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Time-out! New Rules!

It is always important to remember that when you are investing or trading, while the rules appear to be clearly spelled out they may be changed at any time. This can be dangerous if you believe you are playing by Marquess of Queensberry rules when instead the game is now Ultimate Fighting. In particular, policymakers are prone to change the rules according to whim if they feel the game is moving against them; this seems to grow more prevalent these days since policymakers seem not to remember why the rules are there in the first place (the answer, of course, is that regular and predictable rules are necessary to attract the most capital into capital markets, which lowers the overall societal cost of capital and reduces the frictional costs of illiquidity).

Today, the German banking regulator banned short selling and credit default swaps of euro-area government bonds, as well as naked short selling in shares of ten German banks and insurance companies. Conveniently, this comes after the ECB had already bought a bunch of euro-area government bonds; apparently, having the ability to print money was not viewed as enough of an advantage over those powerful hedge funds and investment banks who are out to destroy the dream of European union!

The effect of the ban, among other things, will probably be to reduce credit lines extended to German banks by other banks, who always have assumed they had the option to hedge significant credit risk by buying protection on those names in the CDS market (the regulator seemed to suggest an exception if the CDS is used for hedging, but since CDS are very rarely pure punts - they're almost always hedging something - it isn't clear just what they mean). Since I would be surprised if other euro area regulators do not follow suit, there is some chance that we have just seen the torch-carrying mob set fire to their own town.

Completely ignore what happens in the short term. I am not sure if the ban applies to existing positions; if it does, then you will see a massive credit rally as short-sellers (both speculators and hedgers) have to scramble to unwind positions that everyone knows they must unwind. But the question is what happens thereafter, when no one can hedge the credit risk of their counterparty; moreover, even using the CDS market as an early-warning indicator of distress will become less useful since it is the short sellers who transmit those signals.

This is I think one of the main reasons the stock market declined today (S&P -1.4% after starting the day with a strong gain for the second day in a row), implied vols rose and bonds rallied (TYM0 was +20/32nds and 10y note yields fell to a mere 3.38%). It certainly wasn't the economic data: Housing Starts rose more than expected to 672k and PPI was near-expectations.

Despite any positive economic signals, there is unquestionably a certain amount of hatch-battening going on. Market measures of inflation continue to decline, with 1y inflation swaps down to 0.95% and 2y swaps down to 1.40%. This doesn't necessarily mean that inflation-linked bonds are great bargains here. A commentator on CNBC recommended TIPS at 2.20%; since no TIPS bond has a real yield over 1.74%, I am not sure of the relevance of the recommendation! However, TIPS certainly seem cheap to Treasuries here. While there is a chance that inflation remains quiescent because the global economy continues to thrash about like a drowning man, that possibility is priced into the market. If you buy TIPS and inflation stays low, in other words, you will probably be about as well off as if you bought nominal Treasuries. But if central banks start printing and inflation spikes, you are hands-down better off in TIPS. For your fixed-income bucket, TIPS are the better alternative here I think. Outside of that comparison, though, it is a tougher call.

TIPS have been cheapening lately partly because of expectations for tomorrow's CPI number and also because declining energy prices imply lower inflation accretion a couple of months down the road. The consensus call for Wednesday's release is +0.1% on headline inflation and +0.1% on core inflation, bringing the year-on-year core figure down to +1.0%. That central tendency comes from the fact that the last three core inflation prints are -0.1%, +0.1%, and +0.0% and the last six imply an annualized core inflation rate of a mere +0.6%. So, if you're just looking at the averages, your naive forecast will be around 0.0% or 0.1%.

I think there is some possibility that we print a +0.2% this month, although I wouldn't expect that to signal a reversal in the downward trend of core yet. But the recent rapid decline in core seems to be a bit ahead of where my models suggest it should be (that being said, recall that I have mentioned recently some of the concerns I have about dynamics in the current economy that most models, mine included, may not be picking up). The January core CPI print of -0.1% was a surprise by 0.2%, and the March print of flat was an 0.1% surprise. Economists may be overcorrecting, and certainly the market is bracing for another surprise.

There is no question that the delayed reaction of rents to downward pressure in housing prices is what is causing the sagging core inflation rate, and the core ex-housing continues to rise smartly. The guess on core CPI right now comes down to whether you think rents have caught up or not to the housing decline. I think we still have a quarter or two to go of softness in Owners Equivalent Rent, but at this point I would probably consider a stab at the long side in inflation...if there wasn't an Ultimate Fighting Championship going on in the markets.

In the afternoon tomorrow, the minutes of the Fed's April 28th meeting will be released. It is worth reading these to see what effect the turmoil in Europe is having on the deliberations about domestic monetary policy. I suspect that, whatever the Fed's plans had been about normalizing the statement to reflect a nearer-term interest in raising rates a smidgen, they are on hold for now and will be until the latest storm passes. I'll be looking at the minutes to see if that suspicion is borne out.


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