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160 Billion Euro Later, Not Much Closer To Resolution

By: Michael Ashton | Thursday, July 21, 2011

If €160 billion could somehow be an unimportant amount, today it was. But before we get to the latest discouraging result from the EU, let's do a quick survey of the prior news first.

We'll start with last night's speech by the head of the Fed's SOMA account, Brian Sack. Now, I know that isn't what readers want to know about, so I'll just include a little snippet. Sack, talking about how QE2 went over, said:

"Despite its limits, the expansion of the balance sheet was seen by the FOMC as the best policy tool available at the time, given the constraint on traditional monetary policy easing from the zero bound on interest rates. The willingness of the FOMC to use this tool is indicative of a central bank that takes its dual mandate seriously and does what it can to deliver on it. The disappointing pace of recovery that has been realized since then suggests that the additional policy accommodation provided by the LSAP2 program was appropriate."

Wait, what? Where is Tivo when you need it? Did he say that the decision to deploy QE2 (LSAP2) was proven to be justified because it didn't work?

Keep in mind that speeches by senior Fed officials are ordinarily proofread and vetted a number of times. So it seems that everyone who proofread Dr. Sack's speech felt vindicated by the fact that growth slowed between the time QE2 was instituted and when it ended. I wonder what failure would have looked like!

This morning started with Initial Claims, printing weaker-than-expectations at 418k. Leading Indicators came in at 0.3%, near expectations. Surprisingly, the Philly Fed index did bounce to 3.2, which was even a little bit more of a bounce than economists were expecting. That behavior stands in contrast to the weak Empire figure and therefore clarifies neither.

The TIPS auction went rather well. (Incidentally, an erratum is due here. Yesterday I quoted the WI 10y TIPS based on Bloomberg's numbers, which were completely off. Instead of 0.48%, it was around 0.63%. I should have known better, since I knew the roll was trading around pick-8. My apologies for the error!). The bid:cover was 2.62:1, and the auction stopped through the screens (that is, no tail). Direct bidders took about three times their normal share, around 13.7%. The extra billion they took down allowed dealers to take a billion less, so there is less to clean up. With 10-year nominal yields up 8bps on the day to 3.01%, 10-year real yields were unchanged so inflation expectations rose about 8bps: 10y CPI swaps ended up around 2.82%, once again threatening the highs for the last few years.

None of this mattered. Stocks took any and every excuse to rally. It rallied on good data. It rallied on bad data. It rallied on the rumor that Greece was going to be allowed to default (I suppose because France and Germany had come to an agreement on it). The bullish interpretation is that the market seemed to do really well with bad news. The bearish interpretation is that the news sucks.

It looked like there was a chance it could be worse than it was. As the afternoon dragged on, dealer "analysis of the debt crisis summit" calls began to be postponed. Overnight, we had heard that Sarkozy and Merkel had come to a meeting of the minds (whatever that means when the two people we are talking about are Sarkozy and Merkel); if so, then where was the announcement of the grand plan?

Just before 3:00 ET, French President Sarkozy began to speak with reporters on the results of the meeting. This was our first indication that the meeting was over. There was no communiqué; all of the politicians just started holding press conferences.

I want to make one quick observation here. It is much easier to say something in a press conference and later take it back, than it is to say something in a communiqué that you later want to withdraw.

Sarkozy's comments meandered; there was lots of "we pledged this" and "we can't let that happen" and so on. We heard there were "strong measures taken." Great, Mr. Sarkozy. Isn't the communiqué supposed to tell us what those measures are?

I imagine that there will be a document of some kind eventually, but perhaps not. We know the general outlines of the grand bargain, though, and ... it's pretty much what we already thought it was, and it isn't grand. Here's what Sarkozy said (and it was in substance - whatever that term means when it is Sarkozy speaking - confirmed by other ministerial mutterings):

I might have taken this press conference for a farce and a bad joke, if I hadn't known it was not. The French President, echoed by other senior European figures, said "Greece will repay its debts." Hold it just a minute, Monsieur President...isn't that Greece's decision to make? The EU can make many decisions that affect Greece, but surely the French and Germans don't get to decide if Greece defaults. At best, they can make it less-advantageous for them to do so, although it isn't clear they have done that yet.

The grand plan, the meeting of the minds, appears to have basically produced the plan that the French already liked, Merkel had already rejected, and the ratings agencies had already said would probably be a default. I don't see any new cash. And yet, the stock market rallied. The dollar was whacked to 6-week lows, while equities gained 1.4%. Crude oil rallied 1.2% and is near $100 again although commodities as a whole weakened.

After the close, M2 was released; it rose slightly in the most-recent week. Since it didn't retrace any of the recent spike, the period-on-period growth rates remain elevated and worrisome.

I think that once Friday dawns investors will realize that the European deal isn't that big a deal, isn't even ratified yet, and seems short on specifics. I remain bearish on stocks but I will say this: if we get past the debt crisis - and by 'past' I mean that fiscal and monetary authorities are able to extinguish the contagion and stabilize the woefully under-capitalized banks in a convincing way - then the backdrop otherwise is improving somewhat. The problem with equities is that they already incorporate much of that improvement in the price without incorporating much of the risk, but I don't think it would be impossible to inflate a little mini-bubble. It would be hard to keep it going, because interest rates would have to rise and basically the perfect environment for stocks - low and stable interest rates and inflation - would turn into something less-perfect. But I can imagine the stock market rallying, even from here, if, and it is a very big if, the sovereign debt crisis is stayed for now.

Of course, with the amount of debt and the size of the deficits, the crisis will not go away forever. Indeed, there are plenty of other crises waiting in the wings including the U.S. deficit situation and the wall of money waiting to pour into transactional balances and inflation. But if I pucker up my face just right, tilt my head and squint, I can imagine the equities bull market getting one more leg.

But I am not positioned that way. I am positioned short, through put options, and our models are long commodities and cash in preference to TIPS and equities. The odds still favor a bad outcome for the long equity investor, especially in real terms.


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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