It's Okay to Fight Fed Intentions, Just Not Fed Actions

By: Michael Ashton | Mon, Oct 1, 2012
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Today there was a glimmer of good news today from the economic front. The national PMI (formerly known as NAPM, now ISM) rose to 51.5 from 49.6 last month. Expectations had been weak, especially since Friday's Chicago Purchasing Manager's report printed a contractionary 49.7, the lowest reading since 2009 (see Chart, source Bloomberg).

US MNI Chicago Report

That wasn't the only bad news last week. On that side of the ledger you have to also put Thursday's Durable Goods report, which was awful. The headline was -13.2%, which made headlines since it was the worst since a single -14.3% print in January 2009. But that is obviously significantly due to aircraft. Ex-transportation, though, the number was also weak, at -1.6% coupled with a downward revision of -0.9% to July's report. That's three consecutive negative months, which hasn't happened since late 2008. New orders, ex-transportation, have now declined on a year/year basis. The chart below (Source Bloomberg) shows that declining core Durables Orders doesn't usually happen, except at the margin, outside of recessions. The recessions of the early 1980s, the early 1990s, and the two of the 2000s are all clearly visible on the chart.

US Durable Goods New Orders Total

Now, -1.1% is still marginal, and there have been cases where such a print didn't happen in the context of a recession (such as in 1998). But the next two months bring difficult comparisons, since September of 2011 was +1.9% and October 2011 was +2.0%. It will be pretty easy for this indicator to drop another few percentage points, and if it does then it will be hard to argue we are not beginning another recession.

Perhaps the inkling of this result is the reason that bond yields and breakevens have both recently been soft. Readers of this column know that growth doesn't cause inflation nor recession cause disinflation, but 95% of investors still believe that. This creates, in my view, a wonderful opportunity to buy inflation insurance at a time when by rights it should be egregiously priced. When we look back at this period, right after the Fed began open-ended QE promising to continue until inflation rose or unemployment (or the republic) fell, I can assure you that everyone will remember that 'everyone knew' what would happen. Certainly, our clients will think so, and will wonder why we didn't.¹

Personally, I think Dr. Bernanke must be looking at the retracement in breakevens and the developing view that inflation is no threat and saying to himself "I can't believe they bought it!"

As an example of that credulity, Bloomberg reported today that "TIPS Show Inflation Alarm Fading as Options Give Fed Time." In this article, the journalist noted that "Demand to protect against higher long-term bond yields over the next six months has been static since Fed Chairman Ben S. Bernanke announced a third round of quantitative easing..." I thought it might be helpful here to point out that even if you think the Fed is going to fail to keep inflation down, buying puts on bonds is probably not the right way to play that view. Buying puts on nominal bonds is a direct bet that the Fed will fail to keep longer interest rates down. Since the Fed has both explicitly and implicitly pledged to do so, and is currently buying long-term Treasuries (and now mortgages) in a direct effort to lower long-term rates, investors who buy puts on nominal bonds are simply going head-to-head with the Fed. As Dennis Gartman pointed out to a gathering at an inflation conference last Thursday (at which I also spoke), "the Fed's margin account is second in size only to God's," and it doesn't make sense to bet against them directly.

However, while the Fed may succeed in markets there is certainly no guarantee that the Fed will succeed in the macroeconomy. History is replete with examples of Fed mistakes, and yet many investors seem to have forgotten this history. It seems to me that investors today think "don't fight the Fed" means the Fed will actually succeed in the macroeconomic effects of what they are trying to do. But that's not what "don't fight the Fed" means. It means: don't sell what the Fed is buying, don't buy what the Fed is trying to push lower. Don't bet on higher rates when the Fed is pledging to hold them down forever with actual purchases in the cash bond market. It isn't, in short, surprising that options are 'giving the Fed time;' it's just that many more people are willing to bet the Fed is going to succeed in keeping rates down, than are willing to bet their huge margin account will be tapped out.

But that doesn't mean you have to bet that the Fed is going to be able to avoid the usual macroeconomic effects of loose money. When the Fed says "we intend to keep rates low," they can put effect to that intention. But when the Fed says "we intend to keep inflation low," they have no way to cause this to happen absent pursuing a tight monetary policy, which they most assuredly are not...and even then, they're not actively transacting in inflation but in asset markets. If inflation follows profligate monetary policy much as night follows day, then the way you invest for that possibility is to buy inflation, not to sell nominal rates. That is, be long breakevens, or inflation swaps, or inflation options.

How quickly to do this? Honestly, I am amazed that we still have the opportunity to do it, so perhaps this means there is no hurry. A weak Employment report this week may give another opportunity, and as recessionary signs accumulate then inflation expectations (not to say inflation itself) may decline. The re-developing European debacle might give us a chance to buy inflation cheap. We may in fact have months to put on long inflation trades.

But maybe not, too. And I would hate to have to explain to clients, or my spouse, why I had nothing on when "everyone saw this coming." The regret function suggests to me that this is a prime case for averaging into inflation protection, if you haven't yet begun to.

 


¹Of course I am using the 'royal we' here: our company has been loudly clanging the gong on this for a while and no one will think we didn't see it coming.

 


 

Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
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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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