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Deranged, Faithful, or Phony?

By: Michael Ashton | Monday, March 28, 2011

Happy days are here again!

Well, perhaps not. Over the weekend riots in London's Trafalgar Square highlighted the fact that unrest over government cutbacks is not limited to the MENA countries and the European periphery. While the Queen as yet doesn't need to fear overthrow, German Chancellor Angela Merkel is starting to worry. Over the weekend, her party lost power in Baden-Wuerttemberg, which combined with several other recent electoral drubbings is an increasingly strong statement of the people's unrest. (Incidentally, I learned this weekend that Merkel had also previously ordered seven nuclear power plants shut pending a safety review. Again, this highlights the fact I pointed out right after the Japanese earthquake, that the nuclear disaster will tend to increase reliance on fossil fuels and the price thereof, rather than decrease it.) Already, Merkel was backpedaling from a pledge to contribute €22bln to the new European Stability Mechanism; after resounding catcalls from the media following the pledge, she went back only a few days later to renegotiate Germany's contribution so that it will be paid more slowly.

In Japan, meanwhile, it looks like optimism (which I shared) that the worst for the nuclear crisis was past might have been somewhat premature. Apparently, radiation levels are still rising around the Fukushima complex, and the region was hit by a not-negligible aftershock (magnitude 6.5). Indeed, radiation levels have reached the incredible level of 1 sievert/hour, which dosage would be fatal in only a few hours of exposure.

Needless to say, the markets didn't care about any of this.

More emphasis was placed in investors' minds on the increasingly-incredible discussions about the eventual withdrawal of Fed stimulus and even a cessation of QE2 prior to its completion. Over the weekend St. Louis Fed President Bullard admitted that the FOMC needs to consider whether QE2 should be stopped prior to its completion, and on Friday Philadelphia Fed President Plosser suggested that when the Fed starts to hike interest rates, it ought to explicitly tie asset sales to the rate change so that every 25bps, for example, would be accompanied by the sale of $125bln of securities from the Fed's balance sheet. Yes, that's right: in addition to explicitly raising short rates, the Fed should try to force long rates higher.

I know that's not the way the Fed thinks about this. There continues to be a surreal belief in the happy asymmetry of monetary policy. Buying bonds is very effective at holding down rates, but selling bonds won't push rates higher. Quantitative easing "have helped boost private payrolls by about 3 million jobs through 2012" according to Fed Vice Chairman Yellen, but somehow selling bonds won't reduce payrolls.

These extreme optimists must either be seriously deranged, immensely spiritual in believing that God has created an economic system that by happy accident contains opportunities for costless job creation, or simply don't want to tell people that whatever jobs the economy creates over the next few years will be reduced by 3 million when the Fed sells its securities.

The fourth possibility is that the Fed now believes their stimulus didn't do anything except stoke asset markets and inflation, so that (therefore) its removal will not do anything except slow asset markets and dampen inflation. This is the most plausible reality but I don't see any signs that policymakers believe it. Make no mistake. I don't think that quantitative easing does much for growth, although money illusion certainly seems to be operating with more strength than I would have expected (in the absence of money illusion, increasing the money supply should only change the price level). But central banks certainly think it does, or they wouldn't have instituted QE in the first place!

We seem in any case to be living currently in an echo of history. A good friend (and reader of this column) forwarded me this terrific video, by MGM, touting the power of inflation to get the country moving 1933. (For the record, the trough of the Great Depression in GDP terms was in 1933, but by most measures the Depression lasted somewhat longer).

Increasingly, the 1933-style reflation of asset markets seems the best excuse for what is actually happening. While corporate earnings are definitely improving, they aren't improving nearly enough to keep up with the rise in equity prices. I estimate the cyclically-adjusted P/E (CAPE, aka the Shiller P/E) as 23.2 as of today's close, implying a 10-year real return to equities of about 1.77% - which basically means zero price return since the dividend yield is currently 1.81%. Ten-year Treasury yields were essentially unchanged today at 3.44%. Commodities declined slightly (gasoline was -0.6% but virtually all commodities fell), and the dollar was unchanged. I have the least quarrel with yields, both real and nominal, at these levels; although I think they are eventually going to go higher I can see the argument that the growth outlook and the richness of related markets makes them a fair bet at the moment.


One data point from last week I wanted to return to. Last Monday's Existing Home Sales number was weak, but over the weekend I was updating some charts and noticed that the Median Price of existing home sales has reached a new post-bubble low, and is the furthest below the level implied by the Owners' Equivalent Rent series that it has been in a very long time. My belief that core inflation is going to rise steadily if not spectacularly from here is predicated on the belief that housing isn't going to take another leg down in price. In my view, it would be remarkable if it were to do so given how much cash is in the system, and how much prices have already declined. At this point, buying a home seems to be back to the zero-plus-inflation long-term bet that it has historically been over time (housing, historically, has been a much better savings vehicle than an investment vehicle). But there are certainly many people who fear a housing overshoot, and if we have one then core inflation might rise in more-sluggish fashion than I forecast. However, inventories are declining, and the current level suggests small, but positive, year-ahead housing gains.

EHSL vs Owners Equiv Rent

Home prices suggest that rents will not be advancing very quickly yet.

Tomorrow's data are likely to be somewhat discouraging, which also means they are likely to be ignored. Consumer Confidence (Consensus: 65.0 from 70.4) is projected to decline a little bit from post-crisis highs. However, the combination of high gas prices and frightening geopolitics (and natural disasters!) could and, I think, probably will take more off of Confidence than that. However, more important than the headline number is the Jobs-Hard-to-Get subindex, last at 45.7. It needs to get below 43.5 before we can be confident that the recent improvement in labor market conditions will be maintained and built upon.


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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