But How Near is the Fall?

By: Michael Ashton | Mon, Sep 16, 2013
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I will resist the temptation, succumbed to by many others, to offer a pithy title turning on some pun involving Larry Summers' name. For example, I will not title this article:

Such tomfoolery is occasioned by the news yesterday that Larry Summers has withdrawn his name for consideration to be the next Fed Chairman, succeeding Bernanke. The markets reacted with similar tomfoolery. Although the equity markets hadn't exactly plunged as Summers became the odds-on candidate (at a conference I went to last week, all six of the panelists during one segment said Summers would be the selection), stocks rocketed higher today as this supposedly makes a dovish Chairman more likely. Bonds rallied as well, and the dollar fell - all of these for the same reason. Strangely (but not so strangely if you have been watching commodities for the last couple of years), commodities fell on the potential for a more-dovish Chairman.

The odds-on favorite just became Janet Yellen, with Donald Kohn the runner-up. Both of these are considered to be more-dovish than Summers, which is odd because it is generally acknowledged that Summers had virtually no track record expressing his opinions on matters of monetary policy, and was essentially a policy unknown.

In any event, markets for the nonce are enjoying the notion that a Chairman Yellen or Kohn would bring "continuity" to the Federal Reserve and make the adjustment from the Bernanke years seamless. You can be a short seller of that idea. Volcker to Greenspan, Greenspan to Bernanke...neither of those transitions was expected to make a dramatic difference in monetary policy, but of course ultimately they did. Going back further, Volcker was chosen partly as an antidote for G. William Miller, so it is not surprising that things changed under Volcker - but we were looking for change). You probably have to go back to the Arthur Burns/G William Miller transition in the late 1970s to find a transition that truly didn't matter very much, although that was mostly because Burns had made such a mess of things and triggered such an ugly inflation by adding too much liquidity to the system in order to cure the recession that the only thing Miller thought he could do was to continue on...

Oh. I see the parallel now.

In any event, a Chairman Kohn or Chairman Yellen is very likely to turn out to be something different from what we think we are getting, or from what the President thinks he is getting (not necessarily the same thing). It is much like appointing a Supreme Court justice: after donning the robes, physically or metaphorically, a justice might vote in a way very different from the way his nominator expected him or her to. Just ask G.H.W. Bush. So, regardless of whether the next Chairman is Yellen, Kohn, or some as-yet-unknown candidate, the bottom line is that investors should expect surprises. If your investment strategy is reliant on there not being any surprises, then I advise you to reconsider that strategy!

Speaking of surprises, Tuesday brings the CPI report. The market consensus is for +0.2% on headline and +0.2% on core inflation, with the y/y core inflation reading rising to 1.8% from 1.7%. However, since last year's CPI print was a mere +0.06%, forecasting a rise is very easy. If the monthly figure is only 0.105%, y/y core inflation will still tick up to 1.8% (rounded). Indeed, the risk here is that it only takes a +0.21% to produce a 1.9%, which would make for some panicky portfolio adjustments even though it would not be an extreme outlier.

In my view we are probably overdue for a +0.25% print on core inflation. The current rise of core CPI back towards median CPI, which has been either 2.1% or 2.2% for a year and a half, is happening because some of the unusual effects that pushed core CPI later are waning. Moreover, as I have written about expansively previously, housing inflation appears to have turned up but a more-substantial move higher is due (or perhaps overdue).

The CPI report and the adjustment to the market's expectations about the next Fed Chairman are somewhat related. There is a notion out there - which I think is foolish - that the removal of Summers from consideration as the next Chairman, coupled with slightly weak recent data, lessens the chance that the "taper" will be announced this week. I do not think that either event bears on the probability that a taper will be announced. While I originally expected the taper to come later in the year than this, the voluminous statements of Fed Governors and Fed Presidents seems to indicate that it will begin imminently. The likelihood that a dove will take the Chairman's seat does not change that. However, to the extent that the stock and bond markets rallied because they think a taper is less likely, a CPI print that takes core to 1.9% on the year will extinguish that frail hope. I think today's stock market rally is subject to a near-term disappointment if this happens, and this is likely the case, although less so, for the bond market as well.


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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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