Tug-Of-War Tie? Unlikely

By: Michael Ashton | Wed, Nov 2, 2011
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Markets always have opinions; it's just that the opinions aren't always consistent. This is a far cry from saying they're right, and in fact I think they're often wrong. But I am always interested in opinions (I have collected so many I need to give them away quite often - so that I don't get too much inventory). I am interested today with the fact that Greek bond yields shot higher again. The 5y Greek bond rose 420bps to 31.2% and the 2-year, according to Bloomberg rose in yield by 1,328bps to 83.5%. I know that market is very thin right now, but it is amazing that the 2-year has a price of 36.8 if anyone thinks they're going to get something worth 50! I have heard a fair amount of back-and-forth analysis about whether the Greek referendum will endorse the E U solution or reject it, but the market is clearly expecting it to be rejected.

U.S. bond yields, though, were essentially unchanged, as were the dollar and commodities. For a day, it was as if the dollar market actually stopped to think about what the Fed might be doing on the day of a Fed meeting. Yet, TIPS rallied with the 10-year TIPS yield down another 4bps and breakevens wider by that same amount. Yes, the dollar market is definitely thinking about what the Fed, and other central banks, are doing.

The Fed in fact didn't do much except reduce the hurdles for further quantitative easing. I hadn't expected any big change in the statement, and we didn't get much change. There were nonetheless two details worth noting. The first is that Chicago Fed President Evans dissented from the decision in favor of more monetary accommodation. This marked the first time since 2007 that a FOMC dissent has been recorded in favor of more easing, believe it or not. There is very clearly a bifurcation of the Committee between those who think the Fed should use monetary policy to lower the unemployment rate, like Evans, and those who think the Fed should use monetary policy to address the price level, like Fisher. This is the same battle being fought by economists across the land. The philosophical fissure is pretty wide.

But the second detail worth noting is that all members of the FOMC clearly still believe in the ultimate efficacy of monetary policy to solve whatever problems there are, and they are all very sanguine about the probable outcomes. With the statement, the FOMC also released the economic projections of the FRB Board and Bank Presidents, and the most remarkable thing is that while there is a huge gap between the beliefs of one wing of the Committee and the other, you can barely fit a piece of paper between their economic projections. The Unemployment Rate for 2012 is expected to be between 8.5% and 8.7% (with low and high estimates of 8.1% and 8.9%) , and it is the adjustment of this from the prior estimate of 7.8%-8.2% (7.5%, 8.7%) that got the most headlines. But the full range of projections for Core PCE inflation is 1.3%-2.1% in 2012, 1.4%-2.1% in 2013, and 1.4%-2.2% in 2014. That is, the most-worried FOMC member sees core PCE inflation no higher than 2.2% over the next three years. The core PCE these days is fairly close to CPI but slightly more volatile in general because it has a lower weight on housing, which tends to make core CPI slightly more ponderous (see Chart).

Core CPI vs Core PCE
Core CPI vs Core PCE. Note that the upturn in inflation in 2004...

It is incredible to me, with core PCE around 1.6%, that the least-optimistic policymaker sees no higher than 2.2% over the next three years. By comparison, it was higher than that wayyyyback three years ago, in September 2008, and was mostly higher than 2.2% in 2004, 2005, 2006, 2007, and 2008. It hardly needs to be pointed out that the Fed and other central banks around the world weren't engaged in massive asset purchases and other monetary easing arrangements back then. However, in 2001, 2002, 2003, and the first half of 2004 they were (see Chart). Gee, I don't see any connection, do you?

Easing in 2001, 2002, and 2003
...followed easing in 2001, 2002, and 2003.

Interesting, isn't it, that in each case inflation began to accelerate after the third year of aggressive easing? The difference is that in 2004-05, the Fed began to tighten, while in 2011 they are promising low rates for at least two years more, and other central banks are creating currency in the billions and trillions. I am not saying that I am 100% certain I am right - only Bernanke is that sure. What I am saying is that it is remarkable that not a single member of the FOMC will forecast any meaningful reaction from the stimulus already in the pipeline and the additional amount guaranteed over the next two years. In the past, one could rationalize the Pollyanna projections by saying the forecasters assumed the Fed would act in order to effect those outcomes. But in this case, the Fed has pledged not to do so. The true dynamism of the economy unfettered, forecasters expect...a comfortable stasis. That's nuts. It's like looking at a tug-of-war contest and declaring that the outcome is most likely to be a tie. Actually, that's the one thing you're pretty sure will not happen. In this case, I can make a plausible argument for inflation or deflation, but it is much harder to make a plausible argument that nothing happens (absent a policymaker response) given the dramatic policymaker actions to date!

Tomorrow's economic data includes Initial Claims (Consensus: 400k), which is still trying to break below 400k convincingly, as well as data on Nonfarm Productivity (Consensus: 3.0%) and Unit Labor Costs (Consensus: -1.0%), and the ISM Non-Manufacturing Index (Consensus: 53.5 from 53.0). The item with the largest chance to contribute to market movement is actually Claims; if a sub-400k figure is combined with today's above-100k ADP number the growth bulls will start to get excited again and the market will try to price a Friday Employment surprise. I think the bigger issue, with the weekend coming, is going to be some risk-off action ahead of that data and the possibility/probability of more EU news over the weekend.



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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