Prosperity On The Layaway Plan

By: Michael Ashton | Thu, Aug 18, 2011
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I keep wanting to be bearish on bonds, but for the third day in a row the stock market was unable to achieve the 1200 level and hold it (it "held" the 1200 level on Monday, but only because the bell sounded; it traded sharply lower in the morning on Tuesday). And the bond market is rallying again/still. The 10y note rallied 6bps today (to 2.16%) and the 10y TIPS rallied 4bps (to -0.02%). Volume was light in the equity market, and the essentially-unchanged close obscured a reasonably wide range that was achieved on still-declining volume.

The only news today was PPI - never very exciting - but fear not because there is a large slate of data on Thursday. I'll get to that in a minute, but in the meantime I will say that the technical condition of the stock market is worsening the longer it fails to punch convincingly above 1200, as momentum continues to ebb; meanwhile, the commodity market is hanging in there. It isn't just precious metals, either; softs and grains have also risen over the last month and if it wasn't for the substantial decline (around 8-9%) in the energy complex over that period then the commodity indices would have risen over the last month. Energy prices are the ones which react most immediately to growth scares, which is what we have had. The other components are surfing on the money wave. Energy will eventually follow.

Since the market over the last couple of days has been relatively contained (anyway, compared to the prior week's worth of trading as well as to the turbulent undercurrents), let's not spend much time looking at the past. The markets will have to navigate quite a bit over the next few weeks, running from the heavy slate of data tomorrow until the Jackson Hole economic symposium a couple of weeks hence. In between there could be plenty of randomly-dispersed tape bombs. I am keeping an eye on Capitol Hill again/still. You would think after the last debacle our policymakers would want to leave well enough alone for a while, but noooooo. Today on consecutive headlines Bloomberg TV noted that President Obama is going to ask the deficit-reduction committee to make deeper cuts in the deficit, and is also going to ask for a bunch of new stimulus spending. I guffawed, thinking it was a mistake or a bad joke, and then realized no one else was laughing. So the plan, as I understand it, is to spend a lot now and pay it back later. How creative. How fresh. How different. How very reminiscent of one of my favorite "Saturday Night Live" skits of all time, which also happens to be chock-full of great advice for the current Administration and Congress. The advice is timeless and the clip is free.

I can't predict what the market will do when Obama proposes to increase the deficit again with new spending "to reduce unemployment." I can't imagine it will be a good reaction. The last trillion did nothing other than a temporary spurt, and helped put us on an unsustainable fiscal path. I think investors know this; even ones who didn't know it before understand it now - money injected into the economy has to come from something. You are either taking it from people in taxes or you're taking it from investors and replacing that money with bonds. Only if you're taking low marginal-propensity-to-consume money and putting it into the hands of people with a high marginal-propensity-to-consume should it do anything. Otherwise, it's a net wash except that it changes the allocation of capital. And not in a good way. I thought by now, everyone knew this.

But the alternative fable that big spenders tell is that the stimulus was working and we just got unlucky with the Japanese earthquake and then all the bickering over the debt ceiling. If we'd just spend, spend, spend without griping about it, the story goes, we'd be on the road to prosperity. The funny thing is that the road to ruin looks a lot like the road to prosperity for the first few miles. Current office-holders are sort of hoping that we will not be able to tell the difference for those first few miles, and that they'll be able to slide through the next election. But I think that even equity investors are starting to figure out that "stimulus" spending on "shovel ready" projects and other clever catch phrases are just another way of saying "I will gladly pay you Tuesday for a hamburger today," and I believe if any such proposal appears to have support the markets will react negatively.

Before any of that has a chance to provoke angst in us, however, we will get another gauge of the current prosperity with the data tomorrow. Initial Claims (Consensus: 400k) and Leading Indicators (Consensus: +0.2%) will take a back seat to CPI for July (Consensus: +0.2%/+0.2% ex-food-and-energy), Philly Fed for August (Consensus: 2.0 vs 3.2 last - consensus is probably too high given other activity metrics recently), and Existing Home Sales for July (Consensus: 4.90mm from 4.77mm - watch the inventory, which should rise from 3.765mm) plus the added bonus of a 5-year TIPS auction in the afternoon (and M2!).

The estimates for CPI are interesting. According to my (not very sophisticated) calculations, if we get the consensus +0.2% on headline then the year-on-year figure ought to be 3.4% or 3.5% (depending on whether it is a "low" 0.2% or a "high" 0.2%). But the consensus estimate for the year-on-year change in headline inflation is 3.3%. This seems inconsistent, and it gets worse. To get an 0.2% on headline then unless the seasonal adjustment factors have changed quite a bit this year the NSA CPI index value would have to be no higher than 225.55 or so. But the consensus estimate for that value is 225.85. The answer to this conundrum is that the "consensus" in each case consists of a different sample of economists. The shops that have more experience with inflation are the ones producing the 225.85 estimate for NSA CPI; that would give us 0.4% on headline inflation and 3.6% on year-on-year. In other words, I think there's upside risk on headline just from conducting a beauty contest of economists (ick, bad image).

More interesting of course is Core CPI. It has printed 0.25% and 0.29% month-on-month for the last couple of months, so the consensus guess for an 0.2% is not an aggressive prediction even though it would give the appearance that an 0.2% would follow a couple of 0.3%s (which were rounded into 0.3%s).

I've noted before that the current year-on-year core rate of +1.6% (which even with a consensus number should rise to 1.7% tomorrow) happened a good 3-6 months before the time that my models suggested it should. So it wouldn't be surprising to me to see a +0.2%. But it is much more significant if we see another 0.3%. One reason economists are expecting a retracement is that the recent jump has included some 'non-sticky' groups like hotels, apparel, and vehicles. I don't see the data the same way. What I see is that the rise has been quite broad-based, so that the non-sticky stuff that is rising may simply be rising with the general tide. I agree that Apparel's recent jump is probably not going to persist, but it's only about 5% of core. Hotels are only about 1% of core. And motor vehicles in the PPI accelerated further this month. So, unless housing skitters backward this month, we could well see another 0.3%. Of all the economists, only UBS is forecasting such a print.

Now, 0.3%, pushing the year-on-year core rate to 1.8% or 1.9% (depending, again, on whether it's a 'low' or 'high' 0.3%) instead of the consensus 1.7%, wouldn't have a major implication for central bankers since they can't do anything right now anyway without looking really, really stupid. But it would have an implication in one immediate way: in the auction of $12bln in 5yr TIPS securities, which will happen tomorrow afternoon.

I don't like the 5y TIPS. I never have. I think that people who need inflation protection generally need it for the long-term since inflation is a long-cycle phenomenon. That being said, with the Fed pinning the 5-year nominal Treasury at 0.90% at the moment, consider that even with the real yield of the 5y TIPS bond at -0.85% all you need to be indifferent is for inflation to average about 1.75% over the next 5 years. As of tomorrow, that will be the approximate core rate. As long as energy doesn't provide a net drag, and as long as core inflation doesn't suddenly roll over, you would be hard-pressed to underperform 5-year nominal Treasuries over the next five years. And your real risk is much lower (you can't blow up buying TIPS and not getting inflation; your worst-case is -0.8% nominal return in the case where there is no inflation at all. If there's deflation you still get your money back at par so you again get a -0.8% return. On the other hand, you can completely blow up if you buy nominal bonds and get, say, 5% inflation for five years). Accordingly, even though I hate all of these yields, if you're going to hold 5 year Treasury paper anyway I don't know why you wouldn't hold 5-year TIPS. It seems like a cheap option to me at these levels, even if the optics of a negative real yield are bad. I think the auction will go well, even though I don't like 5-year TIPS as a rule.



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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