A Glimmer Of Hope

By: Michael Ashton | Tue, Nov 29, 2011
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Tuesday was a day with quite a bit of news. Some of that news was good. Into that "good" bucket I would put the rise in Consumer Confidence, which jumped to 56.0 from 40.9. As the chart below makes clear, this doesn't necessarily indicate that confidence is surging, because 56.0 is still egregiously low. Note especially that last November we also had a nice pop in Consumer Confidence, of about 8 points, which followed through for a couple of months before fading.

Consumer confidence jumped, but remains pretty low.
Confidence jumped, but remains pretty low. However....

However, there is a key difference here. Many observers will scratch their heads and say "but where did this come from?" The one thing you need to know about Consumer Confidence, if you know nothing else, is that it is driven to a very large degree by jobs. This particular blip was doubtless enhanced by the stock market rally - which is what caused the temporary rise last year. But I was never fooled by last year's jump, because the responses to the employment question remained poor. The chart below shows the percentage of respondents who replied that "Jobs are hard to get" when asked about the condition of the labor market. It dropped to an almost-three-year low this month.

Best Jobs-Hard-To-Get number in almost three years.
Best Jobs-Hard-To-Get number in almost three years.

Now, the fact that 42% of Americans still call jobs 'hard to get' also doesn't mean that there's a sneaky surge in hiring out there. But it sucks less than it did. And, to a forecaster, it is possibly significant because it isn't just a random data point that is good but part of a broader mosaic that might be pieced together to tell a story. Also rising recently have been commercial and industrial loans, as banks are finally extending credit to businesses faster than they are cutting credit lines (I discussed that part of the mosaic last week). A rise in confidence is made more plausible by an improvement in labor conditions, and an improvement in labor conditions is more plausible if there really is some lending being done. The U.S. economy is finally digging itself out of its hole (which complicates the Fed's policymaking from here, to be sure, but let's just enjoy this for a bit). We're not looking at an explosion in growth, but left to its own devices it is not unreasonable to suspect that U.S. growth could be in the low 4%s next year!

Unfortunately, as big as the U.S. economy is it is still too feeble to withstand a major European meltdown, and that is still the elephant in the room. However, it does create a potential non-disastrous exit from the crisis if everything breaks just the right way. If the U.S. economy continues to gain steam, and if the EU is able to hold off a banking crisis for six months or so and if the EU can quickly come up with a sustainable policy that holds the Eurozone together, then it's possible that the U.S. economy could be strong enough to weather the shock when it comes. Make no mistake, there are shocks a-plenty still coming. But if we get really lucky, we may still be able to look back on this period and still see 2008 as representing the worst of the crisis in the U.S., rather than 2012.

I'm trying to be optimistic. Unfortunately, most of those 'ifs' require strong and capable statesmanship and credible monetary policymaking. Navigating through those black shoals while blindfolded seems terribly unlikely.

Other news today was not so positive. The AMR bankruptcy was a surprise to me, but not to most bondholders apparently. American Airlines bonds are higher now than they were a week ago. The bankruptcy was caused, essentially, by the prior bankruptcies of AMR's competitors. Much less burdened by debt, those competitors could be much more aggressive, and ultimately forced AMR to seek bankruptcy to level the playing field. We saw the same phenomenon in the early 2000s with telecom, and more recently with autos. When a heavily-indebted sector sees one big firm declare bankruptcy but remain in business, the other firms in that industry almost always follow. (This is something to keep in mind if a major bank is allowed to declare bankruptcy but stay in business.)

After the close, S&P cut the ratings of a number of large banks today. BOA, Goldman, Citi, JPM, Morgan Stanley, UBS, Barclays, HSBC, and Wells Fargo all had their ratings cut one notch (according to Bloomberg, "Lenders including Bank of America, Citigroup and Morgan Stanley have said they may have to post billions of dollars of additional collateral and termination payments on trades because of a one-level downgrade in their credit ratings.") A downgrade is always bad news, but in this case the market probably doesn't react much since all banks were downgraded due to a change in S&P's criteria. And, let's face it, these banks are still overrated given their financial soundness.

The more interesting news from my perspective included two items related to inflation (surprise!). First, in the interbank market a 1-year, 4% inflation cap traded at a price that indicates a delta of around 10%, meaning that the market sees roughly a 10% chance that headline inflation will be above 4% one year from now. I think that's weirdly cheap. With core inflation at 2.1% and rising, you're one Middle Eastern crisis away from being in-the-money on those options. The implied volatility that you have to use to get to the option price is quite high, but the use of implied volatility assumes continuous markets for hedging. That's a very bad assumption in inflation, where an index number is released once a month and markets gap abruptly. There's also the old option traders' rule: "don't be a weenie and sell a teeny." Selling 10-delta options is quintessentially picking up nickels in front of the bulldozer.

But in my view, the news of the day was that the ECB did not fully sterilize its recent bond purchases. The way the ECB conducts sterilization is to auction short-term deposits in large size. Today, 85 banks bid €194.2bln for 7-day deposits (that is, they put the money at the ECB for a week, which removes the liquidity from the economy), but the ECB had been trying to take out €203.5bln. I think this is a very important event, because it raises a previously-unconsidered (at least by me) possibility. I had assumed that the ECB might at some point stop sterilizing the purchases and convert the price-k eeping operation to QE ex-post facto. But I never considered that the ECB might not be able to drain the liquidity. What that means, incredibly, is that quantitative easing might be out of the ECB's hands, unless they want to start selling bonds back into the market. Now, more than likely this is a one-off event and the next auction (or at least the auctions after year-end) will go fine, but there must be a limit at some point to how much the ECB can drain and perhaps that limit is closer than we thought. If the ECB reaches that limit, then it must either decide to buy bonds without sterilization - that is, QE - or it must stop buying bonds. In any case, it is a bad time for the ECB to be seeing its options limited.

Stocks ended the day back near the middle of the multi-month consolidation range, around 1200 on the S&P, and in an unstable position. Ten-year Treasury yields are back above 2% (2.01%) and looking technically weak to me. Neither of these markets is about to suddenly go sideways for four weeks into the end of the year. On Wednesday, in addition to reacting to the banking downgrades investors will absorb the ADP Employment number (Consensus: 130k from 110k), and I think there may be a bit of upside given the Consumer Confidence data. Also due is the Chicago Purchasing Managers' Index (Consensus: 58.5 from 58.4), which also may have some upside although it is less clear. In the afternoon the Fed releases the Beige Book.

Whatever the data, the important developments will still come out of Europe. Recent news has been increasingly downbeat about the possibility of actually effecting a new plan (although Juncker announced today that the December tranche of the rescue package will be disbursed). It is important to keep in mind that these are illiquid markets, and investors ought to operate with higher-than-normal levels of caution.



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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