Ex Uno, Plures

By: Michael Ashton | Wed, Feb 24, 2010
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So much for a quiet day in the markets. The fading of momentum from both sides may in fact be, as I feared, a sign of lack of commitment to positions and, therefore, a vulnerability to rapid shifts might exist.

Today's catalyst was a small dip in the Case-Shiller Home Price Index and a big and surprising decline in Consumer Confidence (46.0, with the Present Situation to a 27-year low of 19.4) dropped the stock market and rallied bonds. Stocks fell 1.2% while 10y Note futures rallied an outsized 27.5 ticks with the 10y yield falling to 3.68%. The prospects for a near-term breakdown in the bond market have been temporarily dampened...by the prospects for a near-term breakdown in equities. What a wonderful financial universe we live in. 10y TIPS yield 1.47%.

The Treasury announced an intention in increase its Supplemental Financing Program to $200bln from its current level of $5bln. This will be implemented through a series of eight $25bln weekly auctions of 56-day TBills (which means that they can maintain the $200bln size by simply continuing those auctions ad infinitum). While the "Supplementary Financing Program" sounds like a very agreeable thing, what this actually does is drain reserves from the banking system: the Treasury takes the $200bln so raised and puts it on deposit at the Fed. The theory, I am sure, is that this will mostly drain "excess" reserves, but the long and short of it is that it is a large drain of liquidity. The Fed probably doesn't think it will need to fully replace those reserves, but of course they can add the reserves back by doing coupon or bill passes. This has much more potential to be a significant action, in my opinion, than the hiking of the discount rate did, but the effect will likely be felt only over time.

In short, it's time to hire those old Fed watchers back - the ones who calculated the Desk add needs etc and became less invaluable when the Fed started announcing policy changes. But there's time - the economy can't handle real tightening, and we won't see any for a while.

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I have been talking, even as recently as yesterday, about the importance of looking at core inflation ex-shelter as a way to get a sense of the true underlying trend. So I was initially delighted when the macroblog maintained by the Atlanta Fed had a piece on "Looking Behind the Core Inflation Numbers" in which they initially pointed out that Core-ex-Shelter has been running considerably faster than Core. The macroblog is always an interesting read, and generally the analysis is of a higher quality than much Fed research (which is surprisingly inconsistent in quality).

The fact that someone at the Fed is looking at the relevant inflation metric is great...except that they don't get it. The initial chart shows Core CPI at -1.6%, which I think is actually the monthly number, annualized - a silly way to look at a number that has large mean-reverting errors. And they miss the whole point of the analysis:

"However, once we've opened the door for pruning sectors that have displayed unusual price behavior in recent months, we can find a slew of outlying components to pare. Take, for example, vehicle prices."

The point isn't that shelter has "displayed unusual price behavior," or that it is an outlier. The point is that it is an outlier for a large, known, and (this is important) non-repeating reason. Accordingly, it's silly to not take it out when trying to figure out the underlying trend.

"My point here is not to advocate lopping shelter and vehicles, along with the already excluded food and energy prices from inflation -- which, by the way, would leave us with less than 45 percent of the overall CPI index. In fact, my argument is the opposite. There are always some components of the index that seem anomalous -- on either side of the distribution. Discriminately [sic] cropping entire sectors from the CPI may not be the best method for teasing out true underlying price pressures."

Let me repeat: removing shelter inflation is anything but indiscriminate; it is carefully discriminating in fact. There is a very clear reason to take out shelter: the bubble only deflates once. There is no reason whatever to take out vehicle prices, which are merely abnormally volatile right now.

"The Cleveland Fed uses a more methodical approach to exclude the CPI components that show the most extreme price changes each month."

If by methodical they mean mechanical, this is true. If they mean that Trimmed-Mean CPI or Median CPI is somehow superior to the straight-mean method, they're right. If they mean that this is a good substitute for using one's brain to figure out what is going on in the pricing environment, they're wrong, not to mention totally in denial. This does not come as any part of a surprise, of course: we are partly in this mess because of groupthink at the Federal Reserve caused them to be thinking about tightening policy in the summer of 2008, and then moving only slowly to address the crisis.

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Another unrelated comment: there seems to be an assumption around that "the world is better off with a viable Euro." No doubt, the world is better off in the short run if the currency union isn't sundered, since that would cause tremendous pain. But I don't think it's a slam-dunk verity that the world is better off with the Euro rather than with a bunch of separate currencies. Hear me out.

A common currency brings with it some efficiencies, but there are also plainly some inefficiencies. A common currency is in fact a natural extension of socialism - central planning of a monetary policy. Why is that necessarily good? I would argue that having different currencies with different monetary authorities is a good thing for the same reason that having many gas stations is better than having just one: competition. With many different currencies, each monetary authority has an incentive to manage policy responsibly, because failure to do so will cause its currency to fall. Capital will flow to the best-managed currencies, just as investment tended to flock to Germany under Bundesbank rule.

Moreover, diversification of monetary policy action is also a good thing. A mistake from the ECB (or from the Fed) is colossally dangerous to the global economy. A mistake from the Central Bank of Florida would not have repercussions that are nearly as significant. Finance people like diversification in every other way; why not this one? Not only that, but as it stands now the Fed can do nothing to affect monetary conditions in Florida or California specifically, so it was basically powerless to do anything to stop localized housing bubbles (or the subsequent busts). Arguably, a monetary authority that can manage conditions more specific to the economic region in question may lead to fewer bubbles.

Sure, there is some cost in efficiency of economic exchange, but if exchange rates are freely floating and labor is mobile than I assert that this isn't a big cost. It becomes a normative question. In building a portfolio, we ask whether a given investment adds more in terms of diversifying away risk than it subtracts from return. It is a reasonable question whether the efficiency loss of having multiple currencies - which is much smaller with more-open borders and modern financial markets, to be sure, than it used to be - is outweighed by the diversification of risk. Why should currencies be made too big to fail?

I wouldn't just apply this to the Euro. Especially given the Federal Reserve's performance over the last decade and a half, it's a fair question whether having different currencies for different states (or groups of similar states) in the U.S. could work. Don't get me wrong: we have the world's reserve currency, right now, so it doesn't make a lot of sense for us to squander that standing. But if the USD ever loses that status, why not? You want a smaller, less powerful central government? Make it harder for them to issue debt!

One final crazy point. I think I've shown that it's not an outrageous thought experiment to consider whether more numerous, more focused currencies might not automatically be worse than giant all-encompassing units. But I don't have to prove that; you already believe it. You have your own unique currency: your labor, which is freely convertible into dollars, or yen, or euro. You can maintain your own resources (your physical and mental health; your education; your skills) as you see fit, and trade those resources for other currencies. There are limits to what you can exchange those resources for, and those limits are enforced (at least in a free labor market) by the presence of competing resources from other laborers. But you wouldn't dream of giving someone else control of your "currency," would you? Why not, if common currencies are a good thing? Something to think about. Comment away.

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On Wednesday, we get a Parade of Fools on Capitol Hill with Treasury Secretary Geithner testifying on the 2011 budget and Federal Reserve Chairman Bernanke delivering the semiannual Monetary Policy Report to the Congress (neé Humphrey-Hawkins). Investors will be asked to take down a mere $42bln 5-year notes a few hours after digesting New Home Sales (Consensus: 353k from 342k). New Home Sales won't impress me until it gets over about 422k, but a failure to show some retracement of last month's decline may add a bit more unease to the market.

 


 

Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
E-Piphany

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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