Mister Market Is Cheery For Now

By: Michael Ashton | Thu, Feb 16, 2012
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There was no news from Greece today, although optimistic journalists penned excited articles indicating "progress" such as the idea that the ECB (headed by Mario Draghi, not Mario Monti as I incorrectly wrote yesterday) might exchange its Greek bonds for new Greek bonds. It is unclear to me if this is progress, but it certainly isn't big progress. The latest rumor is that "the deal will be completed on Monday," with a little asterisk that "the deal" is the offer to Greece that has 24 preconditions that need to be completed by the end of the month. And "the deal" doesn't include the private sector initiative. And "the deal" hasn't been signed off on by any of the legislatures that would have to actually approve it. To me, it doesn't sound like a lot of progress, but investors are clearly predisposed to be excited by anything that anyone calls "the deal," even if it's not.

Mister Market was cheerful today, though, and looked kindly on the positive economic data. Initial Claims recorded a new post-Lehman low at 348k, and Housing Starts approached a new high by printing 699k. The Philadelphia Fed was good, except for the "Number of Employees" subindex, which actually looks a little weak at the moment (see Chart).

Number of Employees Subindex

That small blemish is no reason to toss out the entire carton of apples, though, and investors were justifiably upbeat about the data. I have more trouble explaining why Mister Market was so willing to ignore the awful news that Moody's is preparing to slash bank credit ratings soon. I don't think investors understand the implications, perhaps figuring that since a downgrade of the US didn't cause any alarm then why should a downgrade of Morgan Stanley? I explained yesterday why it should, but today bank and financial shares outperformed the rest of the market.

No doubt, U.S. commercial banks are further away from insolvency than they have been in a while, and loan growth is showing it. The chart below (Source: Federal Reserve Board, H.8 report) is updated as of the latest available data: commercial loan growth is now growing at a 4.2% pace year/year, the fastest pace since November 2008.

Commercial Bank Credit

Incidentally, that also means that the enormous cache of sterile reserves the Fed has added is no longer just sitting there. It is starting to circulate, which is one reason that M2 growth is still at +10% y/y, where it has been essentially since August.

But, getting back to the market: while current loan volumes are better than they have been in a while, that's partly because banks don't have many other ways to make a buck these days. And this data is backward-looking, while a downgrade is negative in the future. It isn't as if these banks are good values even before a downgrade: Goldman is at 16x earnings, with revenues down 20% over the last year and ROE is 5.5%. Bank of America is at 8x earnings, with revenues -14.6% and ROE of 0%. I should add that Goldman is up 27% year-to-date and Bank of America is up 45%. (This is not an investment recommendation, and I'm not long or short either stock.)

The rally in stocks helped push bonds lower, and the 10-year yield again reached for the 2% level. Since November, the 10-year note hasn't been outside of a 1.80%-2.10% range, which is amazing quiescence. There are two obvious pressures on bonds. On the bullish side, you have the fact that Europe is and will continue to be a basket case for some time. But on the bearish side, you have 2.2% current (core) inflation and the Fed targeting approximately that level; 2% nominal yields is clearly a losing proposition and clearly too low absent a significant deflation. At some point, this tension will be resolved and yields will move sharply. I will observe that the inflation and Fed targeting arguments aren't going to go away for a long time, while the Europe story will eventually fade. I remain short fixed-income.

The crowning economic data point of the week (well, at least from my perspective) will be the CPI, released tomorrow. The consensus call for headline inflation month/month is +0.3%, and +0.2% on core inflation, leading the headline figure to drop to +2.8% year/year and leaving the core year/year number unchanged at +2.2%.

That actually implies that the market forecast for core is for a "soft" +0.2%, meaning something that rounds up to that figure. A true 0.2% should cause the year/year core rate to rise to 2.3%. Since we haven't had a true 0.2% since August, this seems like a reasonable guess. I think it is a reasonable guess, but not because of the recent below-trend prints. The housing subindex of CPI has been rising at a faster pace than it probably should be, given the inventory overhang, and last month it decelerated on a year/year basis. I think this will probably continue for at least a few months, keeping core apparently tame. That also, though, means that we need to be careful to look at core ex-housing. The expected softness in housing is a wonderful gift to the Federal Reserve here, who could point to the core number and pretend they don't know it's because the unwinding bubble is still dampening the cost of housing. It means there may not be much pressure to reduce their accommodation even if inflation in the non-bubble economy continues. Core inflation ex-housing rose at a 2.5% pace for 2011, up from 1.1% for 2010. I expect a continued rise there although probably at a lower rate of acceleration.

Tomorrow's report also involves revised seasonal adjustment factors, which happen to suggest that either the m/m headline figure will be a little softer than 0.3% or else the actual CPI index itself will be a little higher than 226.573, which is the consensus estimate (this latter figure matters only if you own inflation-indexed bonds; the rest of you may ignore it).

The U.S. markets will be closed on Monday, which also means that this author is unlikely to write then (I will probably write something after the CPI report, but then use the weekend and Monday to work on our firm's Quarterly Inflation Outlook). Thanks to all of the readers who made last night's article one of the most-viewed I have written in a long time. Do pass along these articles, or better yet links to them, to your friends. Tweet them! (And follow @inflation_guy. On Bloomberg, you can type NH TWT_INFLATION_GUY<GO> for my Twitter feed, something I just discovered). And let me know what you think about them.



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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