Overtaken By Events

By: Michael Ashton | Sun, Feb 13, 2011
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One day after Egyptian President Mubarak stated flatly that he would "die and be buried in Egypt," he evidently began to be concerned that his prophecy would be fulfilled sooner than he had planned. The incredible swiftness of the change in direction and sudden resignation shows clearly a man and a government who tried to manage a process that was larger than they were and who were swiftly overtaken by events.

The stock markets took this as good news and shrugged off for a second consecutive day the overnight weakness. This is a kneejerk reaction that doesn't make a ton of sense to me. While I am firmly in the camp that believes a spreading of democracy - even if we don't like who wins the elections - is a good thing in the long-run, in the short run we don't even know who is in charge of Egypt. "The military," we are told, but "the military" isn't the one who makes the decision to pay the coupons on the debt (nevertheless, Egyptian credit improved with the news). Moreover, while this removes some uncertainty and that is clearly a small positive for stocks and a small negative for bonds, it also encourages other democratic movements in the region. It wasn't obvious that Tunisia was a big enough first domino to cause any other regime to topple. But there can be no doubt that regime change in Egypt is a big deal. Maybe there is relief that the situation is resolved, but how long will that relief last if, say, the Saudi "street" shows some unrest?

I am not saying that some natural "thirst for freedom" is going to drive the dominos. Consider however a more pertinent similarity between Egypt and other candidates for unrest: demographics. The chart below shows Egypt's "population pyramid." The population in each age range is shown by a bar. Having the skinny part at the top and the fat part at the bottom shows a country where "disaffected youth" isn't just a parental headache but, when times are difficult, a societal one.

Egypt's population pyramid
Egypt's population pyramid.

You may say "it's normal, isn't it, for the skinny part to be at the top?" Well, sure, but there are degrees of skinniness. For contrast, here is Germany's demographic pyramid (incidentally, the source for all of these is Wikipedia; type "Egypt demographics" into Google and you'll get the right link). In Germany, as to a lesser extent in the United States and to a greater extent in Japan, the problem isn't disaffected youth; it's dispossessed senior citizens.

Germany's population pyramid
Germany's population pyramid.

Now, are the following charts of Saudi Arabia, Syria, and Yemen more similar to Germany or to Egypt?

Saudi Arabia's demographic pyramid
Saudi Arabia's demographic pyramid - look at the bulge especially among young males!

Syria's population pyramid
Syria's population pyramid.

Yemen's population pyramid
Yemen's population pyramid.

So you see, the perils of texting these days may be worse than we think. Revolution could spread by Vodafone. I am not sure what that means for equity valuation. But I know I'd rather be long the "high dollar" tails in energy futures than short those calls!


Not to compare the deposed ruler of Egypt to the second-most-powerful man in the world, but Mubarak isn't the only person around who believes he can manage a process that is larger than he is, nor the only one who is able (and even likely) to be overtaken by events. Chairman Bernanke is staking his entire reputation, as well as (more worrisomely) the credibility of his institution - and perhaps much more - on his belief that buying trillions of Treasury and agency securities will resuscitate the economy but not produce inflation.

It seems to me that he balances that belief on three major premises:

  1. Right now, expansive increases in the monetary base are not translating into goods and services inflation, and any effect that it has on asset inflation is apparently desirous given how much the Fed has trumpeted such. But the major premise is that large increases in zero-maturity money will not precipitate into inflation because economic slack will absorb any inflationary forces.
  2. In addition to economic slack, well-anchored inflation expectations will retard an actual rise in inflation, and
  3. If there is any sign of incipient inflation pressures, the Fed can swiftly remove the stimulus at will.

These premises may prove to be entirely correct. But they're not uncontroversial.

1. Many people, myself included, believe that there is no conclusive link between economic slack and inflation. I demonstrated in this space on February 3rd that while there is an understandable connection between labor market slack and labor market wage growth, there is no identifiable connection between labor market slack and overall inflation. And there's the little matter of the 1970s to explain, if economic slack prevents inflation.

2. The whole "well-anchored expectations" thing is an incredible bit of Greenspanian mind control. I believe Greenspan popularized the notion that if people do not expect inflation to accelerate, then it won't (but the idea derives from rational expectations arguments). It was a puzzle to the Fed to explain why in the 1990s, despite quicker-than-expected money growth, inflation remained quiescent. The "well-anchored expectations" hypothesis sounds plausible. But there's no data to prove it with because nobody has measured inflation expectations in any meaningful way.

For example, in 2007 Frederic Mishkin described recent changes in the persistence of inflation, the tradeoff between inflation and unemployment, and the responsiveness of inflation to other shocks as a function of well-grounded inflation expectations; to proxy inflation expectations he used the Livingston survey and the FRB/US survey which itself consists of the Hoey survey and the Survey of Professional Forecasters (SPF), and also referred to the Michigan Survey of Consumer Attitudes and Behavior (Michigan survey). But what in the world does a survey of professional forecasters have to do with consumer inflation expectations? And the Michigan Survey shows strong evidence of "anchoring," a cognitive bias where a respondent starts the process of determining an answer by choosing an "anchor" and then making an adjustment to arrive at his/her conclusion. So, for example, a Michigan respondent is probably aware (unless they live in a hole) that inflation was just reported at 1.5%, or that it is "around 2%", and then says "my experience is a little higher." The chart below shows the Michigan Survey "1 year ahead" inflation expectations versus actual reported headline CPI.

Michihan Surveyb versus Reported CPI
Inflation expectations are anchored all right - at the most recent CPI print.

That's anchoring, and it renders the data useless for analyzing the point that we are supposed to believe in so strongly. Michigan Survey respondents' inflation expectations may be "well-anchored," but not in the sense that they will continue to be expect low levels of inflation even when prices are rising. By the way, notice that the "1 year ahead" expectations are very strongly correlated with inflation experienced over the past year. That doesn't suggest to me, even if this was good data, that expectations are anchored and will be resistant to change; it rather suggests the opposite (and more reasonable) conclusion: that expectations will follow actual inflation higher.

3. I have no confidence whatsoever that the Fed could easily sell $110bln in securities per month for 12-18 months without causing a crash in the bond market and probably in the stock market as well. That would basically be doubling the amount of net Treasury issuance to his the Street every month (that is, doubling it from what it would be if the Fed wasn't already subtracting that much net issuance every month). And if the Fed could pull off this trick, that pace - which is close to what the Desk says is its limit - is still probably too slow if they wait until they see inflation rising into the danger zone. Perhaps the Fed could withdraw lots of liquidity very quickly through their new term facilities and by raising the interest paid on excess reserves, but would it really choose to make a dramatic tightening of unparalleled magnitude in any case? And even if all of that is negotiable and a way can be found to drain sufficient reserves to backpedal on the massive rise in the money base, I can't imagine that they have the political will to do so when the Unemployment Rate is over, say, 7% and the country needs to generate several hundred thousand new jobs per month to keep the Rate from rising. Is that really plausible to anyone?

So of those three major premises, I don't buy a single one. And they really matter. If #3 is false, or if both #1 and #2 are false, then the error is fatal and the outcome pretty ugly. I may well be wrong, and it won't be the first time. But these are plausible arguments (I think), and at the very least a prudent manager of the central bank would employ great caution on the chance - however remote he thinks it is - that his read of the situation is wrong. The man who is overtaken by events is the man who didn't prepare for those potential outcomes. See Mubarak, H.


Once again, I defer my discussion of the state and levels of the inflation-linked markets for another day. I apologize to anyone who was tuning in expecting to see that, but while some people are overtaken by events, I am occasionally overtaken by rants. However, on Monday I ought to be able to get to that topic, since there is little on the calendar (but then, an overthrow of the Egyptian President wasn't on the calendar either). There is a TIPS buyback scheduled, and NY Fed President (and former Goldman guy) William Dudley is speaking to a regional economic conference. He is scheduled to deliver remarks at 10:00ET.



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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