Trichet At War

By: Michael Ashton | Sun, Jun 12, 2011
Print Email

NOTE - I don't know how this failed to go out Thursday night...I guess this will be my Friday comment, even though there is more to say about Friday. Sorry about that!

***

Incredibly, the ECB is now officially on track to hike interest rates again in July - even as the European Union crumbles around them. When Trichet told the world that "strong vigilance [on inflation] is warranted," it was a code that everyone had been looking for in advance. The ECB is planning to tighten.

I am almost speechless.

The ECB is virtually at war with EU member states. Trichet also said "It is certainly not our intention" to roll over the ECB's holdings of Greek sovereign bonds. Remember that the plan currently being discussed is to persuade creditors to 'voluntarily' roll over their maturing bonds so as to not force Greece into a default (although the ratings agencies are uncharacteristically making things difficult on the politicos by suggesting that a 'voluntary' rollover might not be really voluntary if the alternative is default). If the ECB isn't going to play that game, then the game is all but over. Now, Trichet left the door slightly ajar by saying "We would say it's an enormous mistake to embark on a decision that would trigger a credit event," which creates the wiggle room to reverse if it is made very clear by the agencies that this would not be considered a credit event. So he's saying "we won't roll our bonds because we'd hate to cause a credit event," which is a bit crazy because without rolling the bonds there really aren't many good solutions that don't lead to a credit event!

But then, Trichet seems to be crazy. This is all somewhat reminiscent of something from Law & Order, where the criminal declares that he had to burn down the house to save his family from the devil. And it is a good reminder (Bernanke, are you listening?) of why central bankers should stay away from the microphone.

It tells you how worrisome the sovereign debt crisis is in Europe that, even with the ECB tightening and the Chairman of the Fed making every possible noise that there's not even a reason to meet to discuss hiking rates until sometime in 2012, the dollar hasn't broken lower. By rights it should be in free fall with a hawkish central bank on one side and a dovish central bank on the other side, right? And yet today, the dollar rallied slightly.

The economic data didn't suddenly get better: Initial Claims were approximately on target but a smidge high at 427k with an upward revision to the prior week. The Trade figures for April showed a surprising narrowing, but that was mainly due to oil. Ex-petroleum, the Trade Balance worsened slightly. So really, economically speaking nothing much changed this week (and I can say that since there is no economic data due tomorrow).

The Fed also released the quarterly Flow-of-Funds report today, though, and while it doesn't have immediate implications for trading todaythe way Payrolls or Claims does, the Z.1 always has interesting nuggets. A lot will be made of the fact that household debt has now declined for twelve consecutive quarters, but to me that isn't the interesting story. The continuing story is that the mainflow of funds is the deleveraging of domestic financial institutions, offset by the increasing public debt. I've shown the chart below previously, and it is updated through Q1. Incidentally, in this one I haven't moved Fannie and Freddie debt to the Federal side of the ledger, because I'm not sure if they're included in "Domestic Financials" or "Business."

Share of Credit Market Debt Outstanding
Gov't continues to expand its share of the debt, and domestic financials to shrink theirs.

So, while households have shed a little bit of debt...a grand total of a 4.3% decline from three years ago - the proportion of total debt that is held by households has actually risen since then because almost all of the net deleveraging is coming from domestic financial institutions. It's a beautiful, closed loop. Treasury has effectively assumed the debt of the domestic financial institutions, who in turn buy the Treasury's debt. It's symbiosis (or incest: your call).

.

This week I got a note from my insurance company about my health insurance. They are raising rates for my plan by 18% one year after I first took out the policy. But that isn't the whole story, because in fact the plan is changing subtly. The operators at the company didn't even mention the modifications, because they seem minor, but they are a big reason the price is changing:

Section Prior Benefit New Benefit
Practitioner visits for illness or injury $25 copayment per visit with a $1,500 maximum benefit per calendar year $25 copayment per visit/no annual maximum
Wellness Benefit 100% coverage up to a $750 maximum benefit per calendar year 100% coverage/no annual maximum
Prescription drugs received while not confined in a hospital $15 copay for generic and 50% coinsurance for brand-named drugs up to $1,000 maximum benefit per calendar year $20 copay for generic drugs and a $500 deductible then 50% coinsurance for brand named drugs / no annual maximum
Home Health Care 50% coinsurance up to a $3,000 maximum benefit per calendar year 50% coinsurance/no annual maximum

Now, these changes are occurring "in order to comply with the new Federal requirements under Health Care Reform." They clearly increase the value (and the cost to the insurance company) of the plan, on average, because "no maximum" means the tail value is very large. Options traders know that a big part of the value of any option is in the value of the very-unlikely (but really high value) outcomes, so when you make the insurance company offer those tails the cost goes up quickly.

But I don't want those tails. I have no need for a "no annual maximum" benefit for practitioner visits, because I will go to the doctor when I need it. I'm not worried about home health care. And yet, the law can't allow me to opt out because if only the people who need this care pay for it, then the cost is incredibly high since it would be spread over only a few people. This is typical of most government programs, which tend to spread the costs and focus the benefits because the ones who receive the narrow benefits actually change their votes while the ones paying the diffuse costs tend not to change theirs. At least, this was the way it generally works, until the people paying the diffuse costs are paying so many of them that they start to notice.

More pertinent to my discussion today, though, is the effect this has on inflation metrics compared to the perception of inflation.[1] If the increased price of the insurance policy, in aggregate, summed to approximately the aggregate value received by the small minority who receive them, then the effect on CPI would be nil: the improvement to the average welfare is equal to the rise in the average cost, so while your costs went up so did your welfare on average. If we calculated a price index for every person, it would register a rise for most people (who don't actually receive any new benefits because they don't use the new features, but are paying higher prices) and a massive, massive deflation for the people who are paying 18% higher costs but receiving 10x the benefits they did previously.

And here is the wedge (or anyway, one of them) between measured inflation and perceived inflation. Because the person who is receiving that huge benefit does not see it as deflation. In all likelihood, that person still perceives that there was 18% inflation, even though their standard of living improved demonstrably and dramatically. But the 'losers' (like me) who pay the extra 18% and receive nothing useful in return most definitely perceive the 18% as inflation. In this case, the perception is that medical care inflation was up 18% while, by construction, quality-adjusted prices on average did not rise at all.

Additionally, it hardly needs to be said, the 'uncapping' of these benefits creates incentives for people to consume more medical care, which by itself will tend to raise the real price of medical care over time. And that really is inflation.

 


[1] All of the following discussion abstracts from the fact that medical care inflation is not measured this way in the CPI. The BLS takes a higher-level view of counting the price and volume changes of medical care actually delivered by providers and paid for whether by insurance or consumers directly. The point is still valid but it is easier to illustrate the diffuse-cost, focused-benefit problem this way.

 


 

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.

Copyright © 2010-2017 Michael Ashton

All Images, XHTML Renderings, and Source Code Copyright © Safehaven.com