Pinata Markets

By: Michael Ashton | Thu, May 5, 2011
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The fast money giveth, and the fast money taketh away.

A surprisingly weak Initial Claims figure today - although partially explained by the Labor Department as being affected by the "New York spring break holiday," a new emergency benefits program in Oregon, and auto shutdowns downstream from the Japan disaster - unleashed the hounds on the inflation markets (especially) today. Economists (who ought to be able to incorporate known holiday, legislative, and production calendars into their forecasts, but I suppose that's asking too much) had seen a decline to 410k, but the actual print was 474k.

In an extremely rare show of maturity, equities declined but investors there seemed to understand this for what it is: not good news, of course, but with ADP just behind and Employment just ahead, and the number buffeted by unusual factors, probably not something to overreact to. Yes, growth appears to be slowing and economists' ebullient 2011 estimates are likely going to have to come down (but this has always been fairly obvious). But no, this one number is not the sign that the double-dip is upon us. Yet. (Stocks, though, are valued such that they have plenty of room to decline even with good news, so I'm not saying I'm bullish on them!) The S&P was down only 0.9% on the day.

Bonds rallied with a little more fervor, with the 10y yield down 6bps to 3.16%, but it was the commodities markets that speculators immediately started treating like a Cinco de Mayo piñata. Silver has been beaten up for days now, and that certainly didn't change (it was down another 11%), but today Crude also fell 11% to drop below $100/bbl and Gasoline dropped 8.5%. Grains and Softs were "only" down 2.5%; the DJUBS Livestock index was actually roughly unchanged. It was, in short, the larger and more-liquid contracts that saw the most pressure, a possible hallmark of leveraged players selling.

These movements in commodities are clearly growth-scare reactions, and the speed and severity of them suggest that they had considerable hot money in them. There is every reason for a growth scare - but that is not a great reason to hate commodities here. Gold is not where it is because of industrial demand, nor is Silver. Those are the clearest examples, but for commodities of all kinds it is the case that they aren't elevated because of robust global growth or prospects of the same.

Investors often make the mistake of looking at commodities in nominal terms. Well, they make that mistake about all assets, but particularly in the case of commodities it is plain wrong to do so. Commodities are not valued like financial assets, as the present value of future cash flows. There are no cash flows. Commodities are "stuff," and part of their movement is due to the continually-changing exchange rate between money and real stuff...that is, the depreciation of the value of the currency (aka inflation, technically). When real variables - demand and supply - change, then the real clearing price of a commodity changes. But the nominal value may not.

Consider this contrived example. Suppose that the demand for oil drops 20% against unchanged supply, but the value of the dollar drops 90%. In that case, the nominal price of oil is most assuredly going to rise in terms of dollars, even though it will fall once that price change is adjusted for the change in the buck's value. Now, practically speaking this becomes a little circular, because I don't mean the dollar's value in foreign exchange markets, but the dollar's intrinsic value against stuff. However, this is meant to be illustrative: as I have said for a couple of years now, if you want to reduce mortgage defaults, add a zero to the currency and the nominal price of houses will skyrocket. It won't change real values at all, but it will change nominal values.

This is a very important distinction because commodities aren't at these levels simply because of the demand/supply dynamic. That's part of it, of course, but the nominal price is where it is mostly because there are so very many more dollars out there. Again, measuring the intrinsic value of a commodity is problematic and circular, but there can be no doubt about the direction. The unanimity of the commodities market rally after the late August announcement of QE2 was not due to growth expectations. It was due to an understanding of what that program would do to the supply of currency compared to the supply of stuff.

So, technicians see the commodity rally as overextended, and to some degree they're certainly right. The fact that there is so much fast money coming out right now is an indication of how much of it was in! But the fundamental underpinnings of the commodity rally have very little to do with growth. Even if we were still in recession, commodities would still be much higher today than they were 2 years ago.

My biggest fears about commodities are that the Fed might actually get religion and start draining the money in the way they keep warning us they will. While I think that's fairly unlikely, it would definitely make commodities look less attractive relative to currency. However, weak numbers like we have seen recently actually tend to delay any such occurrence, because the Fed is not going to start pulling back on liquidity when Initial Claims are rapidly rising, no matter what the reason for that rise. Ironically, I think that today's numbers if anything tend to defer the day of reckoning for commodities.

That doesn't change the fact that the technical charts abruptly look poor, so that fast money is going to now do an about-face and sell to the real money guys. The thing is, the real money guys will keep buying because other asset classes don't offer anything worthwhile in either outright or relative value, and eventually the long-term real money guys will win.

This is less true in TIPS, because they are about to lose the Fed as a buyer and that could change the price dynamics even though real money are steady long-term buyers. Today, however, even with nominal bonds up, TIPS declined. This again is consistent with some fast-money exit as well as the notion of a growth scare. The front of the curve got smoked, with Jan 12s selling off 37bps, Apr 12s 20bps, Jul 12s 16bps, and Apr 13s 9bps. Remember, this was with nominal Treasuries rallying, so the blood was running in the streets especially in the front of the curve. This isn't wholly surprising; in mid-March I pointed out that the short end of the TIPS curve was incorporating somewhat aggressive expectations of core inflation and longs there were likely to be eventually disappointed. TIPS trading being what it is, the disappointment tends to be meted out in great big dollops rather than trickling in.

The TIPS curve, however, is still mighty rich, with 10y real yields at 0.68%. The only value there is if your alternative is to hold nominal 10y Treasuries at 3.16%. Sheesh. The inflation swaps curve got trashed (the necessary residual of a rallying nominal market and a sliding linker market), with 3y inflation -13bps to 2.48%, 5y -11bps to 2.57%, and 10y -6bps to 2.78%. Those are not at all outrageously expensive levels given the distribution of possible inflation outcomes in the future - I will have more to say about that distribution (probably on Monday).

The shape of the swaps curve and normal seasonal patterns imply calendar year inflation of 3.7% in 2011, 1.8% in 2012, and 2.5% in 2013 before rising to 3% in 2018 and leveling out after that. That seems to me to be too sanguine about 2012, surely!

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After a very exciting Thursday, what can Friday possibly offer? Well, how about the Employment Report? The consensus for Payrolls is down to 185k (vs. 216k last), with unchanged Hours Worked and an unchanged Unemployment Rate at 8.8%. Forecasting the Unemployment Rate recently has been the killer for prognosticators; while the Rate is usually the steadier of the two numbers this has not recently been the case.

All I know is that, given the rally in bonds today, there is a lot more potential downside than upside. No one took off their long duration risk today! It either means that Employment doesn't matter to investors at this stage, which is possible given the geopolitical situation but inconsistent with the massive beating administered to growth plays recently, or it means that the market is betting on weaker data. To the extent that is true, the best play is to lean the other way despite the technical break to lower yields today.

 


 

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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