Conflict Abounds

By: Michael Ashton | Wed, Jun 8, 2011
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Energy prices jumped today on news that OPEC was unable to reach consensus on an increase in the output ceiling. This would be much more important - and NYMEX Crude prices would have risen more than 1.7% - if OPEC wasn't already exceeding the quotas by 2mbpd, as I pointed out yesterday. Moreover, there is no real reason, other than political posturing, to raise the quotas in order to lower prices. The world can already take pretty much everything that OPEC can pump right now. When is a cartel unnecessary? When prices don't need to be jacked up!

Still, equities and bonds hardly needed anything that might be construed as bad news. The S&P dropped -0.4%, while the 10y note rallied 6bps. Now, notice that the Dow fell only -0.2%, and the NASDAQ dropped -1.0%. That is a subtle "flight to quality" into bigger stocks while maintaining exposure to the market, and is consistent with investors' fear that growth is hitting a rocky patch longer than one month in duration. The old maxim was that in a bull market everything goes up and in a bear market everything goes down, so if you're bearish you should just get out of the market. But many, many investors these days aren't motivated by absolute return. Active equity managers are still equity managers. Pension funds have policy weights that are adjusted infrequently and don't usually vary a ton anyway. So much of the money flow isn't in and out any more, but up and down (in size and quality). CDS spreads have also been widening, with the Markit Investment Grade 5y (June) index up to about 98 from 89 last Tuesday (although as the chart below, of the June14 basket, shows that's not entirely surprising. Actually, I also throw the VIX on here - the VIX and CDX are inverted - and you can see these are all virtually the same charts. You can buy equity risk in equities, in vol, or in corporate bonds. It's all the same risk).

CDX, VIX, SPX Comparison Chart
CDX, VIX, SPX. Source: Bloomberg. Note the VIX and CDX are inverted.

This is a good old fashioned growth scare budding. And yet, I am amazed at how much I am reading about inflation. Really, with housing prices dipping again and 10-year inflation swaps 20-25bps off their highs (see Chart below - in fact, since early May the decline in inflation accounts for all of the decline in nominal rates since real rates are approximately unchanged over that period while nominal 10y rates have fallen 20bps or so), you would think that inflation chatter would be ebbing.

10y US CPI swaps are 25bps or so off their recent highs
10y US CPI swaps are 25bps or so off their recent highs.

But just today, the NY Fed blog had a piece called "Will 'Quantitative Easing' Trigger Inflation" from old friend Ken Garbade, who was once the chief bond strategist at Bankers Trust. Ken is a very sharp guy and his 1996 book "Fixed Income Analytics" was (and probably still is) a must-have book for bond traders and strategists.

Anyway, Garbade in that blog article gives the best and simplest explanation I have seen about why the Fed's payment of Interest on Excess Reserves (IOER) is crucially important in keeping QE1 and QE2 from flowing out into the market and affecting economic activity. Of course, it begs the question what the hell is QE doing if it isn't supposed to affect economic activity! And there are added questions around the policy, such as whether the Fed is really prepared to continue to pay higher and higher IOER in order to keep that money out of the economy, and also whether they can really calibrate policy so finely. Garbade highlights the issues well.

But that isn't the only recent piece on inflation from Fed sources. Last week there was this one from the Atlanta Fed's blog [my comment: inflation traders have long known that the core and headline inflation converge over a period of roughly 15-18 months, so this isn't exactly innovation but the interesting point is that they're discussing inflation]. The same day, the NY Fed blog had another piece, by Eggertsson, entitled "Commodity Prices and the Mistake of 1937: Would Modern Economists Make the Same Mistake?" Here is a teaser:

"The Mistake of 1937 was to relinquish the benefits of reflation and to set all policy levers in reverse. The Fed and key administration officials hinted at interest rate hikes and endorsed austerity in fiscal policy; the key concern now was containing inflation rather than sustaining recovery."

Just yesterday there was another NY Fed blog piece called "A Closer Look at the Recent Pickup in Inflation," which made the surprising argument (coming from the Fed, anyway) that

"the recent pickup in inflation is indeed quite widespread across a broad swath of CPI goods and services, but no one item has registered inflation increases that are clearly outside the norm of the last decade, not even among the volatile food and energy categories."

...although they somehow take a benign message out of that when prospective monetary policy is considered. And, finally, last month the Chicago Fed Letter was on the topic "What are the implications of rising commodity prices for inflation and monetary policy?"

This flurry - this is just over a period of a week or two - is noteworthy since the behavior at the top (i.e., Bernanke) is so boringly stable right now. As QE2 winds down and growth is weakening, there is an increasingly wide range of plausible arguments. While Dr. Bernanke has made clear a number of times that he has no concerns at all about making an error (which implies that either the path forward is clear, or that it doesn't matter), plainly not everyone in the Federal Reserve System is as sanguine. So on the one hand some observers would consider QE2a, reinvesting the maturing bond proceeds ad infinitum, others would wind down the balance sheet over time and still others would start winding it down aggressively. The response of inflation to these actions, indeed the response of inflation to actions already taken, is open for debate.

But while debate is good for the soul, too much of it can be bad for organizations since it tends to produce wishy-washy decisions that displease the fewest number of decision-makers. And in the case of the Fed, too much of it in public is especially bad. The Chairman is trying to appear calm and placid, but his minions are anything but. There is conflict and disagreement around.

And this makes more obvious the fact that the path forward is fraught with risks. And that, in turn, should increase the discount afforded risky assets (actually, the notion of a discount for risky assets is kinda quaint, since most of them are trading with hefty premiums).


Tomorrow is Initial Claims (Consensus: 419k from 422k), the only important data of the week. Look out if the number actually rises, rather than shrinks. That shouldn't be a terrible surprise at this point, since the context has changed quite meaningfully since April when the series first started to rise. We now know the economy is weakening, so a 430k or 435k shouldn't change many minds. But there is still disagreement about whether this period of weakness is a ripple or a wave, and every piece of weak data increases the odds that it is a wave.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

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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