No Engine Left

By: Michael Ashton | Mon, Aug 1, 2011
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The overnight equity-market rally lasted a full three minutes into the trading day before investors began the sell-the-news trade following the generally-expected pop on news that a debt ceiling deal was virtually passed. Although at this hour the bill has still not passed either house of Congress, but it seems likely that this bill (which no one seems to really want) will be making the trip to the White House for the President's signature shortly. The three minutes of rah-rah seemed sufficient, and stocks were already back to nearly unchanged - and bonds, rallying again - when the ISM Manufacturing figure printed 50.9, rather substantially below the 54.5 expectation and the lowest number since 2009.

The manufacturing sector is clearly at "stall speed;" the current level of the ISM index (see Chart) is roughly where the index was in 2007 and early 2008 just before the early stages of the recession helped trigger the mortgage/credit crisis. (The ISM itself says 41.2 is the dividing line between growth and recession, but that's not the same thing. An economy limping along at 1% growth is vulnerable to a shock.) Past is not prologue necessarily, but there is no doubt that the economy is just barely limping along trillions of dollars later.

Stall Speed
Stall speed.

The breakdown of the ISM was no more promising than the headline number. Every activity component fell: New Orders to 49.2 from 51.6, Production to 52.3 from 54.5, Inventories to 49.3 from 54.1, Order Backlogs to 45.0 from 49.0, and the important Employment subindex slipped to 53.5 from 59.9. This last point, combined with the continued buoyancy of the "Jobs Hard To Get" subindex of Consumer Confidence, suggests strongly that the Unemployment Rate might rise still further from the 9.2% reported last month.

There was not much further news, but volume was actually decent by 2011 standards. The VIX index slipped, although it remained fairly high. Stocks, which had spiked lower after ISM and then bled to new lows, bounced off a long trendline (see Chart) and staged an afternoon rally. The agenda of buyers was fairly clear - the 200-day moving average (also shown on the chart, currently at 1285.41) is a widely-followed indicator and a close of the S&P below that level would trigger a flip in some of the momentum crowd. So stocks rallied back above the 200-day moving average, then sunk back to it with three minutes to go before the close. The equity market in short is very finely balanced at the moment on a knife's edge.

200-day moving average and the uptrend-line are both being challenged
200-day moving average and the uptrend-line are both being challenged.

This chart is probably important enough to look at a close-up of the last year or so (see Chart below). There are a ton of support levels in play: the 200-day moving average and the uptrend-line; the June lows at 1258, the March lows at 1249, and some people are watching the trend-line off those two lows, which comes in at 1262, as the 'neckline' of a big head-and-shoulders pattern that projects to, um, 1147.

Maybe you don't WANT to look at this too close-up
Maybe you don't WANT to look at this too close-up.

There is a lot of hurt to be visited on the equity market if the bears get the ball rolling. Frankly, there is enough support that I wouldn't worry about it if equities were cheap. But where they are valued currently, and with the chance of a new recession which is clearly not priced, I think these support levels don't seem so formidable after all.

Soon to be noticed, after the debt ceiling deal is passed, is that Italian 10-year yields just went to new highs at 5.99%, and the 2-year is just below its recent highs (presently at 4.45%). Weakness in Italian debt markets is the circumstance that really causes investors to shudder. Observe the effect that Greece's problems had on the world's markets, and then reflect on the fact that Italy's GDP in 2009 was about six-and-a-half times as large as Greece's (an even larger multiple would apply currently, of course, thanks to Greek austerity measures) and a debt in 2010 of 5.5x (according to Eurostat, although presumably this doesn't include the 'hidden' Greek debt). Italy's economy is roughly the size of the UK. It is rated A+ by S&P, and so it is widely owned. A 6% rate is not a level at which panic should set in, especially when the curve is still sloped positively between 2-years and 10-years, but it is disturbing that these yields are going to new highs. "Too big to save" is the operative term here. And, as the recent U.S. data demonstrates, the global economy is sputtering. There is no engine left to pull the train up even a modest incline.

And that's the message from bonds. As nominal yields continue to decline, real yields are moving right in step. The 10-year inflation swap rate is at 2.78%, not appreciably off the post-2008 highs of 2.89%. But 10-year TIPS yields are at 0.33%, an all-time low. And that means the ratio of real yields is also at an all-time low of 11.7%. In other words, when you buy a 10-year nominal Treasury bond, only 12% of your return is compensation for the use of your money. The rest of the return is compensation for the decline in the value of your money. A more normal ratio is 40-70% (see Chart). But look at the dip at the end of 2007 into the beginning of 2008, before the teeth of the crisis had set in. What we are seeing now is bad news.

TIPS yields as a percentage of nominal bond yields, 10-year maturity
TIPS yields as a percentage of nominal bond yields, 10-year maturity

Tomorrow - assuming that the debt ceiling does in fact get passed and signed into law tonight; if not, then the economic data will be irrelevant for trading tomorrow - the data calendar includes Personal Income (Consensus: +0.2% from +0.3%) and Spending (Consensus: +0.1% from +0.0%), and the Core PCE Deflator (Consensus: +0.2% m/m vs +0.3% last, raising y/y to +1.4%). Car sales will be released throughout the day; they have recently taken a dive and until now the excuse has been the Japanese tsunami and channel effects from that disaster. The tsunami happened in March. At some point, either we need to upgrade our assessment of the long-term effects of the tsunami or acknowledge that some of the weakness may be exogenous. Maybe the tsunami is the next George W. Bush - we will keep blaming stuff on it for the next several years?



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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