Reforming Priors and Re-Forming Europe

By: Michael Ashton | Thu, Sep 8, 2016
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By now, you have probably heard that the sun did not set on the British Empire as a result of BrExit. Here is one chart from Tuesday's Daily Shot letter - and see that letter for others.

UK Manufacturing PMI

This is not at all shocking. While in the long-term it is possible (though I think unlikely) that Germany and other major European trading partners may choose to reduce the business they do with the UK - business which is bilateral, by the way - the immediate short-term impact of a lower pound sterling was much easier to read. In the immediate aftermath of the vote, I made the bold prediction that "Britain Survived the Blitz and Will Survive Brexit," and then later that week in a post called "Twits and Brits" I made the fairly out-of-consensus prediction that "For what it's worth, I think that thanks to the weakening of sterling Brexit is likely to be mildly stimulative to the UK economy, as well as somewhat inflationary, and slightly contractionary and disinflationary to the rest of the world."

Oh, I should also point out that in early July I asked the question whether UK property price declines were rational, or overdone and concluded that "I don't believe the current drop in listed UK property funds is a rational response to correcting bubble pricing, and it's probably a good opportunity for cool-headed investors...and, more to the point, cool-headed investors who aren't expecting to liquidate investments overnight." What has happened since? See the chart below (Source: Daily Shot).

Bloomberg UK Homebuilder Index

I only mention these items in back-patting fashion because (a) I am proud that I responded thoughtfully, rather than hysterically like many analysts, to the Brexit surprise, and (b) I want to promote my credibility when I make the following observation:

Good news for the UK is bad news for the Eurozone. Not for growth or inflation in the Eurozone, but for its very survival.

The audacity of Britain in leaving the EU was shocking to the establishment, but everyone carefully predicted disaster for the ancient empire. They did this not because the economics said it would be that way - as I pointed out, the economics pointed the other way - but because it was in the interest of the common-currency project that there be huge costs to breaking the covenant. The "marriage" of the countries in the Eurozone was difficult and painful, and the ongoing relationship has been difficult on some of the members. If "divorce" is easy - and even worse, if it is beneficial, then the marriage will not last. The experience of the UK so far - not only doing okay, but actually doing well - cannot be escaping notice in Athens or Rome (or Madrid or Lisbon...or Paris).

Now, that doesn't mean the Euro is doomed to fail next week. But it means that in the next crisis, whether that is Greece redux or Italy or some other ground zero, the Eurozone bosses in Brussels will be lacking a major threat to use to force the recalcitrant nation to accept painful austerity. Remember that it was the threat of a generational depression that helped get Greece into line. How is Greece doing? The chart below (source: Bloomberg) shows that nation's unemployment rate.

Greece Unemployment Rate

Admittedly it is not a statistically-valid sample, although to be sure it is a sample that matches the a priori arguments of those who suggested that Greece should leave the Euro: the country that exited the EU is doing fine, and better-than-expected, while the country that remained in the Eurozone is actually mired in a depression. Hmmm. So tell me again why my poor country needs to accept austerity to remain in the Eurozone?

So much about policy depends on one's priors. If your prior expectation is that leaving the Eurozone is likely to be a disaster, then both sides in the negotiation are likely to reach agreement on a relatively smaller inducement to stay than if the prior expectation is that leaving the Eurozone might be a positive event for the leaver. The events to date should cause these priors to shift when the next crisis happens.

Speaking of priors, and changing countries: Friday's employment report did not seem, to me, to be outside of the range of outcomes that would cause policymaker priors to change. That is, if the Fed Chairman was planning to raise rates later this month, prior to seeing the Employment report, then I wouldn't expect the report was weak enough to change that course of action. Conversely, if the Chairman (as I believe) was not planning to hike rates, then it doesn't seem to me that the report was strong enough to change that course of action.

Markets have decreased the implied probability of such a rate hike, compared to what it was before the report. That's just Mr. Market's bipolar nature. The 6-month moving average of payrolls was 189k last month; it is 175k now. The 12-month average is exactly unchanged at 204k. There's nothing here that is out of the ordinary. But if your attitude was that rates should rise because they need to be returned to neutral, then a 151k monthly Non-Farm Payrolls shouldn't affect that decision. And if your attitude was that the economy might be weakening, and can't sustain a rate hike, the number doesn't change your attitude either. So, while Mr. Market has changed the implied probability, I seriously doubt Dr. Yellen wavered at all.

The problem is that we don't know what Dr. Yellen (and let's be clear, hers is the only vote which matters) was thinking prior to the number. We don't know her priors. But, unless the data appreciably strengthens or weakens between now and September 21st, we will know her priors after we see the results from the meeting. My guess continues to be that the Chairman's operating assumption is that low rates do more good than harm, and that therefore a hike in rates is unlikely until inflation (already above the Fed's target, and rising) gets quite a bit more above the Fed's target, or market interest rates signal restlessness with the Fed's course.

 


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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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