Cracking The Containment Vessel on Inflation?

By: Michael Ashton | Wed, Mar 16, 2011
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...and now, I'm supposed to be a nuclear engineer?

Financial engineering is in some ways similar to nuclear engineering, which is one reason we use terms in finance like "nuclear waste" to mean a particularly toxic tranche of a deal that no one wants to have, or refer to a particular credit as being "radioactive." The credit crisis has also been called a "financial meltdown." But most of the products that Wall Street creates don't actually kill people (on the other hand, they also don't get better when you pour water on them, so perhaps the jury is still out on which is worse).

Markets reacted poorly for most of the day today on the news coming out of Japan. The Federal Reserve was forced to cancel its scheduled bond buy-back in mid-stream when the Dow Jones newswire ran headlines saying "EU ENERGY CHIEF: SITUATION AT JAPAN NUCLEAR PLANT OUT OF CONTOL" and "EU ENERGY CHIEF: POSSIBLE CATASTROPHIC EVENTS IN NEXT HOURS." Bonds predictably shot straight up and stocks tumbled until the EU energy chief admitted that his "analysis" had been gleaned from details in news reports. The Fed re-initiated and complete the bond buyback, and everybody learned a lesson not to listen to the EU Energy Chief. Ever. Again.

The U.S. stock market, however, is also in slow-burn mode and starting to wilt. Today's 2% decline in the S&P on the highest volume of the year (1.4bln shares or so) took the index to flat on the year. Easy come, easy go. Meanwhile, the Nikkei rallied overnight (5.7%) and the Yen strengthened to match its all-time strongest level, 79.80 yen to the dollar, last seen in 1995. Yes, you read that correctly. The U.S. market is all aflutter now while the Nikkei is rallying and the Japanese currency is actually rallying. Maybe nuclear engineering would be easier.

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Speaking of the 2008 meltdown, a reminder of it was called up today when the Wall Street Journal ran an article entitled "Banks Probed in Libor Manipulation Case." In 2008, there was another Journal story - and it probably prompted this investigation, as that is the way these things go - that pointed out that LIBOR was exceptionally low given the apparent difficulty many banks were having funding themselves in the LIBOR market. It was clear that it was predominantly hedge funds that were upset by the settings and stirring up trouble; after all, the banks are lending money tied to LIBOR and most of us are borrowing that money...so why would we get all bent out of shape because LIBOR was being mismarked too low?

This whole issue wouldn't even exist if the British Bankers' Association (BBA) hadn't changed the way the LIBOR survey was conducted some years ago. Until 1998, LIBOR was set by a survey in which a large number of money market dealers were asked the following question: "At what rate do you think interbank term deposits will be offered by one prime bank to another prime bank for a reasonable market size today at 11am?" On the basis of that question, the crisis of 2008 wouldn't affect the setting since it became merely hypothetical. There were no prime banks in late 2008, but that doesn't mean it isn't possible to speculate where such banks might have lent to each other. This was a smart way to word the question because it meant that (a) no bank was forced to reveal its own cost of funds to its competitors and (b) it abstracted from the occasional funding difficulties that a bank or two might have in special circumstances. That bank, during its problem, wasn't a prime name bank so it could be ignored for the purpose of the survey.

However, as the swaps market grew and with it, the importance of the LIBOR rate, I suppose the BBA thought it oughtn't be so hypothetical. So the survey procedure was changed, and now banks are asked "At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?" (Thanks to MM for helping me find that.) This is obviously a very different question. Now banks are expected to trumpet to the world when they are having funding difficulties. Moreover, the question leads to absurdities in the circumstances of late 2008. Complainers think that LIBOR should have been marking higher than it was, but how are you supposed to answer this when the real answer is "infinity. No funds are being offered to me or to any other bank at any price"? And that was in fact the situation. Banks were being ordered not to put out 12-month, 6-month, 3-month, and for a time even 1-month and shorter money. If you had offered 100% and been lifted, you would have lost your job (especially if that bank then collapsed the next day and your unsecured LIBOR deposit went down the hole with it). So there was literally no correct answer. Obviously, some banks unilaterally altered the question they were answering (since they are required to answer it, and amended to the question "...and the market was functioning normally." Or perhaps they merely decided to answer the question in the original, pre-1998 spirit. Can we blame people for giving a bad answer to a stupid question? I suppose it makes sense to look to see if there was collusion among the twenty banks that make up the LIBOR survey, although it is a little hard to imagine how a secret agreement could have been kept with so many conspirators.

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This just in: the housing market is still radioactive as well. Today's Housing Starts figure printed at 479k, only 2k above the absolute low of April 2009. This is good, in a way, since less construction means less inventory, which means existing inventory gets worked off more quickly and more homebuyers get shunted to the existing home market where the inventories are really ugly. But it also means that construction is not going to be adding much to the growth figures for a while...

The housing data was lost in the global geopolitical news, as is appropriate. But it was harmonious with what the market wanted to do anyway. Stocks wanted to fall, and they did. Bonds wanted to rally, and the 10y yield declined 10bps to 3.20%, the lowest yield since December and starting to make Bill Gross look kinda bad (but seriously, Mr. Gross has many powers but the ability to predict earthquakes, I suspect, is not among them).

Commodities were flat, with the Ags and Industrial Metals down and energy up. Crude oil regained the $98 level. Opinions on oil vary widely, but I'm a bull. Monetary policy, respectable global growth, damage to MENA production environments, and a decrease in the BTU that can be output from nuclear - that seems like a bullish mix to me.

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Tomorrow's data includes Initial Claims (Consensus: 388k from 397k), Industrial Production/Capacity Utilization (Consensus: +0.6%/76.5%), Leading Indicators (Consensus: +0.9%), and the Philly Fed Index (Consensus: 28.8 vs 35.9).

But by far the most important data is the CPI report. The consensus calls for +0.4% on headline and +0.1% on core, raising the year/year headline number to +2.0% and maintaining +1.0% on core.

I think there is risk to the upside on core inflation. Last month, the print surprised on the upside at +0.17% m/m, which brought the y/y number to +0.95% (rounded to +1.0% in news reports). What are the chances of another similar number, more than 0.1% but not quite 0.2%?

I think the odds are reasonable. Recall that last month, major subindices of the CPI constituting 83.5% of total inflation showed acceleration in the year-on-year numbers (to review what I wrote last month, follow this link). And, as I pointed out just 10 days ago, the recent rise in inflation swaps, especially combined with the decline in forward energy quotes, implies that the market also expects core to rise (updated chart below).

1-Year Inflation Swap and Implied Core Inflation
Purple line is expected core inflation over the next 1 year implied
by current inflation swaps and forward energy futures.

As I said in that recent comment, however, the aggressive expectations that are embedded does create the potential for disappointment. The inflation market is far more likely to respond negatively to an as-expected print than it is likely to respond positively to a higher-than-expected core print. We'd need a strong 0.2%, not just a weak 0.2%, to really goose the market I think, and that seems a stretch.

 


 

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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