It Won't Go UP Forever, Either!

By: Michael Ashton | Tue, Aug 9, 2011
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Stocks traded higher overnight and held those levels into the open, with bonds under pressure. Clearly, there was more than a little whiff that today's announcement from the Fed would include some kind of policy concession to the weak economy. Many Street strategists expected an outright declaration of further asset purchases. Such a feeling probably should be categorized as an occupational hazard of working in institutions (both buy side and sell side) that have been built to sell products, which is clearly easier when markets are rising. Strategists tend to think that what matters more than anything to them - rising markets - must also be equally important to policymakers.

But this Federal Reserve, while it has been more explicit than any other about how the "wealth effect" makes life easier for them, at least deserves credit for recognizing that there are other considerations. For example, it was worth thinking about whether QE2 had any lasting impact, added anything to growth (although the Fed claims the same 2 million jobs saved that the Administration does for its fiscal policies), or was the most efficient way to accomplish its aims. Honestly, I too doubted whether the Committee would be able to resist what the Street was clamoring for, but at least we can say they did that.

So what, exactly, did they do?

The Federal Reserve committed to keep interest rates "exceptionally low" until at least mid-2013. That was just what the market was already pricing, so it's not exactly a market shock to bond guys. The explicit nature of the promise is interesting, because it means that even if inflation starts up, the Fed cannot move rates for two years (unless it wants to permanently lose this as a tool, since if it reneges after one year and hikes rates, no one will ever trust them at their word again). Some wiseacres noted that they could tighten a little and it would still be "exceptionally low," but this is like debating the meaning of "is." We all know what they mean - rates can go down, but not up, for two years.

The folks on financial news kept using words like "the Fed gave us a very grown-up sounding statement," and that's very sad if clearing that hurdle was a surprise! But it's also wrong. What grown-up would ever say to a child "I promise that I will not miss any of your soccer games for two years"? Really, Dad? You mean if I get on a traveling team and play around the country, and you have a presentation to the President of the United States, you'll skip that for my soccer game? Gee, that's great.

That's not grown-up at all. It's selling an option. If it works, then the Fed has gained very little - the market was already pricing that probable outcome anyway. If it fails, it could fail spectacularly with the Fed having to choose between inflation at 5% (or more) or reneging on their promise!

Since the result was drastically less in immediate liquidity than many investors assumed they would get, the stock market initially dove while bonds rallied suddenly and dramatically. I think some bond investors didn't initially realize that the market was already priced for this result, but there were probably also some mortgage-hedging-related flows into a very illiquid market! Bonds settled back by the end of the day, with 10-year yields finishing down 8bps at 2.24% (basically where they had been just after the Fed announcement) and 10y TIPS down 10bps at 0.05% (they traded at negative yields all the way out to 10 years, briefly!). Yes, folks, TIPS out-rallied nominal bonds, which makes sense when the Fed has intentionally disarmed itself in the fight against inflation.

Even if the town is really calm, the sheriff isn't helping anyone if he disposes of his side he?

Curiously, stocks rallied, hard, after turning negative for a few minutes and then waffling for a bit. The cause of the rally is likely due to one of three things: (1) Fed Model people saw drastically lower yields, and listened to CNBC chirping about the "dramatic rally in Treasuries" long after the rally had rolled over and returned to the starting line, and assumed that the equilibrium level for equities should be higher. I sort of doubt this, but it's possible. (2) Shorts were forced to cover. Well, maybe, but I would be surprised if there were many weak-hands that went short into an FOMC meeting that was supposed to produce QE3. I may be wrong. (3) Some analysts seemed to think that this was a "down payment" and makes QE3 more likely at future meetings. I think that's just plain wrong. There were three dissents even to this mildly-dovish decision: Kocherlakota, Fisher, and Plosser. That doesn't mean that QE3 is impossible but the hurdle is much higher than investors think!

In any event, 4.7% on the S&P is a nice rally. Is it sustainable? I doubt it, but as I wrote yesterday the market wasn't going to go down in a straight line. I believe we will see new lows - although probably not tomorrow!

The dollar set back, which seems strange when you consider the Fed did less in terms of pumping liquidity than had been expected. But I think the currency is reacting to the central bank's unconditional surrender to whatever happens with inflation.

Many commodity markets were closed or nearly closed when the Fed action took place, so we will have to wait and see how they open tomorrow. Crude ended up below $80, and now that it's falling the Fed cares about it. But precious metals, industrial metals, and softs rallied, leaving the indices basically unchanged on the day.

Gold had a wild ride, swinging in a $60 range before closing up about $30 (+1.7%). Silver, on the other hand, dropped nearly 4%! It is rare to see two precious metals move so far in opposite directions.

Gold right now - well, some would say always - is in its own world. I am being asked almost daily for my opinions about the gold market. (Incidentally, I can tell you from experience that whatever I say, after this point, will irritate the gold bugs even if I come out as extremely bullish the yellow metal.) I usually respond with approximately the same thing: Gold, like any commodity, will experience a ~0% real yield over time. Right now, that's not at all a disadvantage since real yields on bonds are zero or worse for ten years, but it is equally true for gold and for other commodities. I prefer to diversify into lots of commodities, even if there is one I happen to think is the "best," in exactly the same way that I wouldn't invest in just one stock even if I thought it was a great stock.

But the argument from gold advocates goes that gold is fundamentally different from other commodities, in that it has been and still is used as hard currency itself, so it benefits from being a hard currency and also a superior store of value. Corn doesn't do this. Then the gold advocate usually says "that means that if the world economy collapses and we go into deflation, it will do well; if we enter a spiraling inflation, then it will also do well."

As someone trained in economics and finance, I am automatically suspicious of win-win propositions. If I win in all circumstances, then the price of the game should move to reflect that. In the simplest circumstance, if I toss a coin and pay you $1 if it comes up heads and $1 if it comes up tails, how much will you pay to play the game? You'll pay very close to $1 (especially if you are bidding against someone else). In finance, win-win situations also manifest with a hidden "lose" situation. For example, in this case it could be the case hypothetically that if we entered neither inflation nor deflation, but took a middle road, you would lose a whole lot.

I am not claiming that is the case, but my point is that we need to resolve the whole win-win thing in a rational market context. But I think I have a creative way to look at the value of gold that preserves the gold advocates' argument but also demonstrates that it isn't a sure path to a riskless investment.

Suppose I offer you a call and a put, both struck at $374 (today's closing price) on Apple Inc (AAPL), and I charge you nothing for that straddle. You like that bet, because it is a free win-win, and you accept. If the price of Apple goes to $400, you will win $26 because the call is 'in-the-money'; if the price of Apple goes to $350, you will win $24 because the put is 'in-the-money', and so on.

Now, let's fast forward a few months. Suppose Apple is now trading at $500. Do you still have the straddle? Yes. Is it still a win-win situation if Apple goes up or down?


No, now you clearly want the stock to keep going up, because while you will eventually win on the put if Apple plummets, you will first lose all that you have made on the call.

This is, I think, analogous to the situation with gold. If it is trading at $400 (for example), then I am much more willing to believe it is win-win. But right now, it is a deep in-the-money call option on inflation and an out-of-the-money put option that is nearly worthless. For the deflation-floor value to be realized, gold prices will need to fall a long ways.

The charts below illustrate what I am talking about. The first chart (Source: Bloomberg, Enduring Investments) shows the 10-year forward price level implied by inflation swaps (projected from the the then-current price level), plotted against the gold price. As you can see, when forward expectations rise then the gold price also rises and vice-versa; moreover, over time both of these charts should march more or less to the upper-right as long as the price level (think of it as the CPI index value, currently around 226) continues to rise. At times, the relationship is tighter than at other times, but overall it is surprisingly tight I think.

Gold tends to move with the forward price level through time (but with a beta above 1).

The next chart (Source: Bloomberg, Enduring Investments) shows the same time period but as a scatter plot. The forward price level is on the bottom and the gold price is on the left. I have fitted it with a 2nd-order polynomial curve, and I would suggest to you that it looks a lot like the stylized hockey-stick of a call option.

By golly, this DOES look a little like a call option.

Let's rewind to 2008, when deflation fears were palpable. If the deflation put value of gold had been "in-the-money", then gold should have been rising in price when the forward price level was falling. It didn't. However, it did remain surprisingly stable, suggesting perhaps that we were near the "strike" where the call and put had similar 'deltas.'

I think there may well be something to what the gold advocates say, in other words, about gold having a dual nature as store-of-value as well as inflation-hedge. However, with gold prices as high as they are, they are almost entirely a bet on least, until they've fallen maybe $1000 first!

Now, I am an advocate for commodities in general, so I don't mind having just the call option. I think that the case for higher inflation became stronger today when the Fed promised not to fight it for two years even though core inflation ex-housing is already on track to be at 3% by the end of the year. There is a reason that TIPS, as rich as they seem, still outperformed nominal bonds today. The "tail outcome" of much higher inflation, that depended on a blunder from the Fed to really have much value, just became much more plausible because we've gotten just exactly that blunder.

I want to sell bonds, but I am not so foolish as to do it yet. Within a few days, perhaps, but I don't need to hit the high tick. I never got a chance to buy my small weight in equities today - the market never showed the weakness I needed. So I remain very long commodities and cash, and very little position in anything else.



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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