Same Song, Second Verse...A Little Bit Louder And...

By: Michael Ashton | Thu, Aug 4, 2011
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Well, needless to say there is a lot to cover today.

The overnight session held a lot of intrigue. Japan intervened in its currency markets to push down the yen. It seems like everyone wants their currency lower! Trichet even said (at his press conference, of which more in a minute) that a strong dollar is in the world's best interest. Well, perhaps it is in the interest of the world-ex-US, since it helps all those other countries export to the U.S., but it doesn't make sense to say that having any single currency strong is in the world's collective best interest. Currencies are just a way of trading real goods, and they are zero sum. If the supplier wins, then the buyer loses, and vice-versa.

One way to have a weak currency is to flood the world with that currency. That's what the Swiss National Bank started to try to do the other day, after all. Of course, if everyone starts trying to do it, then there's no telling what will happen to relative currency values. That will depend on who "wins" the currency war. What we do know is that consumers worldwide will lose, as will lenders at the expense of debtors, when the increased stock of money is worth less in terms of real goods.

The Bank of England and the ECB both kept rates unchanged at their policy meetings today, which was no surprise. But ECB über-banker Trichet said that the ECB will conduct liquidity-providing LTROs ("Longer-Term Refinancing Operations") for 6 month terms and MROs ("Main Refinancing Operations") "as long as needed." In a nutshell: they're adding more liquidity. They're easing. According to Trichet, they are going to keep monitoring inflation "very closely" since the risks to the inflation outlook "remain on the upside." Well, that's very prudent, Jean-Claude. Oh, and in the meantime the ECB said they'd be buying bonds, and immediately started buying Irish and Portuguese bonds.

U.S. stocks rallied on that news, which turned out to be one of the worst trading decisions, for those buyers, of the year. And it didn't make sense, either: flushing cash into the system, causing inflation to solve otherwise-catastrophic problems, isn't inherently bullish! Nor is buying the bonds of already-bailed-out countries when there are others at risk!

Trichet also continued his recent crazy-man routine by saying that "banks with limited market access must boost capital." Uh, what? How do you boost capital if you can't get to the market? Steal it?

Irish bonds did great, rallying 23bps on the day. Portuguese bonds were unchanged. Italian bonds fell, pushing 10-year yields to new highs. Spanish bonds fell too, despite the fact that Italian and Spanish central bankers were buying their own bonds. However, these markets are too big for the ECB to do much with at the moment, so Irish and Portuguese bonds will just have to do!

Speaking of bond purchases, the Wall Street Journal had a story quoting "former top Fed officials" (Kohn, Reinhart, and Madigan) as suggesting the Fed ought to consider QE3. But the headline didn't quite get the spirit of the story, which in any case was citing former Fed officials. Here is Kohn, from the article:

Mr. Kohn, who rose to become Fed Board vice chairman before retiring from the central bank in September 2010, said its options to support the economy are "kind of limited." But if inflation comes down and the economy doesn't pick up, he said he would give "very serious consideration" to a new round of bond purchases.

So a couple of guys said that if inflation comes down and the economy doesn't pick up, the Fed should consider QE3. I suppose I can't disagree with the proposition that the Fed should consider alternatives. Of course, inflation is not going to come down; rising core inflation is baked in the cake for quite a while ahead now. And considering QE3 (in light of the fact that QE2 didn't work) shouldn't take long. The only reasons to pursue QE3 are political: that is, the Fed needs to be seen to be doing something even if there's nothing useful to do. Now, if I were around the table and wanted to help, the first thing I would do before adding another trillion in reserves that has no impact on anything would be to lower IOER and get the existing reserves into M2! I understand why they don't want to do that, but it's madness to buy more bonds when the money you injected the first time is still sitting in bank vaults because you're paying banks to keep them there. Madness, I say.

The reason the Fed doesn't want to lower the interest they pay on excess reserves (IOER) is that they believe (and have said so publicly) that it would seriously hurt the money fund industry. But I can't figure out why the government should subsidize higher real rates for savers when in fact you want deeply negative real rates for the economy (in theory, anyway). If the government will support a +0.25% rate when -0.75% is the appropriate rate for the economy, for example, then why wouldn't they in an analogous situation try to hold money market yields at 5% when the market wants them at 4%? It's the same difference. It isn't like the money fund industry would vanish if IOER went to zero. They'd adapt. I can easily think of a couple of alternative money fund structures that would work even if there wasn't a ~25bps floor on rates. Trust markets. Look, some banks are starting to pay negative interest rates on savings, as this story about BNY-Mellon illustrates. IOER is too high.

So the market hung on after trading a little bit up overnight, then a little bit down, then up on the ECB press conference and the as-expected Initial Claims data. Then it went down, and kept going down, even when some investors made sloppy purchases in size to try and scare the shorts a couple of times during the day. But it didn't work, because the selling wasn't coming from new shorts but rather from old longs.

Volume on the day was huge - the biggest non-expiration day since the flash crash, I think. The S&P ended the day down -4.8%, closing at 1200.07. The Dow lost 513 points. Where is the guy who was on my case for being bearish and wrong on the S&P since 1100 last year? I hope he got out a couple weeks ago. This is what I have been saying the whole time - it isn't that the market must go down; it's just that the risks of this sort of event made being long a dangerous gamble. The odds were against you, if you were long at high valuations in a rickety global economy; that didn't mean the market couldn't keep rallying but it meant there was always a chance that you'd roll snake-eyes.

Bonds rallied, hard. The 10y yield plunged 20bps to 2.42%, only a few basis points shy of last October's low yield. TIPS were offered early, but recovered and actually did quite well. The 10-year TIPS yield fell 14bps to 0.21%, another all-time low. If you want to think about how bad the current situation is, don't look at nominal bond yields. They got lower during the financial crisis of 2008 (as distinct from the financial crisis of 2011), but that was when inflation was in the process of coming down and there was reason to expect it to do so. Inflation now is going up, so longer-term real yields- which represent the cost of money - are much lower now. The chart below shows that 10-year real rates (abstracting from the absolute teeth of the crisis when TIPS were treated like corporate structured notes instead of US Treasuries) are much lower now than they were back then.


Real yields are much lower than they were in the first crisis.
This shows increasing fear about the future growth rate.

So investors see the long-term outlook as dim for the economy, and in fact are more morose than they were at the equity market's bottom in 2009. In that context, equities today are still pricing in much more robust long-term growth than the bond market is seeing. Both of these markets are probably too high.

Because TIPS mostly kept pace with nominal bonds, measures of long-term inflation expectations fell only a little bit. And that makes perfect sense, when the world's central banks are now all printing in unison. TIPS are too expensive, but relative to nominal bonds? They're actually probably a better deal!

The short end of the TIPS curve, on the other hand, was savaged. For some while, the 1-year inflation swap has been under pressure. When it was pricing nearly 3% and energy markets were forecasting very little energy inflation, it was plainly too high. As of today, 1-year inflation swaps are marked at 0.88% (plus or minus...it was a dicey close), and since energy markets are pricing in mild declines in prices over the next year, that equates to a core CPI rate over the next year of about 1% (see Chart). But core CPI is currently 1.6% and rising - so 1-year CPI swaps are too low (or forward gasoline prices, too high).


The sharp drop in implied inflation at the front of the curve is overdone,
or at least ahead of the energy markets.

Personally, I am thinking swaps are low rather than gasoline prices too high. Although commodities fell today (about 2.8% overall, energies much worse), and the headline read "Commodities erase gain for 2011 as faltering economy may curb consumption," there are two points I would make. (1) A declining stock market is not a faltering economy. Yes, the economy is faltering but it's not plunging. Some amount of what we're seeing in stocks is just them coming back to more-rational valuations especially considering the economic landscape as it already is. (2) Regular readers of this column know that the supply/demand argument takes a back seat if the world is awash in cash. In that case, the exchange rate between stuff and money is far more important than the equilibrium supply and demand for a particular good. Why did commodities rally in the second part of last year? Was it because the economy was booming? Well, no...the economy wasn't booming, and we knew that. Commodities rallied last year because the amount of money in circulation was rising and was expected to continue to do so for a while.

What are the prospects for that happening again? Well, M2 was released today and showed another hefty gain. The 52-week rise is now +8.1%; the pace is +11% annualized over the last 26 weeks. If deltaM+deltaV≡deltaP+deltaQ (the first-difference form of the crude quantity of money equation), and deltaM is +8% while deltaQ is +2% (to be generous), then we had better hope velocity is declining or...prices are going up.

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While I thought (and still think) that stocks were (and are) overvalued relative to historical earnings as well as considering the economic prospects, the move today is clearly a (market) liquidity event. The fact that commodities declined even though the actions of central banks would argue for a movement in the other direction is one clue. The fact that it is August is another clue. The VIX rose to a post-flash-crash high, but is not near the flash-crash highs nor anywhere near the 2008 highs, so it is hard to say we have reached a crescendo of selling as gut-wrenching as today's action was. There may, in fact, not ever be a crescendo. But with liquidity poor the possibility is there, and the question is whether you want to allocate your liquidity - the cash balances you have been holding in reserve for so long - to equities or commodities or whatever investment you love - at these levels or wait for a true panicky wash-out. Buying those assets now is catching a falling knife and it's a much better strategy to wait until the knife hits and then pick it up off the floor. It would show great courage to buy stocks here. Leave the courage to the other guy. The first guy through the door is the one who is most likely to get shot.

With vols rising so dramatically and the price action so extreme, I covered all but 20% of my equity puts in the last 20 minutes of trading today. The prices hadn't quite made it to my target but the uncertainty is too great and the implied vols are now high enough that it is no longer an efficient way to take that position. I am not sure what will come tomorrow, but if stocks decline just a little bit, or certainly if they rally, volatilities may drop quickly and so I have too many ways to lose. I should have covered the entire position, for while I am still bearish the odds are obviously no longer as much in my favor now. That was an error that fortunately can no longer cost me too much.

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Tomorrow is actually Employment Friday, the most volatile day of the month (ha!). The consensus estimates have Payrolls at +85k versus only +18k last month, and the unemployment rate steady at 9.2%. I think there is room for upside on the Unemployment Rate, but the Payrolls guesses seem conservative enough especially since the +18k last month was likely an aberration that I expect to see revised a little higher. The markets could use an upbeat surprise on Employment, although I think it wouldn't have a lasting impact since there are plenty of trapped longs who will probably sell into a rally. I suspect they may get a mild surprise in that way. But the risk is still skewed to lower equity prices and probably still-higher bond prices until the Fed bats down the notion of QE3. However if, Heaven forbid, a negative Payrolls number prints, this "second verse" could get a little louder and, as the old song goes, a whole lot worse.

Let's hope not. As a young-middle-aged investor, I want lower prices during my accumulation years and higher prices later, when I am divesting - but I don't want them lower all at once!

 


 

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.

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