By: Michael Ashton | Wed, Apr 17, 2013
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The sine qua non for a disaster is that no one is worrying about the disaster. Earthquakes are less damaging in Tokyo than the same earthquake would be in New York, because in Tokyo buildings are designed to be earthquake-resistant. This is also true in markets; if investors are guarded about purchasing equities because of all the bad things that can happen, then prices of equities will be very low and it will be difficult to effect a true crash in such a circumstance.

The opposite doesn't necessarily follow in the physical world (if you don't prepare for an earthquake, it doesn't far as we know...the probability of it happening), but it occasionally does in the financial world. I pointed out in January the work by Arnott and Wu which indicates that a company which enjoys "top dog status" in terms of having the greatest market capitalization in its sector tends to underperform the average company in the market by 5% per year for a decade. This is largely because investors in such companies are not prepared for adverse surprises, so that any such surprises tend to be taken poorly. Similarly, problems in Cyprus had an outsized effect on markets because (remarkably) no one was prepared for there to be problems in Cyprus that the rest of the Eurozone wouldn't simply write a check to cover.

By this standard, inflation is growing more dangerous by the day, as more and more investors and pundits start talking - incredibly - about deflation. St. Louis Federal Reserve President Bullard today told an audience at the Hyman Minsky Conference in New York that it is "too early" to worry about deflation. That statement must hit most readers of this column as hysterically funny, given how many readers typically complain that the CPI is far lower than their personal experience of inflation. Bullard also noted that he favors an increase in the pace of QE if inflation falls further. Since core inflation is currently at 1.9%, Bullard is essentially putting a floor on inflation near where we once thought the ceiling was.

I read somewhere today that the recent declines in copper and gold are "signs of deflation." I disagree. At best, they are signs of fears of deflation, right? But even that, I don't buy. While breakevens in the TIPS market have declined recently, they are still not particularly low by any historical standard (see chart of 10y BEI, source Bloomberg). Moreover, a not-insignificant part of that decline represents a direct response to energy's retracement and isn't a reaction to a softer opinion about core inflation.

10-Year BEI Chart

In fact, the core inflation implied by the 1-year inflation swap, once energy is extracted, is above the current level of core inflation and near the highs that have been seen since early 2011 (see chart, source Enduring Investments).

1-Tear Inflation Swap versus Implied Core Inflation

So I suspect, rather, that the causality runs the other way: the decline in copper and gold has caused an increase in chatter and vocal concern about deflation. But the people who are investing directly on whether deflation will happen aren't seeing it. This is somewhat comforting, as it's the people with actual money (rather than pundits and economists) who determine whether their institutions are ready.

Now, to the extent that the increased chatter actually leads to renewed relaxation in inflation expectations (ex-energy), it sets the stage for worse damage when it inevitably happens. Inflation, like earthquakes, is more injurious when societal institutions have not prepared for it. Median inflation in the U.S. over the last decade is about 2.5%. But in South Africa, it is 5.7%. In the U.S., a 5.7% inflation rate would cause major havoc, but South Africans would be amused at that since they deal every day with that pace of price change (as did Americans, in the 1980s). In Turkey, median inflation has been about 9.5%, but there again the society has adapted to it. To the extent that there is any fear in the U.S. about inflation rising to 5% or to 10%, institutions will prepare for it, and they will eventually learn to deal with it. It's the shift to that new reality that can be especially painful.

The rest of the week has only minor economic data releases, with the Philly Fed report on Thursday (Consensus: 3.0 vs 2.0 last) the most important of them. A few Fed speakers will be on the tape. But the real market concern is concern in the market: the VIX has risen to 16.5 after having receded slightly on Tuesday; the dollar today retraced all of Tuesday's decline and then some. Gold and commodities have not fallen further after the washout on Monday, but neither have they rejected the lower levels and rallied back. The S&P has support at 1540 or so but below that level there could be a substantial further fall. All of these markets have potential for important moves, and in the meantime there is the potential for renewed headlines out of Cyprus where there is consternation over the new demands from the EU. The trader in me would guess (stress: guess) at further weakness in equities, an attempt made by energy markets to hold near these levels, a halting rally into resting sell orders in precious metals markets, steady nominal bond markets but with some rebound higher in long breakevens. But here are the problems: (1) these are all connected - so I could easily miss on every one of these guesses; (2) any big move will affect sentiment on the others, so that there are copious feedback loops; (3) much of what happens will depend on the next quantum of news to hit the screens, and (4) Wall Street is less and less in a position to take risk and maintain orderly markets, as it has in the past. We might even simply tread water into the weekend and take our volatility on Monday. But I'm fairly convinced that more volatility is coming before markets calm down again.

But that's not a problem, if you're prepared for it!


You can follow me @inflation_guy!

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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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