Saturday, September 15, 2012

Long-term inflation expectations coming unhinged?


Longer-term inflation expectations spike in reaction to the Fed

Last Friday's action (discussed here) indeed turned out to be a good indicator of how markets in the current environment would react to Fed's balance sheet expansion. Markets performed as expected: commodities and equities spiked, the dollar weakened, and the treasury curve steepened.

The MBS purchases the Fed has promised today (discussed here) will result in taking out medium to shorter duration paper out of the market. Even your average FNMA 30y 3% coupon bond has a duration of 6-10-years - depending on treasury yields.

Source: Bloomberg

That means QE3 purchases will not directly impact longer duration bonds (at least not as much as the 5yr notes). The longer term part of the curve will therefore be driven by inflation expectations. And longer term inflation expectations, as implied by the TIPS yields, rose sharply today.

10y inflation expectations (10y breakeven)

The combination of the Fed's expected shorter duration purchases and longer term inflation expectations forced the treasury yield curve to steepen. The market is beginning to price in rising inflation and there is only so much negative real yield investors will tolerate.

For illustrative purposes, the current spread between ten year treasury and the TIPS yield is 2.64%. The measure was at its highest back in 2004 and 2005 where it got to a level of 2.76%.

More healing to be done?

GMO's counter to Bill Gross' claim that the cult of equities is dead..... however, I would like to know their thinking on what constitutes "more healing".

GMO: Death of Equities “Greatly Exaggerated”

Bill Gross’ claim that the cult of equities is “dead” has generated a lot of response recently, and now Jeremy Grantham’s GMO has entered the fray, countering many of Gross’ key points.
“Disappointing returns from equity markets over a period of time should not be viewed as a signal of the ‘death of equities,’” Ben Inker writes in a white paper on GMO’s web site. “Such losses are necessary for overpriced equity markets to revert to sustainable levels, and are therefore a necessary condition for the long-term return to equities to be stable.”
While Gross has said that stock market returns can’t continue to run significantly higher than gross domestic product, as they’ve done over the past century, Inker says otherwise. “GDP growth and stock market returns do not have any particularly obvious relationship, either empirically or in theory,” he writes. “Stock market returns can be significantly higher than GDP growth in perpetuity without leading to any economic absurdities.”
Inker says the market has been in a “healing process” since reaching absurd valuations in the early 2000s, and thinks there’s still more healing to be done, which means equity returns will be disappointing for a few more years. But over the longer term, he thinks equities should still produce strong returns. “Whether GDP growth in the U.S. and other developed economies is going to be slower in the future is not, in and of itself, a reason to expect a lower return to equities,” he says. “Likewise, the fact that historic equity returns have been higher than GDP does not mean that the equity market has been some sort of long-term Ponzi scheme.” He says equities are “an ugly asset class — one that is more likely than almost any other to lose investors a significant amount of money at those times when they can least afford it. That is, in a way, their charm. It is why equity is such an appealing form of capital for companies. It is the reason why equities have been priced to deliver good returns historically. And it is the reason why we believe equities are very likely to be priced to deliver strong returns into the indefinite future.”

The effects of QE3... a continued breakdown in financial intermediation

The below post is via Lew Rockwell's blog, the CEO of the Ludwig Von Mises Institute. I think highlights one of the many perilous aspects of fiat money. In a non-competitive fiat money system, money and production become divorced and the propagation of debt becomes paramount to anything else. In addition, it highlights one the key aspects of how QE leads to a breakdown in fully, properly functioning financial intermediation system, distorted interest rates leads to investors becoming disinterested in certain saving vehicles, thus creating a lack of investable funds vis-a-vis saving deposits. I have long held the belief that Bernanke's prior claims of a savings glut was nothing more than misperceived (or least via his public claims) debt.

Here Comes QE3

In the latest round of government "stimulus" the Fed has announced that it will be buying $40 billion in mortgage-backed securities each month for an indefinite period of time.
The logic here:
  1. Buy more mortgage-backed securities (MBSs).
  2. This will in turn increase liquidity available for lending to people to buy houses or possibly other real estate.
  3. All those people buying houses will then have houses to spend money on and they will spend money at Home Depot and other places, and then the economy will miraculously recover.
The effect of this will be:
  1. Even less saving going on than is happening now. Why do the lending institutions need more liquidity? Because there are no real life loanable funds in the first place. No one is putting money in depository institutions, for example, because interest rates are at rock-bottom levels, but also because people have no excess money to save. So, the Fed is creating fake loanable funds through the purchase of the MBSs. Much of this will probably be newly-created money.
  2. It will maintain the focus on consumer spending rather than investment. The idea is to keep people spending on real estate. Thus, less will be spent on business investment.
  3. People will incur more debt.
We've heard for years from some incorrigible economists that what we need is the Fed to pump up the real estate market to get people spending again. Their answer is: more debt, more spending, less savings and investment.
This is what has been happening for years to no avail, of course, and the Fed is now just turning it up a notch. I'm sure recovery is right around the corner.
The definition of insanity/Keynesianism: Doing the same thing over and over and expecting a different result.

Bernanke was born with an inate sense of destiny

Friday, September 14, 2012

All that Glitters 9/14/12- remaining disciplined

I have updated my precious metal timing model for the latest release of money supply. Before I get into the model results, I want to provide a some housekeeping items. Considering the announcement of QE3 or

QE∞, I will adding up to $10 billion a week to estimated money supply to account for the expected $40 billion/month in QE. I plan on doing this indefinitely or until QE∞ ends.

With that said and as I stated yesterday, I remain on sidelines. I still continue to hold positions in gold and precious metal stocks positions representing prior gains. Despite the apparent euphoria towards gold, silver, and other commodities, I am sticking with the discipline, noting that the timing model remains in a highly negative territory. As of the moment, the 6-month model is at a 2.5 while the 1-year measure is measuring in at nearly 0.8. Looking at the historic averages, the Phily Gold/Silver index strongly underperforms the base-and-hold case when these measures are observed. Here are the updated models. 

6-month model

1-year model

Although the trader in me would want to play the short side here, a number of items are keeping on the sidelines. The question you may be asking where I would get back into the precious metal stocks. A number of things would have to happen for this to occur. For one, a precipitous drop in the precious metal indexes may compel me to up my exposure once again. I have also modeled a number of scenarios through the end of October. Assuming a continual $10 billion increase in money supply and a gradual seven percent decline in gold prices would result in the timing model moving back into a buy mode. At that point, I would look for a sign of strength to jump back in.