By
The
Inflation Trader
:
First, an observation: yesterday's article, "
Incredible Inflation Bond Bargain
," received more hits than any other article I have written in
recent memory. Apparently, people still are looking for bargains,
and still looking for
bond
bargains as well. This is heartwarming to a bond guy, and of course
even more to an
inflation
guy. But then, true bargains are rare, and true bargains offered by
the government are even more rare. A belated hat tip to "Gratian",
who asked me what I thought about I-bonds and provoked that
article. Thanks for the suggestion!
There was some mild good news yesterday. Consumer Confidence
rose more than expected, to 70.3 and only a couple of points below
the post-Lehman highs set in early 2010 and 2011. Yes, 70.3 is
still very low (the series is set so that confidence in 1985 equals
100, and in the recessions of the early 1980s and the early 1990s
it was generally in the 55-80 range), but the longest journey
begins with a single step. On the bright side, there's lots of room
for improvement (
see chart, source Bloomber
g).
Click to enlarge
The internals of the Confidence number are not as good. Both
"current conditions" and the 6-month ahead outlook improved,
especially the outlook (when 'my guy,' whoever your guy happens to
be, will be in the White House six months from now, surely things
will be better), but the "Jobs Hard to Get" subindex, which is
highly correlated with the level of the Unemployment Rate, barely
nudged lower. Still, as depressing as it sounds, consumer
confidence is a
relative
bright spot among recent data.
Home prices, as we have documented several times, are rising and
the S&P/Case Shiller Home Price Index confirmed that by
reaching the highest level it has seen since 2010. The 20-city
composite is now rising at 1.2% year/year, which doesn't sound much
but is the highest rate of change since the dead-cat bounce of
2010. Keep in mind that the index methodology involves a fair
amount of smoothing, so it lags the actual improvement in the
market. By comparison, the RadarLogic 28-day composite index as of
the end of July recorded the highest year-on-year change since 2006
(
see chart, source Bloomberg
).
Also relatively good news was the Richmond Fed Manufacturing
Index, which rose to +4 - not as good as it was earlier this year,
but 23 points above its July low. The Richmond Fed district
includes the "toss-up" battleground states of North Carolina and
Virginia and the "leans Romney" state of South Carolina. It is
encouraging that manufacturing in this region (with its 28 toss-up
electoral votes) is outperforming activity in the Dallas Fed
district (Texas, northern Louisiana, and southern New Mexico, none
of which are considered toss-ups), the Chicago Fed District (which
includes Michigan, most of Illinois and Wisconsin, and
6-electoral-vote-toss-up Iowa) and the Philly Fed district (which
is Pennsylvania, NJ, and Delaware, and no toss-ups). This is merely
an observation, and even if there were clear indications that the
Administration was directing money towards projects in battleground
states I wouldn't object to it - that's one of the prerogatives of
incumbency. If you want that prerogative, work hard so that you can
get to be the incumbent.
While the data points yesterday were good, stocks gave up the
ghost and managed to lose most of the post-FOMC rally. That doesn't
really shock me so much. Commodities, which should be more
sensitive to inflationary monetary policy, are
down
outright since the Fed declared an unbounded easing policy, and
both markets have rallied since June on the growing expectation of
QE3. The fact that QE3 was larger than many observers expected
caused some short-covering on the news, but I suspect most
investors who thought QE3 was coming were already long their
preferred assets. The actual open-ended Fed buying will definitely
buoy commodities (which remain undervalued relative to
past
QEs) and might lift equities (which, however, offer fairly weak
prospective real returns given the current market valuations), but
we had already priced in some expectations.
And in the meantime, while yesterday's numbers were not bad, the
overall picture remains pretty weak. I think the threat of
sequestration at the end of the year will start to affect growth
more seriously in October, because the end of the fiscal year for
government expenditures is September 30th. Businesses that have the
government as a significant client recognize that they may well be
in Limbo on October 1st. This is what happens when government
spending is 40% of GDP! The sequestration doesn't happen until
January, so spending from October until December in theory will be
unaffected. But, in practice, the government enters into contracts
(for equipment and construction, for example) that cover many
months, and it isn't entirely clear whether for example the Defense
Department can enter into a one-year contract if it isn't known
that the money will be there. I know several people in businesses
that are directly affected by this issue, and they're concerned
about it now, not just in January.
I saw an interesting study by State Street Global Advisors
mentioned
in a Pensions & Investing Online article
. According to the study, about ¾ of institutional investor
executives consider a 'tail-risk' event in the next twelve months
to be likely. But here is the interesting paragraph in the P&I
article:
"Survey respondents - money managers, family offices,
consultants and private banks - expect the five most likely
causes of a tail-risk event in the next year would be a global
economic recession (36%); a recession in Europe (35%); the
breakup of the eurozone (33%); Greece dropping the euro (29%);
and a recession in the U.S. (21%). (Percentages total more than
100% because respondents could select multiple causes.)"
Apparently, 'inflation' isn't even on the radar as a tail risk.
Of course, as an investor, what is more important than the tail
risks you can estimate the probabilities of are the tail risks you
aren't even thinking about or can't estimate the probabilities of.
Incredibly, not only has the myth that recessions cause
disinflation and deflation failed to weaken during the last few
years, when weak growth has been accompanied by accelerating core
inflation, it seems to have strengthened! While investors, as
evidenced by the performance of inflation-linked bonds and of
breakevens (and inflation swaps) and commodities, believe that
inflation might well be a risk, it doesn't seem that many investors
are focusing on it as a
tail
event. That is, they expect that a "bad" inflation outcome might be
2.5% or 3.0% core inflation. An outlier event to them may be 3.5%
or 4.0%.
But what we know about inflationary outcomes is that if
anything, they have tails that are quite long. And there's
plausible reasoning which can produce very high numbers for that
tail; see for example my article from late last month - before QE3
- called "
What Keeps Me Awake At Night
." I always take care to say that these concerns aren't
predictions,
but they are plausible possibilities, and the bottom line is that
we don't really know how these relationships work at this scale. No
central bank has ever dealt with numbers like this. It is a known
unknown, and thus a source of a tail
risk
of indeterminate
length
.
In my opinion, when it's cheap to insure against such risks then
it ought to be done. Presently, you can (as an institutional
investor) protect against the risk that inflation will compound at
greater than 4% for the next ten years for roughly 2.2% of the
notional amount, or 22bps per annum. There are multiple ways to do
this, some of which may be cheaper and all of which are beyond the
scope of this article - but the point is that we have investors
enumerating downward "tail risks" on growth while equity margins
and valuations are high, and largely ignoring "tail risks" on
inflation that could damage a number of different asset classes. I
see lots of potentially dangerous scenarios for equities in
October, several (but not all) of which are also dangerous for
bonds.
See also
Which Nuclear Energy ETF Is Right For You?
on seekingalpha.com