By
John Overstreet
:
Or, "Why Inflationistas and Deflationistas Are Both Right"
Or, "Rethinking Gibson's Paradox (Part II)"
Or, "Should the Taylor Rule Go The Way of the Fed Model?"
I have more or less made my
macro-calls
for the rest of the year, so now seems like a good time to take a
step back and look at the big picture.
Ever since the Federal Reserve and the federal government went
into action to prop up the market, there has been a raging debate
between inflationistas and deflationistas as to how the markets
would respond. Inflationistas argued that negative interest rates
and QE and bail-outs would result in inflation (or even
hyperinflation) and high interest rates, while deflationistas
have insisted that the debt-to-growth ratio is so high that the
centralized actions to date are insufficient to prop up the
markets. Since then, each side has had occasion to claim
vindication. In early 2011, commodity prices were on a tear, with
the inflationary bellwether of silver revisiting its old 1980
peak in a parabolic move upwards; at the same time, however,
interest rates were skyrocketing in the European periphery. It
soon became clear to nearly everyone (whether they wanted to know
or not) that the eurozone was in deep trouble, and this resulted
in a rush from commodities and stocks to safe havens such as
treasuries and gold. So, now it is the deflationistas' turn to
say "I told you so".
I'm going to try to explain why I think both sides are right
but that it depends on how one defines "inflation". This is not
merely a semantic debate, however. It requires us to expand our
definition of "inflation" beyond price indices and year-on-year
changes in them, but by doing so and differentiating between cpi
and an understanding of inflation tied to the old form of
Gibson's Paradox, this might direct us to a better understanding
of markets and both how to make money in them and how to reform
them.
I might be accused here of moving the goal posts to make the
inflationistas happy, but I think they will have to accept a few
things that some of them are reluctant to grant, as well. For
one, cpi is not a fraud, and even if it is, it is not a
consequential one. Second, there is no evidence of significant
manipulation of precious metals markets.
Let's start with Gibson's Paradox and particularly the
Barsky-Summers model of it. I have talked about this before, so I
won't go into an extended discussion of it, but I would like to
build on what I believe was accomplished before.
Under the Barsky-Summers model, metals prices were a function
of low real interest rates so that low real interest rates
resulted in high metals prices (particularly gold and copper).
Interestingly, the real prices of those metals matched the level
of inverted real rates. If real rates moved up and yet were still
negative, metals prices tended to move down.
Unfortunately, time has been somewhat unkind to this model.
There is an apparent relationship, but it is not especially
clean.
(click to enlarge)
If you look, it seems as if gold responds more positively to
negative rates while copper responds more negatively to positive
rate. And, that indeed seems to be the case.
(click to enlarge)
What makes this even more interesting, however, is when we
shift the gold/copper ratio forward sixteen months.
(click to enlarge)
Under Barsky-Summers, high real interest rates should drive
gold lower relative to prices (i.e., general prices should go
up). Oddly, however, this does not seem to be the case with
copper. By almost any measure, in fact, gold outperformed every
other commodity and the cpi, as well, during the 1970s and early
1980s. The only exception might be silver.
This is as odd an outcome as the original Gibson's Paradox.
But, whatever it might mean, it seems to give us a way to model
the relationship between prices and real interest rates.
But what about the real prices of commodities? If real prices
are not functions of real interest rates, what are they the
function of?
It appears that something like the Barsky-Summers model occurs
again, but in this case, it is year-on-year changes in cpi that
matches up with real prices of commodities. In the chart below, I
compare yoy cpi with a basket of real commodity prices (namely,
gold, silver, copper, and oil).
(click to enlarge)
Unfortunately, that was from 1970-2002. After that, things got
really weird.
(click to enlarge)
It took me a while, but it finally dawned on me that this
looked a lot like the breakdown of the so-called Fed model which
contrasts treasury rates with equity yields.
Equity yields are inverse functions of PE ratios, and PE
ratios are effectively mirror images of the Dow/gold ratio. If
that is the case, then real commodity prices (commodity/cpi)
should be inversely correlated with the Dow/gold ratio.
(click to enlarge)
This is kind of cheating, I suppose, because gold is located
on each side of the equation, but it is suggestive nevertheless
that real commodity prices are not a function of real interest
rates, as in Barsky-Summers, but of equity yields.
(click to enlarge)
One way of "testing" this is to compare the cpi/Dow ratio to
commodities priced in terms of gold. Things get a little messy
here, because I included gold in the original basket of
commodities, so in effect, we are comparing real commodity prices
(silver, copper, and oil) with the inverted real price of the
Dow.
(click to enlarge)
In a way, this is not surprising. High commodity prices are
not good for the economy or for stocks, but on a short-term
basis, that has not been the case over the last few years. Stock
rallies have coincided with commodity rallies, but the stock
rallies are increasingly feeble. This is not unlike the 1970s,
but in our situation, this drag produced by commodity prices is
not showing up in cpi.
In other words, whether or not we have textbook inflation, we
are in the middle of stagflation: high commodity prices, high
unemployment, weak stock markets, weak growth. And, yet cpi has
been extremely low and falling for years.
Is it possible that the Fed should be targeting absolute price
levels rather than rates of increase in those levels? Or, should
it be targeting equity yields, which apparently is a rough
equivalent of the same? I hardly have the capacity to hold an
opinion on that question at this time, but if the Fed should be
targeting absolute price levels, does that really give the Fed
much to do, since under the gold standard, interest rates did
that without compulsion?
In the meantime, it seems highly unlikely for the stock market
to make much traction without a massive retreat in commodity
prices, and yet commodity prices are now highly correlated with
stocks, so the measures it would take to reduce commodity prices
would, one imagines, be economically painful and politically
unpalatable.
In this article, I have looked at commodity prices in bulk,
but in my next article, I'd like to look again at movements
within the commodity complex to gain more clues as to if and when
this log jam will come unstuck.
Below, I put an estimate of the spread between ten-year yields
and S&P yields next to the real price of copper.
(click to enlarge)
It seems to suggest that we're in the right neighborhood when
it comes to reconfiguring Gibson's Paradox, but not quite there
yet. It also seems to suggest that if interest rates were raised
above equity yields, that a reduction in commodity prices could
be brought about.
Stuck between low yields and high commodity prices, there are
few palatable investment options, so it will likely take
relatively tactical maneuvering to gain returns until this market
finds a way out. As the market creeps back towards its
post-collapse highs, shorting equities (
DIA
) becomes an increasingly attractive move.
Disclosure:
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours.
Additional disclosure:
I am long September WTI and short September S&P 500 futures,
as well as AUDCHF AND AUDJPY.
See also
NiSource Incorporated: Earnings Preview
on seekingalpha.com