Three-Theme Monty

By: Michael Ashton | Sun, May 8, 2011
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Friday saw development of all three major themes the markets are struggling with: domestic economic conditions, the commodity rally/rout, and the Euro sovereign crisis.

In the U.S., the Employment data was not terribly encouraging overall. Payrolls exceeded expectations, with a reported 244,000 new jobs, but the Unemployment Rate rose to 8.960% from 8.828% (so reported as 9.0% vs 8.8%). Some of the "internals" that had previously been concerning remain so. The labor force participation rate again failed to improve and remained at 27-year lows (64.2%); one metric I watch, shown in the chart below, is the number of respondents who are "Not In Labor Force, Want A Job Now." Remember, you're not in the labor force if you haven't recently looked for work, so these are people who aren't technically in the labor force but would quickly get to that point if there was a sign that there was a suitable job available for them. That number is still rising:

Jobs Index
It is hard to perceive this as a serious recovery until the "want a job now" numbers drop a lot!

So the employment report wasn't exactly a strong number. However, the market had seemingly braced for a very weak print after Initial Claims and the somewhat soft ADP earlier in the week, and this wasn't a bad figure at that.

The resulting trade was obvious: stocks rallied strongly, bonds dipped, and commodities were recovering. NYMEX Crude, which had dipped below $95 in the morning, traded briefly above $102.

Then a well-timed rumor circulated that Greece would call an emergency meeting this weekend and leave the Euro, and ... the dollar started to rally, stocks rolled over, bonds shot higher, and commodities faded. How very fortunate for the wrong-footed on Friday that rumor started when it did! The rumor was ostensibly related to a Der Spiegel report that Greece is considering withdrawing from the union. Well, of course they're considering that, and no doubt have been considering that for months; only fools wouldn't have thought of that as a possibility especially since the rest of the Eurozone is being fairly unhelpful (hiking interest rates, for example). But there's no way that they're very close to that decision, because the issue hasn't yet been forced.

Like most "successful" rumors, this one had some seemingly-confirming facts. The euro-area finance ministers did in fact call a meeting for Friday, and there was no doubt that Greece would be on the menu. After the meeting, the group's chairman Jean-Claude Juncker said "We think that Greece does need a further adjustment program...We're not discussing the exit of Greece from the Euro area. This is a stupid idea - no way." They might "require" (translation: ask nicely) collateral from Greece for further aid. This is an interesting thought. What status does "collateral" pledge by a sovereign nation to another body have, really? Suppose Greece pledged collateral, and then decided to default. Someone from the EU calls up and says "we're foreclosing on the Acropolis." How exactly are they going to enforce that? Send troops?

Greece is surely mulling how an eventual exit from the Euro would work, but they won't do it with EU approval, unless it's presented as a fait accompli (we're resigning, so you ought to make it look like you agreed). To let Greece "voluntarily" leave the EU would destroy one of the main pieces of EU rhetoric: that the union is irreversible. Now, I think that Greece leaving will eventually happen (although I'm not sure why it would necessarily weaken the Euro), but not until they've tried a couple of other things. And in the meantime, the implicit threat is a great bargaining chip. From the same story linked to above, the budget spokesman for German Chancellor Merkel's party said "We'll just have to bite the bullet. We need to help Greece help itself. What's the alternative? We don't want to be pushed over the edge into restructuring."

Nice negotiating tactic there, sir. Be sure to tell them they hold all the cards!

In any event, although the weekend has subsequently shown the folly of the rumor, it was enough on Friday to rally the dollar index about 1% and drop Crude from the $102 level back to $97.18. Bonds ended up slightly on the sunny side of unchanged (3.15% on the 10y note). Stocks touched unchanged but eked out an 0.4% gain to end a rotten week.

Now that we know the rumor was false it will be interesting to see what Monday brings. I find it fascinating that after one day of serious commodity correction on Thursday - and a few more days of the unwind of the silver bubble, the "I told you so" columns started flying thick and fast on Friday. Personally, the lesson I think commentators should have gleaned from the Flash Crash one year ago was this: if you're going to say I told you so, you ought to wait and see if the drop lasts at least a week!

And perhaps it will. The technical damage done to the commodity indices over the last couple of days is pretty ugly. But the commodity indices, unlike stock indices, are pretty heterogeneous, as I discussed back in April. I wonder if I'd rely as much on technical analysis for an index that is an amalgamation of disparate elements. I think sellers here have the fundamentals wrong, because the commodity rally isn't a supply/demand thing but a supply-of-paper-currency thing; nevertheless, I'd be cautious about increasing positions until some sign of ebbing downward momentum occurs.

One of the biggest arguments for being in commodities right now remains: as protection against inflation, there are not many attractive alternatives. With TIPS around 2%, it's a different story; with 10y TIPS at 0.66%, I'm willing to accept some possible commodities downside rather than accept the almost-certain (mark-to-market) downside of TIPS.

There is no economic data scheduled for Monday, so the main thrust of the session will be sorting through what didn't happen this weekend. Indeed, there isn't a lot of data-driven excitement until Thursday's Initial Claims and Friday's CPI report, so keep an eye on the commodity and currency markets from whence the headlines (both real and imagined) will flow for the first part of this week.

I find myself modestly bearish on stocks (what else is new?) but not concomitantly bullish on bonds. I feel like bonds have come a long way since the 3.60% of early April and I don't expect the data to weaken as severely as bond buyers seem to expect. Along with that we must keep in mind that the biggest buyer is preparing to exit the stage, and while the Fed is sanguine about that eventuality I don't think that seems rational. I've watched bond markets fall apart with a lot less selling than the trillions the Treasury will be offering without a pre-packaged buyer waiting with bids in hand.

 


 

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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