Monday there was a glimmer of good news from the economic front.
The national PMI (formerly known as NAPM, now ISM) rose to 51.5
from 49.6 last month. Expectations had been weak, especially since
Friday's Chicago Purchasing Manager's report printed a
contractionary 49.7, the lowest reading since 2009 (see Chart,
(click to enlarge)
That wasn't the only bad news last week. On that side of the
ledger you have to also put Thursday's Durable Goods report, which
was awful. The headline was -13.2%, which made headlines since it
was the worst since a single -14.3% print in January 2009. But that
is obviously significantly due to aircraft. Ex-transportation,
though, the number was also weak, at -1.6% coupled with a downward
revision of -0.9% to July's report. That's three consecutive
negative months, which hasn't happened since late 2008. New orders,
ex-transportation, have now declined on a year/year basis. The
chart below (Source Bloomberg) shows that declining core Durables
Orders doesn't usually happen, except at the margin, outside of
recessions. The recessions of the early 1980s, the early 1990s, and
the two of the 2000s are all clearly visible on the chart.
(click to enlarge)
Now, -1.1% is still marginal, and there have been cases where
such a print didn't happen in the context of a recession (such as
in 1998). But the next two months bring difficult comparisons,
since September of 2011 was +1.9% and October 2011 was +2.0%. It
will be pretty easy for this indicator to drop another few
percentage points, and if it does then it will be hard to argue we
are not beginning another recession.
Perhaps the inkling of this result is the reason that bond
yields and breakevens have both recently been soft. Readers of this
column know that growth doesn't cause inflation nor recession cause
disinflation, but 95% of investors still believe that. This
creates, in my view, a wonderful opportunity to buy inflation
insurance at a time when by rights it should be egregiously priced.
When we look back at this period, right after the Fed began
open-ended QE promising to continue until inflation rose or
unemployment (or the republic) fell, I can assure you that everyone
will remember that 'everyone knew' what would happen. Certainly,
our clients will think so, and will wonder why we didn't.
Personally, I think Dr. Bernanke must be looking at the
retracement in breakevens and the developing view that inflation is
no threat and saying to himself "I can't believe they
As an example of that credulity, Bloomberg reported Monday that
TIPS Show Inflation Alarm Fading as Options Give
." In this article, the journalist noted that "Demand to protect
against higher long-term bond yields over the next six months has
been static since Fed Chairman Ben S. Bernanke announced a third
round of quantitative easing…" I thought it might be helpful here
to point out that even if you think the Fed is going to fail to
keep inflation down, buying puts on bonds is probably not the right
way to play that view. Buying puts on nominal bonds is a direct bet
that the Fed will fail to keep longer
down. Since the Fed has both explicitly and implicitly pledged to
do so, and is currently buying long-term Treasuries (and now
mortgages) in a direct effort to lower long-term rates, investors
who buy puts on nominal bonds are simply going head-to-head with
the Fed. As Dennis Gartman pointed out to a gathering at an
inflation conference last Thursday (at which I also spoke), "the
Fed's margin account is second in size only to God's," and it
doesn't make sense to bet against them directly.
However, while the Fed may succeed in markets, there is
certainly no guarantee that the Fed will succeed in the
macroeconomy. History is replete with examples of Fed mistakes, and
yet many investors seem to have forgotten this history. It seems to
me that investors today think "don't fight the Fed" means the Fed
will actually succeed in the macroeconomic effects of what they are
trying to do. But that's not what "don't fight the Fed" means. It
means: don't sell what the Fed is buying, don't buy what the Fed is
trying to push lower. Don't bet on higher rates when the Fed is
pledging to hold them down forever with actual purchases in the
cash bond market. It isn't, in short, surprising that options are
'giving the Fed time;' it's just that many more people are willing
to bet the Fed is going to succeed in keeping rates down, than are
willing to bet their huge margin account will be tapped out.
But that doesn't mean you have to bet that the Fed is going to
be able to avoid the usual macroeconomic effects of loose money.
When the Fed says "we intend to keep rates low," they can put
effect to that intention. But when the Fed says "we intend to keep
inflation low," they have no way to cause this to happen
absent pursuing a tight monetary policy, which they most
assuredly are not
…and even then, they're not actively transacting in
If inflation follows profligate monetary policy much as night
follows day, then the way you invest for that possibility is to
, not to sell nominal rates. That is, be long breakevens, or
inflation swaps, or inflation options.
How quickly to do this? Honestly, I am amazed that we still have
the opportunity to do it, so perhaps this means there is no hurry.
A weak Employment report this week may give another opportunity,
and as recessionary signs accumulate then inflation
(not to say inflation itself) may decline. The re-developing
European debacle might give us a chance to buy inflation cheap. We
may in fact have
to put on long inflation trades.
But maybe not, too. And I would hate to have to explain to
clients, or my spouse, why I had
on when "everyone saw this coming." The regret function suggests to
me that this is a prime case for averaging into inflation
protection, if you haven't yet begun to.
 Of course I am using the 'royal we' here: our company has
been loudly clanging the gong on this for a while and no one will
think we didn't see it coming.
ECRI's Weekly Leading Index Moves Higher To 62-Week
High - I Still Like SPY