Warning: Flabbergasting Area

By: Michael Ashton | Mon, Jul 11, 2011
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These days I find myself alternately flabbergasted and outraged, with very little else.

And sometimes, I am both. Exhibit "A' is the bill that my company received over the weekend, from the New Jersey Department of Labor and Workforce Development. I can do no better than quote their explanation of the assessment:

"The New Jersey Department of Labor and Workforce Development (Department) was required to borrow funds from the United States Treasury in order to pay Unemployment Insurance benefits. Payment of the interest on the outstanding loan balance starting January 1, 2011 is due September 30, 2011.

"As required by N.J.S.A. 43:21-14.3, the Department must assess all employers for the interest due...

"The calculation of your Federal Loan Interest Assessment for 2011 is shown below. Payment is due 30 days from the mailing date of this notice. After 30 days, interest will accrue at the statutory rate of 15% per year."

I am speechless. Business owners are being assessed, in a way completely unpredictable to a business owner, for a loan the state took out to pay obligations the state incurred on behalf of the citizens of the state. And if the business owner doesn't pay within 30 days, it's actually better for the state because the state will make 15% on that assessment and assuredly isn't being billed 15% by the Treasury. This is both flabbergasting and outrageous, and probably part of why hiring is slack!

Less incredible, except for the fact that it took this long, is the news from Europe that leaders on that continent are "...prepared to accept that Athens should default on some of its bonds as part of a new bail-out plan for Greece... It also marks the possible abandonment of a French-backed plan for banks to roll-over their Greek debt." This was only one of the headlines over the week hinting that the "French bank deal" might have hit a snag and that leaders are now thinking about how bad default might be. Another story noted off-handedly (cited here) that "at least five" banks were asked by the ECB to apply to act as advisers in the event of a sovereign default in the Euro area. And Germany's ruling party seems to understand that they can try to keep the Euro together, or they can try to maintain their capacity to govern Germany, but probably not both: Chancellor Merkel told Italy that it needs more "frugality' and her finance minister said that Germany would not give the bail-out fund the ability to engage in price-keeping operations in the Italian and Spanish bond markets.

This seems eminently reasonable, since when the ECB tried buying Greek bonds to control the slide into oblivion all it did was delay the crisis a few months. Holders of PIIGS debt, who were evidently counting on having that door to exit through, decided to get out before the door shuts completely. Greek yields...well, never mind. Portuguese yields rose 42bps to 12.51%. Irish yields jumped 28bps to 12.65%. Spanish yields leapt 33bps to 5.98%. And Italian yields sprang 42bps higher to 5.67%, a level that one story said was enough to threaten the viability of the Italian budget. Seriously, if you can only finance your country if interest rates are below 5.7%, then it was doomed to eventually end anyway - for how many years, out of the last 300, have Italian yields been below 5.7%?

Italy is an interesting case because she issues inflation-linked bonds. So does Greece, but Greece only had a handful of small issues whereas Italy is the fourth-largest issuer of ILBs in the world behind the US ($723bln), the UK ($442bln), and France ($255bln). Italy has $158bln outstanding in 10 inflation-linked issues. The real yield on Italy's current 10y inflation-indexed bond rose 54bps today to 3.905%.

This could perversely benefit the U.S. and U.K. inflation-linked bond markets, because a severe worsening of Italy's prospects and rating would have a much more-serious effect on the size of the inflation-linked bond market than it would have on the nominal market. There are many substitutes for Italian government bond issues. There are not very many substitutes for Italian BTPis and BTPeis - the corporate linker markets are far too small and illiquid, and the major sovereign markets are those I've just listed. So you can't go from Italy to Germany in linkers: Italy is $158bln in size; Germany is $72bln. Indeed, the world sovereign inflation-linked bond index ex-US, France, Italy, and UK is only $242bln. So, while I was very bullish on TIPS when the Fed was buying all of the visible supply, and then turned bearish (the 10y TIPS yield is only 0.55%, after all), I can't imagine wanting to sell them, though, if there's going to be another $158bln looking for a home in the inflation-linked world.

Back to flabbergasted: a Bloomberg story entitled "Fed Data Cruncher Finding No New Normal Unemployment Nationwide" discussed the work of some Fed researchers who are "scouring data, examining models and gleaning anecdotes to determine why the jobless rate has remained stuck around 9 percent or more since April 2009." This is borderline crazy. Here is a quick summary of the article: Why didn't it work? Is it because of structural unemployment? No? Then is it because we mismeasured the natural rate of unemployment? No? Then obviously what we're doing will eventually work and we should keep doing more of it.

Shouldn't they also ask the question about whether the world doesn't work according to their models, at least if you get outside the normal range of activity on which those models were based? Maybe it didn't work because it isn't supposed to work. These are, after all, only theoretical models and they rely heavily on the notion that money illusion is a strong force. Continuing to do more of the same, if the thing you're doing is completely ineffective - and the evidence suggests the effect of LSAP was well-nigh zero once you take away the complimentary short-term effects of fiscal stimulus and the natural tendency of the economy to cycle anyway - is just plain stupid. Well, perhaps "stupid" is strong; "uncreative" would be more charitable. Maybe, just maybe, the world doesn't work the way they thought it did.

And that's just one of the many reasons that Bernanke's famous "one hundred percent" expression of confidence on "20/20" was so ridiculous. You can't even be that sure that the model you're using is right. Heck, I'm not even 100 percent sure that gravity is a universal constant, but at least we've spent more time testing that hypothesis.

It is hard to be long risky assets when there are so many things that regularly flabbergast or outrage you, and today we had another "risk off' or "growth off' sort of trade as equities dropped 1.8%, bonds rallied 11bps to 2.92%, and commodities declined 0.5%. But the commodity beating wasn't uniform, as Livestock rallied and industrials and agriculture fell. The dollar rallied again, and once again the dollar index is threatening the 76.00 level above which things get interesting. I am not sure it will hold, this time, as bad as our domestic problems seem to be.

Tomorrow, we get to see the minutes from the June FOMC meeting. There shouldn't be any major surprises there, but those investors who still can't bring themselves to understand why QE3 hasn't been announced yet will scour the minutes for evidence that it may yet happen.

And who knows? I am certain that there is more flabbergasting ahead.



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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