No, Mister Bond, I Expect You to Die!

By: Michael Ashton | Sun, Jul 10, 2011
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Warning: excessively long post. And I apologize about the many different fonts on the various charts!

That was not the Payrolls number I was expecting, nor the number the market was expecting. The economy created only 18k new jobs in June; combined with a net downward revision of -44k to the prior two months, the net was negative. That wasn't the only bad news. The Unemployment Rate went back to 9.2%, up from 9.1%. That means it is 0.4% above the lows set in March, and here's why that's scary: when the Unemployment Rate rises 0.5% from a low, at least since the 1960s it always has gone at least another 1% higher or more after that.

Once the Unemployment Rate starts to rise,
it usually keeps rising for a while.

Past may not be prologue here, since there aren't many examples of the Unemployment Rate descending a lot and then bouncing back at least 0.5%...but, by the same token, there aren't many examples of the government spending trillions to push the Unemployment Rate down artificially without having organic growth recover. More on that later.

The report is rotten clear to the core. The Labor Force Participation Rate fell to 64.1%, another multi-decade low (see Chart).

Labor Force Participation Rate continues to dive.

One more Employment-related chart: this is one of my favorite charts of labor underutilization. It shows the number of people (in thousands) that are not technically in the labor force, but nevertheless want a job now and would take one if it was offered. To be "not in the labor force," you can neither have a job nor be looking for one. This includes students and retired people, as well as people who have given up looking for work. This indicator went to new all-time highs - again. More than six and a half million people aren't even looking for work, but would take a job if one was available. That's 1.5mm more than normal, and in my opinion at least those extra 1.5mm ought to be considered as part of the unemployed. (The effect on the Unemployment Rate itself, in case you're curious, would be to push the 'Rate to about 10.1%).

This is a very evocative series - people who aren't even looking,
but would take a job if one was available.

So this is pretty ugly all around. And the curious thing is that there wasn't any obvious sign of this coming. ADP didn't show the same weakness, and although Initial Claims is rising it didn't suggest weakness this profound. For the time being, we need to regard this as an aberration from the presumed underlying trend of 100k or so. Note that that's a pretty weak trend, and not enough to keep the Unemployment Rate from rising, but it's better than outright contraction. So in my opinion we can reject the null hypothesis that the jobs situation in this country is improving , but we can't reject a null that the jobs situation is treading water.

As an aside, I wonder at the size of another effect that I am sure is operative but presumably is pretty small right now. I wonder by how much jobs are underreported simply because more people are working off the books due to the health care law and other onerous government requirements? As if we need another reason to repeal Obamacare (and polls continue to indicate that a majority of Americans favor repeal) there is this one: if the law pushes more economic activity off the books, it is activity that the government can't tax. See: "Greece."

Now, some people are saying that the weak Jobs figure puts pressure on the Fed to roll out QE3. I cannot think why that would be the case. It seems more reasonably to be evidence supporting the notion that QE2 didn't do very much...isn't it? Agreed, it is going to put pressure on the Committee to "do something," but it would seem to me the last thing they'd want to do is something which has already failed. The definition of madness is to do something over and over again and expect a different result, right?

Some folks also think that the current spate of weakness means that the Congress ought to stop talking about serious deficit reduction. Most of those people are Keynesians (e.g., Krugman, who on Friday said "The situation cries out for aggressively expansionary monetary and fiscal policy," which makes you wonder how the actions of the last few years don't qualify as - at least - aggressive) who have never questioned the efficacy of excessive government spending despite copious prior evidence that it doesn't have a lasting effect (See: FDR, George W. Bush). They are not likely to put any more weight on the most recent experience, which at best showed that massive deficit spending has a short-term effect, and seems not to have the 'kick-start' effect that most proponents considered almost automatic. And we haven't yet seen the other side of the coin which must come, when the deficits must be cut and the short-term effects run the other way. Or perhaps we have begun to see this - as state and local governments continue to lay off workers, that is certainly contributing to the rise in the Unemployment Rate. Push it down with trillions, watch it rise back when the trillions are gone...

But I think Congress will continue to talk about deficit reduction, and will reach an agreement to cut the deficit by at least 1-2 trillion over the next decade as part of an agreement to raise the debt ceiling. Do you know why I think that? Because the debt ceiling once raised will not come back down, but the budget cuts can easily be rescinded whenever they like. Like, for example, if there were "economic emergencies" that demanded the cuts be restored. Since no deal the two sides make today will have anything to do with next year's budget, they'll reach some sort of agreement or I'll eat my hat.


In Thursday's article, I noted the recent rise in the M2 money supply rates of change to post-2009 highs. I meant to say a little more about that. I should have added that the latest week of data was for June 27th, so some of the most-recent surge may be quarter-end. The Fed may also have wanted to let the market get a little extra liquid with Greece in the backdrop - that explanation is somewhat more pleasing since the jump in M2 rates of change isn't a one-week phenomenon but the rates of change have been edging higher for a few weeks now.

But there's a problem with that explanation, and that's the fact that the Fed doesn't control M2. In fact, the relationship between M0 and M2 - the money multiplier - has been unstable since the wall of money was first unleashed a few years ago. And that leads to the real fear, which is that the wall of money in M0 is finally starting to pass into M2. That is, the fear is that the money multiplier is recovering.

Until now, if the Fed added more reserves through LSAP it manifested in higher M0 and a lower multiplier. That is, M2 didn't really show much effect. The multiplier I first discussed here is down to 3.5 now that QE3 is complete. With the monetary base at $2.6 trillion, if the old 8.5 multiple were to suddenly re-appear tomorrow (and I am not saying I expect that) then M2 would rise from $9.1 trillion to $22.1 trillion. That rise in transactional money would almost certainly be extremely inflationary! The point is that if the multiplier, which collapsed mainly because the Fed was paying banks to hold reserves, were to suddenly start rising again, it becomes a clear and present danger requiring aggressive and determined response from the central bank - which, with the Unemployment Rate rising, would be ticklish to say the least.

Now, I wrote Tuesday about the conversion of Ron Paul and the implications of his plan for explicit monetization of the debt (effected, in his plan, by having the Fed "tear up" the bonds it has bought) on the risks for inflation. And now I've just written about the acceleration in money supply growth and the risk that the multiplier could rebound for reasons we may not correctly anticipate (or more to the point, the central bankers may not correctly anticipate). But what about the implications for the bond market, and other markets, generally?

Both of these things are potentially 'tail events,' but they are both strongly inflationary. We're not talking here about a rise in core inflation to 2%, which is roughly where my models have it going over the next year-plus based on historical relationships with the money supply, the dollar, private debt, and so on. The risk is that it goes much higher, and surprisingly quickly. Not since the early 1980s have we seen Core CPI accelerate more than about 1% in a year, but from February 1978 to June 1980, Core CPI rose from 6.2% to 13.6% and from August 1973 to Feb 1975 Core CPI went from 3.2% to 11.7%. Remember, this is core inflation so the OPEC embargos are not the cause (in the 1973-75 example, the removal of wage and price controls probably contributed as official prices rose to match black market prices). So an acceleration of 5% or more in a single year is not impossible...and back then, while monetary policy was irresponsible the Fed was not purchasing trillions of dollars' worth of bonds and then (if Congressman Paul has his way) ripping them up.

I think it's important here to point out that I am not talking about probabilities . I am not predicting 7% core inflation next year. My point forecast is 2.1% for 2012. But the distribution is extremely skewed to higher outcomes, and has fat tails in that direction as well. I am talking about possibilities , and they're worth talking about since they're no longer hundred-to-one long shots but maybe five-to-one or ten-to-one. Since 7% or 13% core inflation would pretty much destroy most plans based on assumptions derived from the last twenty years, it's not a bad idea to ask how your plan might fare in such a case. Here's a quick cut giving my basic thoughts; if you want more color then ask me about becoming a client!


For starters - even if you think that equities are an inflation hedge, you should be aware of this fact: since 1881, when inflation has been between 1% and 2% the average Cyclically-Adjusted P/E (CAPE) has been 19.97; when inflation has been between 2% and 4% the average CAPE has been 17.95; when it has been over 8%, the average CAPE has been 10.12 (Source for those numbers is Robert Shiller, via So let's assume that prices rise 10%, and corporate earnings rise 12% (certainly, corporate earnings cannot rise much faster than inflation overall, although there certainly would be winners and losers). Then we would expect the market to fall precipitously. Let's suppose that cyclically-adjusted earnings are $10 in year 0:

Market index in Year 0: 17.95 x $10 = 179.50
Market index in Year 1: 10.12 x ($10 * 1.12) = 113.34

As long as you're willing to wait for a while, your 'inflation hedge' will end up doing okay, but "a while" might be 20 years. In the meantime, you're staring at a 37% loss in year 1. It is much better to be underweight stocks when conditions (in particular, interest rates and inflation) are perfect, because they don't do very well in the transition to less-than-perfect!


There are a lot of people getting this wrong right now. Gary Shilling, who I think is terrific, in a recent note made the same mistake so many people make: he says that coming recession in China, and weak growth elsewhere, will tip the supply/demand balance and trigger much lower commodity prices. As far as that thought process goes, in a ceteris paribus way, it is surely right. But the much bigger effect is the effect on the money:stuff exchange rate. The error being made here is analogous to the one made by investors in stocks who think equities are inflation-protected: they are right about one effect, but they miss a much bigger effect. In the case of stocks, they are missing the reduction in the multiple that is associated with higher inflation outcomes, and that effect dominates the rise in nominal earnings that goes along with higher prices. In the case of commodities, the two effects are ordinarily unrelated so normally the main thing you have to worry about - and surely the most important thing for a short-term investment in a single commodity - is the supply/demand balance. More acreage planted and higher yields in corn will assuredly push prices lower.

But prices are denominated in dollars, and if the supply of dollars relative to the supply of corn rises , then the relative price of corn may rise even if there is more corn this year than there was last year. The mistake we make is that we think of dollars as being some fixed thing, when it is more accurate to think of them as a counter with no intrinsic value of their own. If you're up $50 in a casino, you flip the dealer two bucks. If you're up $5000, you slide him a hundred-dollar chip. Why? Because in the latter case, dollars are less scarce.

If the money supply rises 4% next year, then the supply and demand of commodities will dominate. But if the money supply rises 50%, the supply and demand simply won't matter - all prices will rise. And that is potentially a much larger effect, although one reason I like commodities is really that there are two ways to win: you can win the supply/demand game, or if there is another recession and a QE3, you can win on the too-many-dollars game.


Obviously, a huge rise in inflation will absolutely kill nominal bonds (and also any TIPS other than very short-dated ones, although in TIPS' case their return will catch up over time while that will not happen with nominal bonds), and that is all I need to say about that! But I think bonds are in trouble anyway. The chart below is one I've run before; it shows the 10-year Treasury yield on a logarithmic scale through the entire multi-generational bull market.

Logarithmic scale - the secular bull market in bonds technically is still in place.

I am on record as saying that the bull market is already over, and that yields are slowly working their way to the top of this channel and through it (as of this month the top channel line is at 4.27% although there is a secondary one that comes through essentially at this year's high yields). We are right now roughly in the middle of the channel and technically speaking rates have done nothing "wrong" yet. A weak economy would seem to keep a lid on rates, but that is true only if the Fed and the Treasury can resist throwing more fuel on the fire by rolling out more stimulus. I don't think they'll be able to resist for very long.

What is concerning is not the eventual move from 3% to 4% (which, incidentally, I expect we will not see until early next year unless the rise in M2 is really the beginning of something big). The risk is that somewhat higher interest rates will make the government's fiscal position that much less tenable. The interest on the Federal debt is $242bln in the President's Fiscal 2012 budget, and already is expected to grow to $494bln by 2015 (because of a larger debt but also because of the interest rate assumptions: 91-day T-Bills are expected to rise to 4% and 10-year notes to 5%). Suppose rates instead went to 7% and 8%? We have seen recently how uptrends in yields in Greece, Ireland, and Portugal helped precipitate crises at the same time as they were telegraphing the crisis. My concern is not so much that bond yields go to 5%, or even higher. My concern is that they go high enough to start the death spiral.

Now, that's a strategic view: nominal bonds are going to get crushed. Tactically, though, let me return to what I said earlier. Congress and the Administration are going to come to an agreement on a big deficit reduction measure, with high confidence, in the next couple of weeks. When that is announced with much fanfare, bond prices are going to rally, the ratings agencies are going to take the U.S. off negative watch, and everyone is going to make snide comments about Bill Gross. But when that is done, we're going to see bond yields start to slip higher and it will be the beginning of the end.



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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