It's A Big Graveyard

By: Michael Ashton | Wed, Apr 6, 2011
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For some time now, the markets have been 'whistling past the graveyard,' impressively ignoring and/or shrugging off a fair pile of news that ought definitely to be negative for equities and probably somewhat negative for bonds as well. I've detailed these things previously and they don't really need much repeating.

But it's one thing to go whistling past the local church graveyard, something else entirely to keep whistling when the graveyard stretches on for miles. Today, Portugal formally asked the EU for a bailout. "I tried everything but we came to a moment that not taking this decision would bring risks we can't afford," said Prime Minister Jose Socrates. A day or two ago, there had been talk that Portugal wanted a short-term loan to float it past a big slug of bond redemptions that is approaching; the EU said 'it doesn't work that way,' so Portugal was forced to throw itself on the mercy of the Union.

Well, this is something less than a total surprise, and indeed Portuguese bond yields rallied 17bps, along with Ireland's 32bp rally and Spain's 6bp rally. I don't know how Portugal seeking aid improves the lot of Ireland, but there it is. Now, I don't really care about a one-day rally but the significance of Portugal succumbing is that the market's crosshairs will now be trained on Spain, Italy, or Belgium. Judging from market yields, it would appear Spain is likely to be the next one 'on the clock.' And that's really the main event, because Spain's economy is much larger than Portugal's, Greece's, or Ireland's.

The graveyard stretches onward. How long can markets keep whistling?

U.S. 10y note yields reached 1-month highs at 3.55%, and I will not be at all surprised to see them keep going higher. I believe the economic data is going to be flattening out a bit here, but not quickly enough to get investors champing at the bit to take up the slack once the Fed stops buying in a couple of months. Real yields are back to 0.96% on the 10y - still too expensive for my tastes but it is easy to say that; harder it is to find good alternatives. Even OSM, which I wrote about a year ago when it was trading at 16, only sports a yield of CPI+4.8% or so. After accounting for the credit risk of the issuer, that's not particularly cheap (although probably better than many alternatives - I am not selling mine yet).

Energy markets continue to ooze slowly higher. The impacts of the Japanese disaster are continuing to spread and be felt. The financial impacts won't be measured by Geiger counter readings, but by guidance from companies whose supply chains have been disrupted by the crisis. That guidance and those calls will start to happen when earnings announcement season gets kicked off on Monday (although the companies affected probably aren't those that report next week but in the week or two thereafter).

And the money spigot the Fed has turned on will be turning off in only a few months.

Some people would say that this is all part of the "market climbing a wall of worry." But that's not right. A "wall of worry" is when investors are timid because of the possibility that things might go wrong, and they're worrying about what might go wrong. That's not the situation here. These things are not possibilities; they are things that are actually going wrong, right now. It's whistling past the graveyard (frankly I picture it more like Michael Jackson's Thriller, with lots of ghouls and ghastly things reaching out to clutch at the passersby).

Tomorrow, there are two main events on schedule. The first is the announcement by the ECB of the results of the monetary policy meeting. There is total unanimity among economists (at least, the 57 polled by Bloomberg) that the ECB will hike rates by 25bps even as Portugal, Greece, and Ireland are foundering on high rates. I think that will be a colossal error, although if they stop after one tightening or indicate that there will be a pause of some length to let the policymakers evaluate the effect of the move then it may not be as big of an error. But tightening policy now, given what is happening in MENA, given what is happening in Japan, and given what is happening with oil (which price rise is already contractionary), is a mind-boggling decision. And, as I have said before, it clearly points out that the EU doesn't care much about the periphery countries and that policy is being run for the core. That's fine, unless you're a periphery country! We will see, I suppose, how willing the consumers of Europe are to take slower growth or a return to recession in order to restrain inflation.

This was always going to be the battle. Inflation, given the scale of central bank response to crisis, was always doomed to turn higher long before the "economic slack" (which is to say, jobs for the people) had evaporated. In the U.S., I have long assumed that the Fed would be very slow to hike rates for this reason and because the institution - despite its apparent independence - isn't insulated from public rancor or from the brickbats of Congressional blowhards.

The other report is the weekly Initial Claims data (Consensus: 385k from 388k), which is unlikely to have a major impact unless it spikes well above 400k. A 410k print would get people wondering whether Claims are turning higher again, but a better-than-expected number has a high hurdle because the presumption is that Claims are in a downtrend.

For my money, I'm watching the ECB, listening to the press conference afterwards, and wearing a garlic necklace.



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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