August Hangover

By: Michael Ashton | Tue, Sep 4, 2012
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Don't begin to worry, just yet, about the continued low volumes. It isn't unusual, following a long weekend, for the first day back to still be sluggish. People are catching up with e-mail, greeting friends (friends which, in Europe at least, they may not have seen for a month or more), and so on.

And anyway, we should put today's light volume - 599 million shares on the NYSE - in context. The average for all of last month was only 581 million shares, and only 544 million for the last half of the month. Only eight days in August were busier than today's total, and three of those were the FOMC meeting day, the last day of the month, and Employment day. That's slim solace if you're a broker, I am sure, but brighter and busier days are ahead. In fact, proximately ahead.

European bonds rallied strongly as details of the ECB's plan to buy Eurozone bonds were leaked; ECB President Draghi told the European Parliament in a "closed door" (but apparently open-mic) session that the ECB simply must buy bonds because the traditional instruments of monetary policy are ineffective. "We cannot pursue price stability now with a fragmented euro area because changes in interest rates affect only one country, or two countries at most. They have no importance whatsoever in the rest of the euro area." It is true that to a man with a hammer, everything looks like a nail, but Draghi was essentially arguing that in want of a hammer, anything that will pound a nail will do. In short, because the traditional tools don't work, Draghi claims that anything else which accomplishes the same ends is allowed.

The Bundesbank will not agree.

But Draghi claims the Euro's survival depends on his being allowed to buy bonds under 3 years to maturity (why there is a limit at 3 years is unclear to me; if it was necessary to extend the program to 5 years because buying everything less than 3 years wasn't working, why won't the same argument work?), and it seems unlikely that there will be enough opposition to dissuade him from this action. It is one thing to ask legislatures to write a check, but the costs of profligate monetary policy (as we have seen) are not as apparent and not as immediate; and anyway, the politicians can campaign later on the need to have them around to fix whatever new problem that is created as a result.

The continuing question should be - if there is no cost to buying huge numbers of bonds, then why should the central banks ever have eschewed that action? Of course, there is no such free lunch, as William White wrote last week. But from the standpoint of a politician, it's almost a free lunch. "I'll glad you pay you next election cycle for a hamburger today," as Popeye's pal Wimpy might have said.

Or, better yet, chastise the monetary policymakers for not foreseeing the true cost of that hamburger today!

One more comment on that William White piece. In it, he discusses among other things the many ways in which overcapacity has developed last couple of decades in many countries and many industries. He does this to illustrate the concept of "malinvestment," which mainstream economists these days pooh-pooh but which many Nobel Laureate economists (such as Hayek) did not.

However, like many of those earlier authors, White seems to take the existence of overcapacity as implying that deflation is a serious risk. I think this is based on a misunderstanding and misapplication of the original concept of malinvestment. Overcapacity implies that resources have been mis-allocated in the past, and this creates a cost in the future - but it only implies deflation in the presence of traditional monetary response (which, let's remember, we haven't had in a decade or more). Overcapacity implies declining real prices, and declining real returns to property, plant, and equipment relative to labor - and that is good news for consumers. But, if this overcapacity is coupled with ample money printing, this is not inconsistent with rising, rather than falling, price levels.

Remember that the original Keynesians and Austrians were writing in a period during which most of the historical record involved a money supply effectively, if not explicitly, limited by linkage to gold. In the presence of a fixed money supply, overcapacity most assuredly leads to deflation. But in the presence of a rising money supply, these are no longer automatically connected concepts: overcapacity is a statement of investments and returns in real space, while inflation measures a change in nominal prices.

And that's why the malinvestment of the 1990s and 2000s need not lead to the same end result as the malinvestment of the 1920s. Indeed, unless something very odd happens - and I gave the parameters I would consider odd last week - deflation, with or without the hangover effects of prior malinvestment, isn't going to happen.

The next few weeks will be more increasingly more active, to a degree that we may long for the quiet days of August. Keep in mind that it is a very strong time of the year for bonds, seasonally speaking, and a weak one (although not as consistently so) for stocks. But I wouldn't try to play those zig-zags. The DJ-UBS index reached a 6-month high this morning, before backing off; that's where I would have (and do have) my money.



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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