A Many-Ouch Day

By: Michael Ashton | Fri, Sep 16, 2011
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Once again, the news was almost uniformly bad; once again, equity markets reacted as if each piece of bad news just brings closer the days of good news. Bonds also suffered today, for a change, but that is more likely related to the inflation data.

I shouldn't get ahead of myself. Our first ouch was provided this morning by UBS. For the love of Pete, when will these banks learn to supervise traders? UBS announced a $2bln loss stemming from "unauthorized trades" in the equity unit. Seriously, how hard is it? Someone needs to be sending collateral around - is it so difficult to get the collateral management system to talk to the risk management system? Granted, it's very difficult to catch a determined rogue trader from causing damage in a short period of time - real-time surveillance isn't possible when markets require real-time reactions. But these losses - today's announced $2bln loss, the $7.2bln that Kerviel lost for Soc Gen, and others we have heard about and smaller ones we have not - generally occurred over a period of time, exploiting a loophole in the system.

This is another argument for smaller financial institutions. Forget "Too Big To Fail;" what about "Too Big To Supervise"?

After the UBS announcement the economic data ouches started to roll in. Initial Claims rose to a 2-month high at 428k, and is essentially unchanged from a year ago. Empire Manufacturing, expected to be -4.0, was actually -8.82. Philly Fed was -17.5 versus -15.0. And of course, there was CPI.

The consensus for core inflation was for a 'soft' 0.2%; instead, we very almost saw another 0.3% print. Year-on-year flashed 2.0% (although it was actually 1.951%). These sound like small details, but the internals of the number were strong. For starters, core inflation ex-housing is at 2.2% and a bit ahead of pace to reach the 3% by year-end that I first mentioned in this July comment. So, while core CPI is approaching 2.0%, remember that it is being restrained by housing.

Having said that, it isn't being restrained that much anymore, although I think there's another down-leg to housing prices now that foreclosures are picking up again. The following table shows the year-on-year change by major subgroup in the CPI. Housing is now back to 1.6%. Along with Apparel, Food & Beverages, Recreation, and Education/Communication, the y/y pace of change quickened in August. That's ¾ of the whole CPI, and the balance is either unchanged or showing marginal declines in the case of Transportation.

  Weights y/y change prev
y/y change
Year ago
y/y change
All items 100.0% 3.771% 3.629% 1.148%
Food and beverages 14.8% 4.372% 4.001% 1.000%
Housing 41.5% 1.627% 1.453% -0.391%
Apparel 3.6% 4.183% 3.056% -0.395%
Transportation 17.3% 11.684% 11.980% 4.918%
Medical care 6.6% 3.194% 3.199% 3.168%
Recreation 6.3% 0.063% -0.173% -1.075%
Education and communication 6.4% 1.094% 0.982% 1.929%
Other goods and services 3.5% 0.878% 0.847% 2.948%

This breadth of advance is one reason that the CPI figures are starting to get scary. I pointed out last month that the Cleveland Fed Median CPI is no longer giving reason, as it did throughout 2010, to think that core CPI still has a lot of catching up to do. The Median CPI printed 2.0% this month, just what core CPI did.

I think what is also underappreciated is that while the level of inflation isn't worrisome yet, the acceleration is. Core inflation, and median inflation, are by design very stable. They're supposed to capture just the important moves. The chart below shows that the Cleveland Fed Median CPI hasn't accelerated by more than 1% in a year since 1984, and only deceleratedfaster than that in the recession of the early 1990s and in the credit crunch when the velocity of money plunged. In short, median CPI is pretty stable. The picture for Core CPI looks similar.

This kind of acceleration in median CPI was last seen under Reagan
This kind of acceleration in median CPI was last seen under Reagan.

It is in that context that we might look with some alarm at the 1.5% acceleration in median CPI (and 1.1% in core CPI). Not only is it already quite unusual, it is almost guaranteed to get worse in the next couple of months (since the bottom in CPI was in October 2010). Note, by the way, that the acceleration in 1984 occurred in the context of much higher core numbers, so a 2% acceleration was less impressive than it would be today.

Now, a fellow inflation trader pointed out that previous spikes in the acceleration were always in the past followed fairly quickly by an outright drop in inflation. The difference, though, is that in those cases the spike precipitated Fed action to restrain inflation. The Fed was tightening in 1988, in 2000, and in 2004. That is why inflation decelerated, not because of any natural cycle. The difference is obvious - in this cycle, the Fed is aggressively easing. I trust I don't need to connect the dots any further than that!

In case it helps, though, I will note that with the release of today's M2, the 13-week rate of change is now over 24% (annualized), the 26-week rate of change is up to 14.7%, and the 52-week rate of change is 10.55%. And I will also point out that today the SNB, BOE, ECB, Fed, and BOJ jointly announced the provision of dollar liquidity arrangements to banks that need it. (Seems it was only a day or two ago we were told no banks needed it!)

And that, perhaps, is the biggest ouch of all. The inflation data, and not the growth data, was the reason that 10-year rates rose 10bps today. Half of that came from breakevens, and inflation swaps at the short end of the curve were even more well-bid. TIPS continue to sport extraordinarily-low yields, but we are seeing why.


Housekeeping note: This is the last commentary I will be writing for a couple of weeks. My family and I are traipsing off to New Zealand on a vacation and to watch some World Cup rugby (Go Eagles!). My next post will be circa October 4th. Good luck in the meantime, and good trading.



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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