is a daunting challenge, and retaining unanimity will be a great feat indeed. But for now, still page 5 and the dollar keeps sinking against the Euro.

The Treasury market was near unchanged, and the inflation market mixed. Stocks rallied back to Friday's high (still 5 points shy of a new rally high) on very light volume of less than 1bln shares. Equity volumes so far this year, in fact, have remained slack despite the widespread opinion that a new bull market is underway. Perhaps some of that may be due to the weather, but as the chart below shows the volumes for the first 15 trading days of 2011 are the slowest of the last half-dozen years.

Chart 1
Equity volumes have been more consistent with bear-market than bull-market sums so far in 2011.

Draw whatever conclusions you wish about the technical state of the market (although "sputtering" seems fair), but I'd also return to the point I raised the other day about the profitability of dealers. While trading volumes remain slack, it will be difficult for these firms to consistently make as much money as their shareholders would like, absent the releasing of credit reserves.

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With a Fed meeting on Wednesday, it is worth taking note of an article in the Wall Street Journal today entitled "New Push at Fed to Set an Official Inflation Goal." I had written about this last month in an article I called "Inflation Targeting - Bronco Ben Rides Again?" Indeed, I think that setting an explicit inflation rate target, as opposed to the unofficial 2% target that everyone knows they have, has almost no upside and lots of downside. That's more of the "writing policy options" approach that the Fed has preferred over the last couple of decades, choosing a course with small and/or uncertain benefits but large and/or certain costs, and it is a bad idea.

It is especially a bad idea because of the widespread skepticism of the concept of core inflation, not solely among retail investors any more but also among some institutional investors who prefer a median CPI or trimmed-mean approach. If the Fed targeted headline inflation, they are sure to fail over most meaningful horizons because the mean reversion period of headline inflation is longer than the policy horizon...which means that even a policy that held core inflation exactly at the target would frequently be seen to have failed against a headline inflation target (and the FOMC clearly cannot affect food and energy prices in the short run!).

A more interesting change for the Fed would be to move to price level targeting, and that is superior to the current practice of ad-hoc adjustments to hit an inflation rate target only one year out. But it is still a bad choice, as my December column argues. (Also look to Kahn's piece, "Beyond Inflation Targeting: Should Central Banks Target the Price Level," for good background on the issue. I summarize the paper in that column).

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The first January data shows up on Tuesday in the form of Consumer Confidence (Consensus: 54.0 vs 52.5). If we are expanding, rather than merely bouncing after a deep trough, then Consumer Confidence needs to rapidly move above 80 (see Chart). So far, there has been no sign of that. I expect we will begin to see some improvement, but rising gasoline prices and falling housing prices are currently counteracting any positive confidence from the equity rally.

Chart 2
I am not confident in Consumer Confidence until we're above 80 or so.

The "Jobs Hard to Get" subindex was last 46.8, and it needs to be below 40 before we can be confident that employment is really going to be steadily improving. The last time that subindex was below 40 was in November 2008; in January 2008 it was at 20.6.

Also out tomorrow is the FHA Home Price Index for November (Consensus: +0.0% vs +0.7%) and the Richmond Fed Manufacturing Index (Consensus: 23 from 25), but neither is a market-mover.

 


 

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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