Surrounded

By: Michael Ashton | Mon, Mar 14, 2011
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The American economy and markets are now beset East as well as West.

Battle still rages in Libya and Saudi troops moved into Bahrain as part of the Gulf Cooperation Council's effort to help pacify Shiite protestors. In the other direction, thoughts (and the fears of investors) reside in Japan where thousands of people were killed by the magnitude 9.0 earthquake, the ensuing tsunami, and (less dramatically but no less tragically) hardships in the form of hunger, lack of potable water, and lack of heat and shelter. A less-cohesive society than Japan's would be experiencing riots, looting, and worse.

Oh, and then there's the fact that several nuclear power plants are in various stages of meltdown. It is unclear how much radiation has been released, and how much will be released, but a half-million citizens have been evacuated and a quarter-of-a-million doses of iodine distributed so this isn't trivial.

The Nikkei index plunged 6.2%, unsurprisingly. But what was a bit more of a surprise was that the initial reaction in global equity markets was very muted. Normally, even if damage done to a country's market is due to reasons idiosyncratic to that country, there is an echo effect as some accounts liquidate positions in other markets. That there was no meaningful echo (although intraday today the S&P was down a whopping -1.4% around lunchtime before closing -0.6% on only 919mm shares) tells you just how irrelevant as an investing consideration most investors consider the Nikkei these days. Perhaps it is time to invest. Japan's dividend yield is as high as ours, but in Japan's case that's 60bps above the 10-year bond yield and in our case it's 160bps below. My only concern about that investment thesis is that the long-term solution for Japan is clearly monetization since they cannot possibly pay the accumulated debt, and I'm concerned about buying a currency that could well underperform the dollar in the long run. (An arbitrageur can hedge this risk very cheaply since currency forwards indicate the yen ought to appreciate against the dollar, but an individual investor has few alternatives in this respect.)

Speaking of monetization, many people have raised the question about what the significance of this event is for global inflation. Oil initially declined because clearly this event will have a significant impact on Japanese growth, and despite the "lost couple of decades" Japan's economy is still very large.[1]

But that's the wrong reaction, because unless Japan just ceases to exist it will still need to consume a large amount of energy. As of today, much less of that energy is likely to be coming from nuclear reactors for the foreseeable future. Roughly a third of Japan's energy is generate from nukes, so if any number of them are taken offline for inspection the power will need to come from somewhere else. "From fossil fuels" is a fairly likely bet of a source. And let's face it: this doesn't exactly help the push in places like the U.S., where there is already a NIMBY attitude to the building of new plant, to begin producing more energy from nuclear power. By the end of the day, Crude was back to unchanged - although it is admittedly hard to disentangle the Japan reaction from the MENA reaction. It remains above $101 (WTI).

The bond market rallied, bringing the 10y yield down to 3.36%. Inflation breakevens declined a little more than would be expected with that rally, but the market is holding up nicely given the uncertainty. Perhaps "waffling" is a better term, given the upward pressure from the recent improvement in housing inflation and the unrest in the Middle East and the presumed downward pressure from diminished growth prospects in Japan.

But let's examine this latter assumption because I am not so sure that even a strong negative growth response in Japan is necessarily disinflationary. Today the Bank of Japan (BoJ) added $186bln in liquidity to stabilize markets. If this disaster is what provokes the BoJ to finally begin monetizing in earnest rather than the temporizing half-measures they have taken over the last decade (half measures which are admittedly more prudent than seeking to monetize the debt), then this may in fact not be disinflationary at all. It is, after all, easier for a central bank politically to justify flooding cash into the economy to save freezing and starving people than to justify the same maneuver by declaring an intention to nudge inflation from -1% to +1%.

I am not saying that is what will happen, but I think a good case can be made that this event is at modestly inflationary after the initial growth shock. Think about it another way: to the extent that $100-200bln in real property was literally washed away and needs to be replaced, the same amount of money (in fact, more) will be spread around fewer real goods that are extant.

This is also not the same as saying the market will come to the same conclusion in the near term as I have. That often is not the case. In any case, I think the short end of the inflation curve is (as I wrote a week or so ago) expensive to the likely path of core inflation and the forward energy markets. It has flattened quite a bit recently and inflation swaps are inverted to the 5-year point. I like 5-year inflation at 2.36% better than I like 1-year inflation at 2.55%.

Tomorrow the Empire Manufacturing Index for March (Consensus: 16.10 from 15.43) is an 8:30ET release but the key event is clearly the FOMC meeting with the announcement due at 2:15ET. The only real question is whether the Committee will begin to soften the "for an extended period" language to foreshadow the eventual end of low rates and effectively foreswear any possibility of QE3. I am not sure there is much to be gained by their doing so at this meeting. There is little to no chance that the Fed funds rate will be raised this year, absent a true explosion in growth that takes Unemployment down several full points, and not much chance that the Fed will even venture to begin draining the "emergency" liquidity (let's face it, draining it again almost immediately after having re-written the record books in implementing QE2 would show a colossal indecision attached to numbers with lots of zeroes). If I am right about that, then even if the Committee wants to beat its collective chest and declare its dedication to squash inflation - and the perceived value of the declaration itself is the only reason it would make any sense to do it at this juncture - then there is no hurry, and no reason to confuse the market by signaling higher rates while you still have three months of bond purchases to go.

The fact that the bond market has recently rallied to near the strongest levels of the year is one counterargument in favor of an announcement tomorrow. If you're going to bomb the market with a scary, hawkish declaration, it is (a) better to do it when it is strong than when it is already week, and (b) better to do it when the Desk still has a couple hundred billion to buy and can help control any negative market reaction. But the FOMC has shown in the past a remarkable ignorance of, or at least complacency about, the importance of pre-existing market conditions when significant announcements are made.

 


[1] Actually, it isn't so clear after all. If economic growth is unit root, then Japanese growth will initially fall but then accelerate to resume the prior trend (such as it was). No one is sure if growth is unit root or trend-stationary, though. See my comment here for a quick discussion of what the heck I mean.

 


 

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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