Shooting The Messenger

By: Michael Ashton | Wed, Feb 9, 2011
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The news was a bit more varied and interesting on Wednesday; bonds were higher and stocks lower but it is hard to attribute that to any one piece of news.

For a change, not all of the interesting news was overseas but much of it was. There were reports that protests in Egypt were "regaining momentum," which if true is certainly unusual. Protests that flare up and burn out are less risky to a regime - as long as the "flare up" isn't so high that it leads to a sudden transition of power - than ones that have a steady burn. Maybe we were too quick to push this issue to the back page just yet.

More concrete were two inflation stories. I'm seeing more and more inflation stories globally. This is also a change of tenor; until now it had seemed as if the stories were mostly "one-offs" but if there is one thing the unrest in the Middle East has done it is to draw journalists' (and policymakers') attention to the issue of food commodity price increases. In the UK, there was a report from the British Retail Consortium that food prices were +4.6% year-on-year, the fastest pace since the middle of 2009. The official UK price data isn't due out until next Tuesday, but the inflation market is showing strains. As the chart below (Source: Enduring Investments) shows, 5y inflation swaps are on the verge of performing the rare feat of crossing above the 5y, 5y forward inflation rate.

UK 5y inflation about to cross above 5y, 5y forward inflation
UK 5y inflation about to cross above 5y, 5y forward inflation

That is, traders are expecting inflation to be lower from 5-10 years from now than they think it will be for the next 5 years. This last happened in the U.S. in the summer of 2008, when high energy prices combined with a slowing economy led investors to expect that the gasoline spike would not be repeated: $70 to $140 oil is one thing, but to expect headline inflation to continue to be as far above core inflation as it was required you to expect a move from $140 to $280 since inflation is a rate of change, not a level. Of course, that didn't happen.

In this case, however, it is less clear that the arrow of growth is clearly pointed downward, at least for a year or two forward as it was in mid-2008. And recognize (look at the chart) that both of these measures are around 3.5%, well above the BOE's 2% inflation target. The market is almost urging the BOE to tighten policy, although there seems little chance of that at present.

Even more interesting is the news out of Argentina. Actually, the story was out last Friday in the Financial Times and I missed it. A summary of the story, and a link to the FT if you subscribe, is available here.Today, Bloomberg ran a similar headline, which is why I saw it. To summarize: independent measures of Argentina's inflation (such as that produced by the Billion Prices Project at MIT, about which I wrote just last week - and pointed out the Argentine discrepancy) show inflation running at about three times the government's measure. The Argentine government, in an attempt to bully these independent surveys into saying inflation is closer to the 10% they claim, threatened them with a large fine if they did not produce their methods and, more chillingly, their sources within 24 hours. The way inflation is typically measured, such as by the BLS, involves flesh-and-blood human beings walking around and writing down prices in a systematic way. Argentina is making a thinly-veiled threat against the people who are doing this.

An important point, though, is that everyone knows the Argentine numbers are cooked. Arm's-length calculations from these agencies and the BPP@MIT show much higher inflation. And the inflation-linked bond markets also recognize the lower quality of the index that Argentine bonds are linked to compared to, say, Chile's or Colombia's. Argentine real yields are 7.6% while Chile's are 2.7% and Colombia's 3.3%. Investors are compensating for the artificially-low inflation compensation that they get in Argentina by insisting on a higher real rate (even so, investors clearly are hoping that there is some chance the government will start reporting the correct figure rather than continuing to prevaricate for the next couple of decades).

All of this is interesting to an inflation guy, and I suppose the point is that these inflation stories are increasingly of interest to non-inflation guys. But I don't like the idea of shooting the messenger, because in some sense I am one of those messengers.

The fact that there is a percolating global inflation is a surprise to no one except, perhaps, Ben Bernanke. The Chairman appeared before a House Budget Committee hearing today and, despite the increasing alarm about how inflation metrics appear to have bottomed virtually everywhere and commodities-based indices are flying, responded to a question about a future QE3 by saying that if the economy is still stagnant in June when QE2 is done, "we would have to think about additional measures."

This is wrong on a bunch of levels, but let me mention just two. First, the answer ignores the Fed's dual mandate and focuses on just the growth mandate. The reason that QE2 could be plausibly enacted wasn't that growth was slow but also that inflation was low and still declining (although you didn't need to be a great forecaster to see than in Q4 the year-on-year measures would begin to rise at least from base effects). That latter point is no longer true, and so any consideration of a QE3 should involve the question of growth but also the question of whether inflation and the inflation outlook is acceptable. But the second, and perhaps more grating error is that if the economy is still stagnant after QE1 and QE2, a rational person would say 'hmmm, this doesn't seem to be working' and look for something else to try. The Fed these days is anything but rational, though. The Chairman had the temerity to drag out the Fed's estimate that monetary policy had 'saved or created' 3 million jobs. I still can't figure out if he is taking credit for the 3 million or so that the President and Congress saved, or if he's talking about an incremental 3 million jobs.

In my opinion, concern about the stewardship of the fiscal and monetary policies of this country and most others is rational, warranted, and overdue. That creates many risks, but the clearest one I think is in inflation - global as well as local.

I will talk tomorrow about the state of the inflation market in the U.S.. The only interesting data of the week, Initial Claims (Consensus: 410k from 415k) is also due to be released. Claims should be starting to calm down after the crazy seasonal adjustment issues that are normal this time of year but that this year were even more severe. If there are going to be downward economic surprises this week, it comes down to this report because that's just about all there is!

The Treasury will also seek to sell $16bln long bonds, which is an awful lot of duration. Today's $24bln 10-year notes, however, drew a strong 3.23 bid:cover ratio on the back of a huge indirect bid (often seen as a proxy for foreign central bank interest) of $17bln. Dealers took only $6.7bln for the lowest percentage I've ever seen. This means dealers most likely have powder dry and will be able to bid for the long bond with some comfort.

True, yields are the highest they have been in a little while, but people are lining up for 3 5/8% 10-year notes? And 4 ¾% long bonds maybe? I salute these buyers and wish them the best of luck. Maybe Dr. Bernanke will buy them back.

 


 

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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