Shots Fired

By: Michael Ashton | Wed, Jan 29, 2014
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This isn't the first time that stocks have corrected, even if it is the first time that they have corrected by as much as 4% in a long while. I point out that rather obvious fact because I want to be cautious not to suggest that equities are guaranteed to continue lower for a while. Yes, I have noted often that the market is overvalued and in December put the 10-year expected real return for stocks at only 1.54%. Earlier in that month, I pointed out and remarked on Hussman's observation that the methods of Didier Sornette suggested a market "singularity" between mid-December and January. And, earlier this month, I followed up earlier statements in which I said I would be negative on stocks when momentum turned and added that I would sell new lows below the lows of the week of January 17th.

But none of that is a forecast of an imminent decline of appreciable magnitude, and I want to be clear of that. The high levels of valuation make any decline potentially dangerous since the levels that will attract serious value investors are so far away. But that is not tantamount to forecasting a waterfall decline, which I have not done and will not do. How does one forecast animal spirits? And that is exactly what a waterfall decline is all about. Yes, there may be precipitating events, but these are rarely known in prospect. Sure, stocks fell sharply after Bear Stearns in the summer of 2007 liquidated two mortgage-backed funds, but stocks reached new highs in October 2007. What happened in mid-October 2007 to trigger the top? Here is a crisis timeline assembled by the St. Louis Fed. There is basically nothing in October 2007. Similarly, as Bob Shiller has documented, at the time of the 1987 crash there was no talk whatsoever about portfolio insurance. The explanation came later. How about March 2000, the high on the Nasdaq (although the S&P 500 didn't top until September)?

What two of these episodes - 2000 and 2007 - have in common is that valuations were stretched, but I think it's important to note that there was no obvious precipitating factor at the time. It wasn't until well into the stock market debacle in 2007-08 that it became obvious (even to Bernanke!) that the subprime crisis wasn't just a subprime crisis.[1]

Here is my message, then: when you hear shots fired, it isn't the best idea to wait around to figure out why people are shooting before you put your head down. Because as the saying goes: if the enemy is in range, so are you.

And, although it may not end up being a full-fledged firefight, shots are being fired, mere days before Janet Yellen takes the helm of the Fed officially (which may be ominous since Fed Chairmen are traditionally tested by markets early in their tenure). Last night, Turkey was forced to crank up money rates by about 450bps, depending which rate you look at. When Argentina was having currency issues, it wasn't surprising - when you have runaway inflation, even if you declare inflation to be something else, the currency generally gets hit eventually. And Russia's central bank was established only in 1990. But Turkey, about 65% larger in GDP terms than Argentina, is relatively modern economically and has a central bank that was established in the 1930s and has been learning lessons basically in parallel with our Fed since the early 1980s. Heck, it's almost a member of the EU. So when that central bank starts cranking up rates to defend the currency, I take note. It may well mean nothing, but since global economics has been somewhat dull for the last year or so (and that's a good thing), it stands out as something different.

What was not different today was the Fed's statement, compared to its prior statement. The FOMC decided to continue the taper, down to "only" $65bln in purchases monthly now. This was never really in question. It would have been incredibly shocking if the Fed had paused tapering because of a mild ripple in global equity markets. The only real surprise was actually on the hawkish side, as Minnesota Fed President Kocherlakota did not dissent in favor of maintaining unchanged (or increased) stimulus - something he has been agitating for recently. Don't get too used to the Fed being on the hawkish side of expectations, however. As noted above, Dr. Yellen takes the helm starting next week.

The Treasury held its first auction of floating rate notes (FRNs) today, and the auction was highly successful. And why should they not be? They are T-bill credits that reset to the T-bill rate quarterly, plus 4.5bps. In the next few days I will post an article explaining, however, why floating rate notes don't provide "inflation protection;" there has been a lot of misinformation about that point, and while I explained why this isn't true in a post from May 2012 when the concept of the FRN program was first mooted, it is worth reiterating in more detail.

So we now have a new class of securities. Why? What constituency was not being sufficiently served by the existing roster of 1-month, 3-month, 6-month, and 1-year TBills, and 2 year notes?

I will ask another "why" question. Why is the President proposing the "myRA" program, which is essentially a way to push savings bonds (the basics of the program is that if you sign up and meet certain income requirements, the government will give you the splendid opportunity to put your money in an account that returns a low, guaranteed rate of interest). This is absolutely nothing new. You can already set up an account with http://www.TreasuryDirect.gov and have your employer make a payroll direct deposit to that account. And there's no income maximum, and no requirement to ever roll it into an IRA. Yes, it's true - with Treasury Direct, you will have to pay federal taxes on the interest, but the target audience for the myRA program is not likely to be paying much in the way of taxes so that's pretty small beer.[2]

The answer to the "why" in both cases is that the Treasury, noticing that one regular trillion-dollar buyer of its debt is leaving the trough, is looking rather urgently for new buyers. FRNs, and a new way to push Treasuries on middle-class America.

Interest rates have declined since year-end, partly because equities have been weak, partly because some growth indicators have been weak recently, and partly because the carry on long Treasury securities is positively terrific. But the Treasury is advertising fairly loudly that they are concerned about whether they'll be able to raise enough money, at "reasonable" rates, through conventional auctions. Both of these "innovations" cause interest payments to be pegged at the very short end of the curve, where the Fed has pledged to control interest rates for now, but I think interest rates will rise eventually.

Probably not, however, while the bullets fly.

 


[1] In a note to Natixis clients on December 4th, 2007, entitled "Tragedy of the Commons," I commented that "M2 has grown only at a 4.4% annual rate over the last 13 weeks, and that's egregiously too little considering the credit mess (not just subprime, as I am sure my readers are aware, but Alt-A and Prime mortgages, auto loans and credit cards too)," but the idea that the crisis was broader than subprime wasn't the general consensus at the time by any means. Incidentally, in that same article I said "We have not entered a recession with core inflation this low in many decades, and this recession looks to be a doozy. I believe that by late 2008 we will be confronting the possibility of deflation once again. And, as in the last episode, the Fed will face a stark choice: if short rates don't get to zero before inflation gets to zero, the Fed loses as they will never be able to get short rates negative," which I mention since some people think I have always been bullish on inflation.

[2] I wonder how the money is treated for purposes of the debt ceiling. If the Treasury is no longer able to issue debt, then surely it won't be able to do what amounts to issuing debt in the "myRA" program? So if they hit the debt ceiling, does interest on the account go to zero?

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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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