Promising Isn't The Same As Delivering

By: Michael Ashton | Sun, Feb 5, 2012
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Yet another weekend appears to be poised to end without the promised big-picture agreement on Greek debt. The BBC was reporting earlier today that talks between the Greek Prime Minister and the leaders of other coalition parties had concluded without agreement to take additional austerity measures; at this hour Bloomberg is reporting that there is agreement on cuts of 1.5% of GDP although these will not be finalized until Monday. These Greek-on-Greek talks became necessary because European Union representatives demanded additional austerity measures. On Friday, a report from Radio Netherlands Worldwide said that the AAA countries demanded "that the [Greek] government implement agreed reforms and austerity measures by March at the latest. Otherwise they will withdraw the bailout funds pledged last year."

In case you're wondering: yes, when those bailout funds were announced last year the stock market rallied because the problem had been solved. You see, it is easy to announce the desire to help. It is harder to actually help.

I wonder if the U.S. will consider throwing in a little help now that we have had a couple of months of decent data (more on that in a moment). I think it would be a mistake, both politically and economically, but this Administration has tended to have a tin ear politically since taking office. A driving force of its foreign policy has been a desire to be loved worldwide, and it would not surprise me a bit if we started to hear about the U.S. taking a bigger role in talks. Would this be bullish or bearish for our markets? It might be bullish since it would increase the perceived chance of the immediate crisis being averted, but it might be considered bearish since it increases the chance of a crisis later. It would, though, change the equation significantly since the U.S. is the only power capable of writing a hundred-billion-dollar check alone (heck, that's only a tenth of a trillion!). I imagine the stock market would like it but I'm pretty sure the bond market would hate it.

This wasn't even a consideration a couple of months ago, when we had enough of our own problems to deal with. Those problems are still here, but the problems we have - high private leverage, a chastened although recovering banking system, an addiction to extremely high budget deficits with little appetite to reduce the size of government, and a dangerously loose monetary policy - are not the problems that the Administration (and the Fed) believe we have. It is true that if the economy can grow at 4% for 5-7 years, many of our problems will diminish, but policymakers seem to think the weak growth is not an effect but rather a cause of our current circumstance. And recently, the news on growth has been better.

On Friday, the Employment Report produced a new jobs figure of 243k, which was about 100k greater than expectations. The Unemployment Rate dropped to 8.263%, only a whisker away from triple-downticking. Aggregate hours worked and average hourly earnings both rose, which means that Q1 income got off to a good start.

The January report is a little quirky, partly because of the usual seasonal adjustment issues around year-end and partly because benchmark revisions take place in this month. I'm not terribly uncomfortable with the overall reading of mild strength, because it's consistent with most other labor market indicators showing the same thing. (In my mind, the question is more about sustainability of this mild strength if Europe holds to current trends.) The Unemployment Rate plunge was on the quirky side because the Household Survey from which it is derived incorporated the annual adjustment to population.[1] According to the BLS, the adjustment "increased the estimated size of the of the civilian noninstitutional population in December by 1,510,000, the civilian labor force by 258,000, employment by 216,000, unemployment by 42,000, and persons not in the labor force by 1,252,000." Overall, however, the civilian labor force grew by 508k and employment by 847k, which means that the addition from other than the population adjustment was 250k to the civilian labor force and 631k to employment. That's quite a large number, and won't do anything to soothe those who think that every number is a government conspiracy. But, as I said, it's not inconsistent with other signs of decent employment growth.

On the unfortunate side, the participation rate plunged to 63.7%, the lowest since 1983 (see Chart, source Bloomberg). The BLS explained this by saying "This was because the population increase was primarily among persons 55 and older and, to a lesser degree, persons 16 to 24 years of age. Both these age groups have lower levels of labor force participation than the general population." However, notice that while this explains the sudden drop, what it means is that the prior ratio was overstated, not that the current ratio is understated. So this is something less than encouraging.

Labour Participation Rate

On this point, Julia Coronado at BNP (whose analysis of economic releases is generally among the more clear-eyed reads) made a great summary observation. She said "It is becoming increasingly likely that the path toward lower unemployment rates will mainly be through fewer workers rather than an acceleration in job growth." Since economic output is workers times hours worked times productivity, this means the path to a full recovery in economic output is either going to be longer hours or an acceleration in productivity. That's really the path we're going to be on for a long time hence, now that the baby boom generation is beginning to be of retirement age. And if I may say so, it is a prime argument for allocating more GDP to the private sector, where productivity enhancements are generally developed, and less to the public sector. The government can keep redistributing the pie, but it would be better to grow the pie and government has had an abysmal record at doing so for roughly the last eight thousand years. We could hope for a better result in the future, but to do so would seem audacious.

Another growth sign from Friday were good as well. Non-manufacturing ISM reached an 11-month high at 56.8, far above estimates. All of this news helped push stock prices 1.5% higher, commodities prices 0.8% higher (despite a 1.1% fall in Precious Metals), and 10-year yields 10bps higher to 1.92%. Even TIPS yields rose, finally, by 8bps at the 10-year point.

In other inflation-bond-related news, Japan is reportedly considering a re-start of its inflation-linked debt market. As I illustrated recently, Japan's inflation rate has been rising since early 2010, and as the tsunami effects finish passing through the system the core rate will likely rise to above zero and end the nation's deflationary period. The last Japanese inflation-linked bond was issued in June 2008 when year-on-year core CPI was +0.2% but large investor losses in illiquid Japanese inflation markets in late 2008 combined with a plunge of core inflation to -1.6% in early 2010 meant the Ministry of Finance feared there would be scant demand for the bonds, which unlike those in other countries never carried a 'par floor' (so, in the case of persistent deflation, you could get back less than you invested in nominal terms).

That structure detail annoyed bond salesmen, but it is the right treatment. Otherwise, investors get a free option on deflation that means their real return will rise in a deflationary environment although it is constant at any positive level of inflation. That turns out to be painful to model, and awkward to trade, as asset-swappers learned to their/our chagrin in 2008. Having said all of that, I expect there will be a strong sentiment to add such a floor to the JGBi when and if the program re-starts.

On Monday, most of the day in the U.S. will be occupied with discussing the Super Bowl. But be aware that St. Louis Fed President Bullard will be speaking in Chicago at 8:55ET on the topic of inflation targeting. Listen carefully for any intimation that the Fed is trying to generate support for a policy of price level targeting as opposed to inflation rate targeting. I wrote way back in December 2010 about the Fed Chairman's affection for inflation targeting, some of his prior words on the subject, and of the (better) arguments of KC Fed economist George Kahn. It's worth a review if the topic comes up again. In the current context, whipping up a fresh discussion of price-level targeting would be another excuse to let inflation keep accelerating for a while. Under a price-level target, the Fed just promises to hit the price-level target on some future date, implying an average level of inflation between now and then. So, if for example the Fed wanted to run inflation a little faster right now, it could do so and pretend that this didn't impair their credibility as long as they eventually hit that target.

I think the FOMC is looking carefully for ways to let inflation run faster without the bond market charging higher rates for that policy. If they can somehow convince investors that the 10-year average inflation will be 2%, even if it happens to be 3-4% over the next, say, 3-4 years, then 10-year nominal rates would stay down and real rates very negative despite an inflationary policy. I doubt they can pull it off, because I don't think they have much credibility as it is. And, as Kahn pointed out in 2009, "[central banks] have no modern practical experience with such targets."

The lack of practical experience, however, has never stopped this Fed before. I continue to marvel that investors are willing to be long rates here. You see, it is easy to announce the desire to price-level target. It is harder to actually price-level target.


[1] The BLS recognizes that the nation adds these citizens over the course of the year, but rather than make monthly estimates of labor force growth it adds them all at once in January. This year, the jump is large partly because it reflects the results of the decennial Census, which marks the actual population to the estimated population as of 2010.



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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