No Coup, No Grace

By: Michael Ashton | Fri, May 13, 2011
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The economic data failed to give an excuse to administer the coup de grace to the commodity bulls, the equity bulls, and the bond bears. Initial Claims was as-expected; PPI a tiny bit higher than expected but nothing alarming. Retail Sales was also about as-expected but with upward revisions. Without the tailwind from a weaker data print, markets couldn't push through the relevant technical least for a day.

So stocks and commodities were able to recover a little, and 10y notes dropped back to 3.23%. This is at this point nothing more than a failure to commit, rather than a failure. The economic outlook is certainly less than completely rosy. 434k Initial Claims is not exactly soothing, except when compared to last week's spike (see Chart). And, I suppose, when compared to a year ago when 470k was fairly routine. But it is still one of the worst levels of the year.

US Initial Jobless Claims
Good or bad Claims? Depends on what your frame of reference is.

Weak economic data weighs against overvalued equities and supports what look to me to be fully-valued fixed-income markets. It certainly doesn't help commodities markets which have come a long way, but I will keep reminding readers that the long-term commodity play isn't a supply/demand thing but a monetary-inflation thing.

On the other hand, as I said above the economic data is not so much weak as weaker-than-expected. Initial Claims would be considered weak if maintained at this level, but this is likely just a burp and I wouldn't yet reject the hypothesis that employment is still improving albeit slowly. The other data we have seen recently have mostly been soft, though, only through the lens of over-ebullient economists and stock shills. The Citi Economic Surprise index has fallen all the way from an all-time peak of 97.5 back in early March to a 10-month low around -36 right now. There is plenty of room for further disappointment, but mostly this has been about splashing cold water in the faces of the Pollyannas to bring them to their senses. The old recovery paradigm is not the right paradigm. The economy is not launching.

Now, as the Economic Surprise index continues to drop and the economy continues to surprise on the downside, it may be instructive to remember that Bernanke's suggestion that QE2 might be worth considering followed a month or two of downside surprises (and some positively ugly surprises in early August of last year). I don't think there is any chance that QE3 is on the table; too many Fed officials have drawn battle lines too clearly for that to happen without a lot of people losing face. "Well, maybe they'll lose face," you might think, because surely monetary policy will not be held hostage to reputation. This is true, but the stronger message is that these officials were permitted to say these things. Remember that senior members of the Fed have their remarks vetted ahead of time. Some Chairmen are more relaxed about letting their colleagues sing a different tune, but you can be sure that even the relatively relaxed Bernanke would like to make sure they are not opening a different hymnal altogether.

The hawkish chatter from the hawks is probably not indicative of a growing interest in actually tightening policy. Indeed, the chatter may be in lieu of actually tightening, since this Fed believes very strongly (and, I think, wrongly) that inflation expectations are key. But at the same time, if further easing actions were being seriously considered you can bet your bottom Weimar Deutsche Mark that the hawks would be closer to the reservation.

QE3, if it comes, is more likely to come from Europe after the failure of its ill-considered and premature tightening policy, than from the Fed. But neither is especially likely I think.


And now we move on to what for me is the main event of the month, and that is tomorrow's CPI data. Consensus estimates call for +0.4% on the headline figure and +0.2% on the core, bringing the year/year rates up to +3.1% and +1.3%, respectively. The expectations for the core are actually for a 'soft' 0.2%; if it is being rounded down to 0.2% then it's more likely we will see 1.4% on year/year core CPI.

While I would like to see that for business reasons, I think the risk is lower. The assorted models I employ all "expect" (if you will allow me some anthropomorphism) core inflation to flatten out around this area for a few months before accelerating into year's end. The main reason for this is that housing inflation, a key part of core inflation, appears to be a little ahead of itself. The high inventory of unsold homes (for the model, lagged appropriately) should keep Shelter inflation from continuing to rebound as aggressively as it has been. Six months ago, Shelter CPI was -0.39% year/year; three months ago it was +0.45%; two months ago +0.76%; and last month +0.91%. My model has it estimated at +1.0% to +1.2% for the next few months.

However, some observers who look more closely at things like the National Multi Housing Council's Market Tightness Index (see Chart below) don't expect the Shelter component to decelerate at all. If those people are right, then my 1.6%-1.7% estimate for 2012 core inflation is going to be end up being too low.

National Multi Housing Council's Market Tightness Index
Apartment tightness index might suggest Shelter inflation will keep on rising.

And the inflation swaps market is still insisting just that. While 1y inflation swap rates have plunged from 2.83% to 2.20% in just two weeks days, that is all about the drop in energy quotes. The decline in year-ahead gasoline futures implies that while on April 28th energy was projected by the futures market to rise about 11% (taking into account the required lag) and to add 0.36% to headline inflation, the market is now pricing in an 8% decline in gasoline and a drag of -0.28%. The net result is that core inflation over the next year that is implied by the 1y inflation swap and energy quotes is still about 2.5%. The chart below (Source: Enduring Investments) shows 1y inflation swaps (black line) and the implied core inflation, extracting the market's assessment of energy.

1-Year Inflation Swap
Market still sees core inflation around 2.50% over next year.
Potential errors to my estimate are accumulating on the high side.

To my mind, this is still aggressive. While there is much uncertainty to the possible outcome, and all of the long tails at this point are to higher inflation rather than deflation, the central tendency of my models from March '11 to March '12 is still just shy of 2% on core inflation. As an investor, I'd view the 50bps difference as the option premium I need to pay to own that headline-inflation tail, but as a relative value investor I would consider selling inflation swaps and buying gasoline futures to implicitly short core inflation at around 2.50%.

The weird thing is that the markets don't seem to be consciously pricing higher inflation. Equity prices are too high and Treasury yields much, much too low to be expecting core inflation around 2.5% in a year. And Fed funds futures for next year (99.70 for March 2012) are essentially pricing an aggressively easy FOMC. Now, it may well be the case that the economy remains too weak in early 2012 for the Fed to do much tightening even if inflation is creeping higher, but in that case what are stocks doing this high? If it's because there is too much liquidity, then what are commodities doing going down? My problem isn't with understanding the pricing of any one of these markets in isolation; it is with understanding their collective pricing. In my view, the resolution is likely to be higher real rates, higher nominal rates, higher inflation swaps, lower equity prices, and higher commodities. But there might be twenty zig-zags before we get there. The most vulnerable market in the short term looks, to me, to be the bond market, which has been riding the weaker-than-expected data higher and will be the first to suffer if the data merely stops surprising low.



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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