Now It Begins...Again

By: Michael Ashton | Tue, May 8, 2012
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Well, there are quite a few things we have to discuss, aren't there?

On Friday I had a couple of tweets about the Employment number (I've discovered that publishing a full article on Friday is seldom a useful thing to do) that I posted along with a chart of the labor force participation rate. It turns out that the participation rate was the part of the report that really stood out, and a number of commentators reflected on it. An article on Bloomberg this weekend discussed the problem of "hysteresis," which means that after a long period of weak economic growth, a group of workers finds that their skills have deteriorated (or are assumed by employers to have deteriorated) and so they are unable to find a job - so that these people become chronically unemployed. The Bloomberg article said that this problem is a "focus" of the Bernanke Fed, and a reason to keep extraordinary stimulus in place a while longer.

This is a real phenomenon, and it shows up partly in the series I've shown here previously: the strangely-named count of people who are "not in the labor force, [but] want a job now." Since to be considered part of the labor force basically all you have to do is to look for a job, these are people who want a job but don't consider it even worthwhile to look. As the chart (source: BLS) shows, the number of such people exploded in the crisis, and continued to climb into 2011 before leveling off. But it's not falling. Yes, this is a concern, and it's one reason the Unemployment Rate is as low as it is despite an employment market that is fairly described as very weak.

Not in Labor Force, Want a Job Now

Over the weekend, of course, the French Presidency was ripped from Sarkozy (as was generally expected) and the Greek Parliament was completely scrambled (as was not necessarily generally expected). The effect of replacing Sarkozy with Hollande won't be insignificant, but firebrands tend to moderate once they actually hold the key to the city so the impact of Hollande's ascension will probably not be immediate - however, the next time there is a crisis that requires France and Germany to quickly agree to something, the fact that Sarkozy is no longer the one meeting with Chancellor Merkel (assuming she's still around, which is not a sure thing given how her party has been doing recently) will make the process more dicey.

But the more immediate problem is Greece...again. The two parties which had previously formed a coalition government were soundly whipped, and the message from the electorate seems clear. Greece has had for some time a simple choice: leave the Euro, and someday get your country back, or stay within the Euro, and be indentured servants. The last "rescue package" actually increased the notional amount of Greek debt, and the previously-dominant parties were seen as complicit in the mortgaging of Greece's future. Since the election, no governing coalition has been formed. Meanwhile, more debt payments are soon due, and the country has not made any movement towards fulfilling the "requirements" of the last bailout. I suspect that whether they mean to or not, Greece will be calling the bluff of the Troika. And it is unclear, given the condition of the Germany-France relationship, whether the Eurozone is ready to send more money with essentially no strings attached. For a long time I've said that Greece would end up leaving the EZ; after the last bailout I thought they'd pushed that off for a year or two. As it happens...probably not.

As the Continent has digested these events, Spanish and Portuguese yields (which had been healing modestly) have started to head back up, and Continental equity markets took a beating today. (It's actually a little surprising that they hadn't taken a beating yesterday, but markets globally were very quiet on Monday.)

And of course, pressure remains on commodities, especially energy. NYMEX Crude fell below $100/bbl (closed today at $97.35) and gasoline futures fell below $3/gallon before rebounding today after a very large draw on gasoline inventories - among the 10-20 largest in the last decade - in the weekly API report. Prices at the pump are still $3.76 nationwide, so while they have retreated some they're not exactly plunging.

In domestic markets, the S&P broke below last month's lows before clawing back to close with just a narrow loss. The selloff was contained by the 100-day moving average, but I don't think it's going to be for long. Apple (AAPL) is also back to nearly the April lows. After the ill-advised spike higher on the April 24th earnings report (you know, the one with severely negative forward guidance), the stock has drifted lower almost every day since. I wonder how all the people who chased it feel? I'd written prior to that release that the market's ability to look past weak reports would be considered a good sign, and it was - but that was then, and we're now looking at a skein of what are likely to be economic reports of decreasing strength for a while. For of course, we cannot avoid feeling the European recession. Bonds know this; the 10-year yield fell to 1.85% with the 10-year real yield at -0.35%.

On the monetary policy front, there was an interesting development in that year-on-year M2 money supply growth finally declined in the U.S. to under 9% (to 8.85%), the first time this has happened since last July. However, we should also note that European M2 as of the end of March (the last available data) accelerated to 3.3% year-on-year, the highest level since September of 2009.

Indeed, if you are surprised that the robust M2 money growth has not resulted in faster inflation in the U.S. (I am not; in fact core inflation is running ahead of where my models expected it to be), you should remember that in a global economy money is fungible! Adding liquidity in the U.S. pushes up prices everywhere - but holding it down in Europe dampens price increases everywhere. In fact, if you run the contemporaneous correlation of year-on-year core US CPI versus year-on-year US M2 money growth back to 1999, you get 0.44. But if you run the correlation of year-on-year core US CPI versus year-on-year Euro and US M2 growth (adding together European M2 and US M2 and then computing the growth rate), the correlation rises to a whopping 0.60. The chart of this relationship is shown below.

y/y Growth in Euro + US M2 versus US Core CPI

This is hardly definitive; the quality of the single-variable unlagged relationship breaks down back in the 1980s and early 1990s (of course, the global financial system was less-integrated then, too). But I hope it makes the point that if US money growth lags, it ought to be more than made up for by Euro money growth. Frankly, I don't expect US money growth to slow very much, or to stay down, because corporate credit is growing well and the Fed isn't about to try and restrain money growth. But I do expect European money growth to accelerate, since 3.3% in the current economic conditions is going to be viewed as too tight.

Actually my next chart is pretty interesting. It shows Euro M2 and US M2 separately. Which country do you think had a central bank with Bundesbank DNA?

US M2 versus EU M2

The Fed clearly has, to date, done the heavy lifting of staving off deflation, while the ECB worked at restraining inflation. But now with the ECB under new management, they are pulling on the rope in the same direction.

In this context, it is comforting that the initial results from the poll I posted last week show that only 3% of respondents report that they are not concerned about inflation and have no plans to take any explicit inflation-protection steps. Fully 73% report either that they feel they have completed taking steps to protect their wealth against inflation (17%) or that they have taken some steps, but plan to do more (56%). Nineteen percent of respondents have not yet taken inflation-defensive steps, but plan to do so by the end of 2012 (12%), or in 2013 (7%). The poll is still open - feel free to log your perspective!

With European M2 rising relative to the U.S., and the increasing likelihood that the Euro's membership will come into question soon (and once one adjustment to the roster has been made the second is much easier) and weaken the Euro versus the dollar, I think it's likely that European prices will rise at least as fast as US prices. And yet the 10-year Euro inflation swap is at 2.09% while 10-year US inflation swaps are at 2.54%. That difference may have made sense when the ECB was run by Trichet and it was the US fighting a banking crisis. But now the ECB is run by Draghi and it is Europe with the banking crisis. While I think inflation is going to continue to head up everywhere (Japanese 10-year inflation swaps are at +0.50%!), I think Europe is going to be catching up to the U.S. in the monetary-profligacy race.



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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