By: Michael Ashton | Mon, May 16, 2011
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I am sure it is just pure chance, but sometimes it seems as if the market action matches the weather. Today in New York it was cold and rainy, with the prospect of more of the same for a few days. And the stock market (-0.6%) and many commodities (Crude -2.3%; Industrial and Precious Metals and Livestock all lower, but Grains and Softs +1% or so) were drippy as well. TIPS dripped, with the 10y real yield up to 0.77%. Treasuries rallied 2-3bps, because bond traders are happiest when everyone else is miserable (right??).

Or, perhaps, it may not have been the weather after all.

The Empire Manufacturing Index fell to 11.88, the lowest level of 2011. This isn't really an important number, except that it has been confounding expectations on the high side all year and so a downward surprise is unusual (except in the context that most other indicators have also been surprising in that direction lately).

The United States hit its debt ceiling, provoking more discussions about whether the U.S. will default, and what it would mean. I have stopped worrying about this and the implications for the U.S. credit rating. As Mark Steyn pointed out a couple of weeks ago (thanks DS for bringing this column to my attention):

...generally speaking, when you hit your "debt ceiling," your credit is at risk. If you've got a $10,000 credit card, and you run it up to the limit, but you need a couple more grand right now, pronto, because you outspend your earnings by 50 percent every month and you have no plans to change that anytime soon, well, the bank might increase the limit to $15,000, or $20,000. Or they might not. There is a question mark over your credit because there is a question mark over your credit worthiness: It is at risk.

That seems to me to be a good point, as long as we distinguish between the credit rating and creditworthiness. The credit rating measures the probability that an entity will default, whether because it cannot pay or chooses not to. In neither case should there be any chance for any outcome other than a narrow technical default, since the federal government can always print currency to pay its debts...or to buy goods and services directly, without even raising debt in the first place (indeed, if we're never going to pay it back, it would be less dishonest to just print-n-pay). The credit rating of the U.S., Japan, and probably all countries that can print their own currencies - that is, not European nations - should be very high and probably uniformly AAA.

But creditworthiness measures the borrower's probability of actually making good on the debt. In the case of a sovereign that controls its own currency, "making good" surely ought to include the addendum that the debt is paid back in currency that has not depreciated dramatically in real terms (some mild depreciation is probably okay, since after all that is part of the interest rate that the sovereign is paying). And, given that the Federal Reserve is currently buying all of the Treasury's new debt, there is at least a prima facie case to be made that we are not a very creditworthy borrower. As Steyn points out, it really shouldn't be surprising that the creditworthiness of this nation is being questioned.

Now, in market terms how significant is this debate? Actually, I think what would happen if the U.S. stopped spending more money than it took in is that growth would take a near-term hit, which is why stocks and commodities would tend to drift lower, while the credit of the U.S. would improve marginally and Treasuries would become relatively more scarce. Presumably, the Treasury would take some of the maturing Treasury Bills and reissue longer debt to hearty demand, keeping the total amount of debt outstanding unchanged. And in what would be the most dangerous thing to both political parties, we would discover that life actually can go on without the government spending like a drunken sailor. But that's just my guess, and I don't expect that there will be a government shutdown of any meaningful duration so we won't get to test it.

Markets are probably reacting less to the issues with U.S. debt than to the issues with Greek debt. Over the weekend, European leaders seemed to decide to use the word "re-profiling" to describe what may need to happen to Greek debt. This word means, as far as I can tell, to change the maturity profile and potentially the interest rate of the debt. The other word we have for that is "default," but "re-profiling" sounds more like you're sanding down a door to make it fit better. Ahhh...fits like a glove! Greek 10y is still around 15.5% and the 2y around 25%. A lower "profile" there sure would feel better, wouldn't it?

But for all the news, equities fell (and did on Friday as well) but did not have a meaningful breakdown. The dollar rallied over those two days, but didn't break through important resistance to launch higher. Crude oil declined today (and on Friday), but has so far averted a collapse. Bonds rallied to new low yields on the year (3.15%), but haven't exactly lifted off yet. Markets are doing one of two things: we are either bracing for a crisis-ish sort of break (sharply lower equities, commodities, and TIPS, and a sharply higher dollar and Treasuries) or we're getting bears, bears, bears, bulls, and bulls respectively overcommitted ahead of that break and instead markets are going to reverse hard if nothing bad happens in the near-term.

The introduction of new terminology ("re-profiling") suggests that the singularity is near. But I suspect it is further than we think it is. I would be cautious about following breakouts in any of these markets in the absence of crisis-type news, but as traders we might get sucked into such positions because market moves often precede the public news. If that happens, then for goodness sake make healthy use of protective stops!

On Tuesday, the expectations are for another tepid Housing Starts figure (Consensus: 569k vs 549k last) and decent Industrial Production/Capacity Utilization figures (Consensus: +0.4% vs +0.8% last, 77.6% for CapU). But traders main attention will remain on the tape.



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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