New Year 's Revolutions

By: Michael Ashton | Tue, Jan 3, 2012
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If it's January 3rd, it must be time to buy with both hands, right?

Markets leapt higher today, led by commodities. In December, managers evidently pursued a policy of buying what had worked (bonds, inflation-linked bonds) and selling what had not worked (commodities), but with a new year and a new P&L statement the money is springing back to where the opportunities are. And, while equities are not completely unattractive - they rallied today probably because that's just what they do on Jan 3rd - in my view commodity indices are the most attractive, as I pointed out in my article "Long-Term Portfolio Projections Update" late in December.

To be sure, the increasing volume of saber-rattling in Iran helped put a bid in energy products. The Iranian regime warned U.S. warships to stay away from the Straits of Hormuz while Iran was conducting exercises, saying that they "will not repeat its warning," while the U.S. responded that "deployment of U.S. military assets in the Persian Gulf region will continue as it has for decades." Oil prices leapt more than $4/bbl to the highest WTI closing level since May of last year. But it would be a mistake to think that the movement in commodity indices was all about Hormuz. Agriculture was up more than 2%, Energy up 3%, Precious Metals up 4%, and Industrials and Livestock up more than 0.7%. No commodity in the DJ-UBS index declined.

Manufacturing data was decent, both the ISM (which rose to 53.9 from 52.7) as well as purchasing managers ' indices from Italy, France, Germany, and the UK, which all exceeded - albeit slightly - expectations.

Let us not forget that all of these PMIs, with the exception of the US, are also below 50. And let us also not be tricked into thinking that strong equity markets indicate that all is well with the world. This morning, a spokesman for Greece went on television to say that if Greece and the Euro Zone don 't reach an agreement on the second tranche of the bailout (some €130bln, due in March) quickly, the country will fail. Specifically, Greece would leave the Euro:

"The bailout agreement needs to be signed," he said. "Otherwise, we will be out of the markets, out of the euro. The situation will be much worse."

Strikingly, investors ignored this suicide threat today, but I wonder if they can continue to ignore it interminably. If everyone truly believes what the banks are saying, that a Euro breakup would be the end of organized cellular life on this planet, then Greece basically can get whatever it wants. Frankly, right now Greece and Iran share strikingly similar positions. Both can probably do what they are threatening, and so there are three questions for economic or military policymakers. (1) Do we really think the consequences are so devastating as they say? (2) Will Greece/Iran be willing to accept the consequences of their own actions, if they choose that path? And (3) given the answers to those two questions, can we bear the risk of finding out? With Iran, the answers are probably 'no, ' 'maybe, ' and 'yes, ' but I am not as sure of the answers to the same three questions with Greece. Moreover, my answers would very likely be different from those of economic policymakers in Europe!

And, speaking of policymakers, the main economic event for Tuesday was the release of the FOMC minutes from the December meeting. There were some interesting tidbits in these minutes, which isn't always true. Bond investors blanched at this phrase:

With regard to the forward guidance to be included in the statement to be released following the meeting, several members noted that the reference to mid-2013 might need to be adjusted before long.

However, it isn't clear from the minutes exactly what that means. It may mean that, as bond investors feared, the Fed will 'adjust ' the reference by shortening it, but this seems unlikely in the context (and because it would weaken the credibility of Fed communications if 'at least ' turned out to mean 'at least, maybe '). It probably means that the FOMC figures they need to eventually change to a more-vague goal, or roll the guarantee forward in some way, lest they converge on mid-2013 and be confronted with the same decision at a period of much more significance. This is one of the reasons it was dumb to make the guarantee in the first place, but policymakers apparently didn't fully think through the 'exit ' step.

The Fed in early December remained quite cheerful about inflation:

Inflation continued to decrease relative to earlier in the year. Indeed, the PCE price index edged down in October... Consumer prices excluding food and energy also continued to rise at a more modest pace in October than earlier in the year.

Recall that October's figure on inflation, which the FOMC had at the time, had been a downside surprise. This may have contributed to the Committee 's optimism. But subsequent data on November prices, after the FOMC meeting was completed, showed an upside surprise in core inflation. (I discuss the release in "The Inflation Trend Is Not Yet 'Tamed '".)

The FOMC was more than happy to extrapolate the stabilizing and decline in headline inflation, and the brief stabilization in core. This is bad science even though it passes for okay economics in some schools: since new data can only cause a rejecting of existing hypotheses, there is no reasonable way that a one- or two-month slowing in core inflation should have caused the FOMC such elation:

Most participants anticipated that inflation would continue to moderate...Indeed, some expressed the concern that, with the persistence of considerable resource slack, inflation might run below mandate-consistent levels for some time.

Fortunately, some intelligent people were in the room too, and pointed out the incongruity of expecting resource slack to lower inflation when it clearly hasn't done that in the last couple of years:

However, a couple of participants noted that the rate of inflation over the past year had not fallen as much as would be expected if the gap in resource utilization were large, suggesting that the level of potential output was lower than some current estimates.

Policymakers saw a lot of risk from global financial strains, and "a number" of them saw that there may be a need to ease further. Again, all of this happened before the 'surprising ' continuation in the core inflation uptrend was made evident, so the doves may be more hawkish now. Somehow, I doubt it though.

There was also much-anticipated development in the Fed's "communication strategy" (I can remember when they didn't really feel they needed communication, much less a strategy). The plan at present seems to be for Members of the FOMC to publish their projections of the Fed Funds rate along with their projections of growth and inflation in the four-times-annually "Summary of Economic Projections" (SEP). This is also a bad idea, but it's going to happen despite the adroit observation of some participants:

Some participants expressed concern that publishing information about participants' individual policy projections could confuse the public; for example, they saw an appreciable risk that the public could mistakenly interpret participants' projections of the target federal funds rate as signaling the Committee's intention to follow a specific policy path rather than as indicating members' conditional projections for the federal funds rate given their expectations regarding future economic developments.

Yes, that's just one way in which giving this additional information has more downside than upside, but it continues a long-standing trend at the Fed towards "openness," which is perceived to be a good but no one ever seems to actually analyze the costs and benefits. (As an aside, it illustrates the power of words. If instead of saying 'the Fed increased its commitment to openness ' I said 'the Fed decided to show how well or poorly it forecasts by leaking those forecasts ', we would 't automatically agree that is a good thing. But the current policy is only different in that a 'leak ' is awkward and potentially damaging information that was not supposed to be released, and this is awkward and potentially damaging information that is supposed to be released.)

On Wednesday, there is only light data being released as the ADP report has been moved to Thursday. For all the fury of today's 1.6% rally in stocks, it was the worst NYSE composite volume for the first trading day of the year in at least a decade. Last year, 166 trading days saw less than 1bln shares traded on the NYSE. The year before, there had been 113 such trading days; in 2009 only 35. In 2011, it was 't until February 14th that we had a day with volume as light as it was today. That probably means that volume will grow over the next few days. But it's just not a great way to start off a year reaching to higher prices. Now, in 2011 stocks rallied for the first six weeks of the year, hitting a high for the first quarter in ... hey, look at that!...the week of February 14th.



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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