This Is Your Brain On Leverage

By: Michael Ashton | Tue, Apr 3, 2012
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The event du jour on Tuesday was the release of the FOMC minutes from the March 13th meeting. There was almost nothing surprising in the minutes, although the market's reaction suggested otherwise.

Prior to the release, there had been some very odd reports from respected sell-side shops (such as Goldman) that predicted the Fed was about to announce an extension of Operation Twist or some other policy initiative. Those reports were nonsensical. This was not an FOMC meeting; it was the release of minutes from a meeting several weeks ago. The Fed has never use the minutes as a way to announce new policy measures; not surprisingly, new policy measures that need to be announced are announced, either in the statement following the meeting or on rare occasions in a separate news release. It is a real head-scratcher to me why these economists in the last few days suddenly decided that the FOMC minutes might be the place we find out about an official new policy.

At best, the minutes occasionally reveal more concern, or less concern, about a particular economic variable than the market expected, or more interest or less interest about a particular policy tilt. The one quasi-surprise in these minutes was that the Fed explicitly stated that their description of the period of extremely low rates "at least" until mid-2014 was conditional:

"It was noted that the Committee's forward guidance is conditional on economic developments, and members concurred that the date given in the statement would be subject to revision in response to significant changes in the economic outlook."

In other words, it isn't "at least" at all. Rates will be low until they need to be increased, which means it was complete idiocy to ever put a date in the statement to begin with. If it is a promise, it bound their hands unnecessarily; if it was not a promise, then (a) why say it at all, since the operating understanding is that the Fed will change rates when it feels conditions require, and (b) learn some English, and don't put absolute phrases like "at least" in statements meant to be squishy on timeframe. I draw the almost inevitable conclusion that the Fed believed we cared about their forecast of economic conditions two years forward, as if they not only are not the worst economic forecasters out there, but actually are dramatically better than most other economists who feel that a 6-month forecast has pretty big error bars.

Either that, or the statement was never meant to do anything other than jack around with interest rates. Perhaps it shouldn't be surprising that the Fed, and even the Chairman himself, are alternating between saying dovish things and saying hawkish things (or re-interpreting prior dovish statements to appear more hawkish). The Fed's main tool right now is its "communications strategy," in which it wants to talk down inflation expectations while also talking down interest rates. The former requires hawkish talk, while the latter requires dovish hints. While QE3 is probably still coming (although I don't see a "sterilized Operation Twist," which doesn't really accomplish anything I can think of), it's a decidedly more-difficult operation now when core inflation is at 2.2% and global inflation is rising than when it was at 0.6% and bottoming. Before, they didn't mind if inflation expectations rose; that also suited their purpose. Now, though, it would damage the same purpose.

The reaction in the bond market was swift and violent although the 'disappointment' was small and insignificant. The severity of the move - 10-year rates rose 14bps in minutes - is a direct result of the Fed's policy of pegging interest rates and trying to be very transparent. In short, rates are so stable that "2 basis points is the new 5 basis points." With no market movement, traders and investors put on larger positions because they are confident that there won't be violent moves with Sheriff Bernanke on the watch, and because to make any money at all from a trading position, trading size needs to be larger. When there actually is a market move, the move will tend to be more violent because positions are larger (and, because of the Volcker Rule, liquidity once the market leaves its safety zone grows thin quickly).

You can see this in the curve's movements today. While the main change was that the FOMC made the unconditional rate pledge entirely conditional, 2-year rates moved only 4bps. But 5-year and longer rates rose 12-15bps on the announcement (the 10-year note is now at 2.30% again). Honestly, 2-year notes at 0.37% if the Fed isn't promising to keep rates low seems a little rich to me (meaning that the yields are too low), if only because of the relative lengths of the up and downward tails (since the bearish tail is not truncated by the Fed promise!), although I happen to believe the economic situation is such that the Fed will end up honoring its pact despite inflation that will continue to accelerate.

Nonsensical was the trashing of TIPS today. Inflation-linked bonds fell just as far as nominal bonds, so that inflation breakevens were approximately flat on the day. That's wild. It isn't as if the inflation outlook depends on the next trillion in Fed-sponsored liquidity! The global spigots remain on, and the Fed has already done far more than enough to ensure inflation will keep rising unless money velocity rolls over again. 10-year breakevens have risen this year from 2.00% to a recent high of 2.45%; at the current level of 2.35% they remain an easy buy. 5-year breakevens at 2.06% are an even better deal, since headline inflation over the next year will be well above that level thanks to gasoline. You're buying forward inflation there at a very cheap level, in my opinion. (Retail investors can't directly access the short inflation part of the curve, although they can participate in a general rise in inflation expectations through the INFL ETN and the RINF ETF. I own small positions in both of those securities and have no plans to change that position in the near-term).

To be sure, negative real rates are not sustainable in the long run, and while the 10-year TIPS real rate of -0.07% is starting to look almost cheap compared to where it has traded in the last six months - and indeed, I think investors will scoop them up at 0%, and 30-year TIPS if they get to 1.0% - they probably won't be there a year from now. But TIPS are still a better deal relative to nominals, so if you must own some fixed-income, I prefer to position in real rates.

Wednesday's main release is ADP (Consensus: 206k from 216k). Although this report is losing its punch as it fails to track the Payrolls number well, in this case there may well be more attention paid to it than usual because the Employment Report will be released in thin market conditions this Friday during a half-session recognizing the Good Friday holiday. Accordingly, if ADP contains much of a surprise, you may well see an outsized-reaction.



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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