Unglued

By: Michael Ashton | Thu, Aug 18, 2011
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The precipitating force for today's selloff again came out of Europe, but this time it had plenty of help from events and data here in the United States. I had mentioned yesterday that the equity markets had been losing momentum and volume at the same time in the bounce that had carried to the 1200-1205 area on the S&P but was unable to exceed that level. On a closing basis, Elliott Wave guys will point out that the bounce was almost exactly 38% of the decline. The ebbing volume bespoke a lack of commitment to take prices higher, and so stocks were vulnerable.

A story that had gotten some quiet discussion yesterday was one describing how Finland either had reached a deal with Greece on collateral for their share of the Eurozone loan, or had not reached a deal. It was a little unclear which it was, but it was a trick question. If Finland had succeeded in getting collateral, then other countries would want collateral as well. If Finland had not succeeded, then the disbursement of the life-saving tranche to Greece was in jeopardy. Only if the talks had not happened at all was this okay.

After mulling on that overnight, Austria, the Netherlands, and Slovakia said they also want collateral on the loans they are making to Greece. And who wouldn't, since almost everyone knows the money is never going to be repaid, and more importantly in some minds, when one's constituents see that the Finns got collateral they will wonder why their country did not? (Incidentally, the collateral is said to be a cash deposit roughly equal to the loan, raising the question of where they're going to get the money to make that deposit since the bailout was in principle to help Greece pay its debts?)

So suddenly, when we'd been getting all worried about Spain and Italy, it turns out that Greece isn't entirely put to bed either. No wonder markets reacted violently. Equity markets throughout Europe dropped 4-7%.

The U.S. markets dutifully followed suit.

There was an additional following wind for domestic investors: the data today were just awful. Although I always follow CPI dutifully, the number of the day was the Philly Fed index. Remember, it was expected to be +2.0 after +3.2. I said parenthetically yesterday that the estimates were too high. Little did I realize howhigh. The actual print was -30.7 (see Chart), near the worst levels of the 2001-02 recession and not far from the lowest levels of 2008.

Philadelphia Fed Business Outlook Survey Dillusion Index
Hey, where did all the business go all of a sudden?

In the region, new orders simply collapsed. The New Orders subcomponent, which was +0.1 last month, now stands at -26.8. The Number of Employees subindex fell to -5.2 from +8.9, which is comparatively good - worse than at any time during 2010, but in 2009 that number got to -49.6. I guess if you're still hunkered down from the last recession, you don't need to immediately lay off as many people. Echoing that theme, Initial Claims was higher than expected but not much.

Existing Home Sales came in at only 4.67mm units versus 4.90mm. That's not a bad miss but it is the wrong direction for an investing community that was already jittery.

Incredibly, New York Fed President William Dudley said today that he expects second half growth should be "considerably firmer" than the first half. But the world's other economists, the bond and stock markets, the oil market, and common sense disagree.

Oh yes, Crude Oil. Energy markets were crushed today, but none more than Crude which fell nearly 7%. Actually, industrial metals rallied, as did precious metals, and agricultural commodities were only down 1%. It was the energy sector, and pretty much only the energy sector, that responded to the sense of the world coming unglued.

Aside from the kneejerk reaction that we have all been taught to have, that low growth leads to low inflation (despite the number of counterexamples that are 'inconvenient truths' to that theory), the current inflation data continues to disappoint on the upside. CPI came in higher-than-expected on headline, and core recorded a "high" 0.2% to push the year-on-year rate to a (rounded up) 1.8%. Two-thirds of CPI is accelerating: Food & Beverages, Housing, Apparel, and Medical Care showed faster year-on-year growth than they did the prior month. 21% is decelerating: Other Goods & Services and Transportation (although Transportation fell to 11.98% from 12.58%, so it's decelerating but from a high level). The balance, Recreation and Education/Communication, is neither accelerating nor decelerating. Core inflation, ex-Shelter, rose to 2.02% and is on track to be at 3% by the end of the year.

There is something else that is interesting about the inflation data recently. Look at the chart below, which shows both Core CPI and the Cleveland Fed's "Median" CPI.

Core CPI and the Cleveland Fed's Median CPI
Core CPI and the Cleveland Fed's Median CPI are now moving in almost perfect unison.

The fact that "mean" CPI - that is, the normal concept of average price changes of a fixed basket of goods - has recently started matching so well to "median" CPI has a quantitative implication. When the mean and the median match, it says that the distribution of price changes is balanced, with outliers either nonexistent or balanced. In other words, prices are rising in a very orderly manner.

That's actually not very good news. The ordinary give-and-take of a capitalist economy means some goods and services will always be increasing in price relative to others, even if there is no net rise in price. But if the same tide is lifting all ships, then there's no reason for relative prices to change sharply. I think that tide is the green tide of money.

And that tide continues to rise, incredibly. M2 was up another $43 billion last week, raising the 13-week annualized rate of change to 22.9%. That is actually higher than it was in late 2008 (by a smidge). The 26-week annualized growth rate, at 14.33%, also exceeded the 2008 equivalent. The 52-week change, still puttering along at a mere 10.179%, is still a bit shy of the level it reached in the credit crunch. But we also don't even have a crunch yet.

Despite the CPI figure and a fair auction of 5-year TIPS, the inflation-linked bond market was completely clocked. While nominal yields fell 8bps in the 10-year note (2.08%, after briefly dipping under 2%), nominal yields on 10-year TIPS rose6bps. The combination of those effects means that breakevens dropped 14bps, and the carnage was worse at the long end than at the short end. 10-year inflation swaps are now the cheapest they have been since the growth scare last year, and lots cheaper than they were a couple of weeks ago (see Chart).

10-year inflation swaps are cheaper than they have been for a while
10-year inflation swaps are cheaper than they have been for a while.

Now, we should remember that during the elevated period between late 2010 and now, the Fed was pretty much buying all of the new float in TIPS and that had something to do with the wide breakevens. But notice that the run-up in 2010 started when Bernanke first hinted at QE2 in August. And now, we have a Fed that has completely taken its hands off the wheel at the same time that money supply is surging. It seems to me that there is a lot more upside to this relationship than there is a downside. I included the end of 2008, when horrible liquidity in inflation-linked bonds helped drive breakevens and inflation swaps much lower, so you can see how low some people will expect that inflation expectations could fall. But at the time, crude oil was also in the process of falling about 78% and Lehman had collapsed. The lesson of 2008 is that even with an almost completely-frozen financial sector and with 40% of the consumption basket collapsing (that is, housing), core inflation couldn't drop into deflation. It would be wonderful to be able to buy 10-year inflation protection below 2%, but I will be very surprised if it happens. Inflation is as cheap as it has been in a while because the people who believe that growth causes inflation (you know, like the inflation we have now: clearly caused by the run-away growth we are experiencing!) like to sell commodities and inflation-linked bonds when growth surprises on the downside. Look for opportunities to buy inflation. TIPS are getting cheaper, at least relative to nominal bonds!

Brace yourself for a bumpy ride. Although there is no economic data tomorrow, there is a lot to work out about Europe and not a lot of good news here. We've just had a high-volume selloff and the calendar says Friday. I would not be timid about cutting risk further.

 


 

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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