Is Higher Inflation on the Horizon?

Wednesday, July 18th, 2012

by Orhan Imer, Ph.D., Columbia Asset Management

For nearly two decades, inflation in the U.S. has been fairly contained except for a few periods of moderate acceleration around peak levels of economic activity. More recently, headline inflation as measured by the year-over-year change in the CPI-U (Consumer Price Index for Urban Consumers) declined from 3.9% in September 2011 to 1.7% in May 2012, driven primarily by the slowdown in the U.S. economy and the sharp drop in energy and commodity prices.

While the current level of inflation remains subdued, investors should be prepared for risk of longer-term inflation associated with highly accommodative monetary and fiscal policy actions taken by the Fed and the U.S. Government since 2008.

During the past several years, the Fed’s monetary policy decisions, intended to stimulate U.S. growth, have become less centered on containing inflation. In particular, the Fed’s near-zero interest rate policy and expanded balance sheet along with deficit spending by the government to lift the economy out of recession have raised the risk of future inflation. Other conditions that may add to inflationary pressures over the next decade and beyond include:

1. Accelerated government spending on healthcare and other non-discretionary spending programs (such as Social Security, Medicare and Medicaid) necessitating continued high levels of federal borrowing
2. Demographic shifts in the U.S. population as baby boomers begin to retire leading to lower savings and productivity
3. Higher tax rates on income and capital gains raising the cost of capital dampening capital investment and productivity
4. Weakening of the U.S. dollar due to Fed’s interest rate policy and massive monetary easing which may promote inflation through higher energy and commodity prices
5. Emerging market countries representing a growing share of global GDP and driving up the demand for scarce resources (commodities, land and other real assets)

While the recent slowdown of the global economy along with the continuing weakness in the U.S. housing market and excess manufacturing capacity in many industries may keep inflationary pressures at bay near term, investors should protect themselves against unexpected inflation, as surprises in inflation can have a meaningful impact on the performance of inflation-sensitive assets.

Read more in this week’s Perspectives.

See more Market Insights from Columbia Management.

Tags: Baby Boomers, Columbia Asset Management, Commodity Prices, Consumer Price Index, Deficit Spending, Demographic Shifts, Discretionary Spending, Emerging Market Countries, Global Gdp, Headline Inflation, Imer, Inflationary Pressures, Interest Rate Policy, Monetary And Fiscal Policy, Monetary Policy Decisions, Peak Levels, Policy Actions, Real Assets, Term Inflation, Urban Consumers
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The Three-Part Case for Commodities (Koesterich)

Tuesday, May 22nd, 2012

With both gold and broader commodity indices down significantly month to date, many investors are asking if they should lower or even remove their commodity exposure. I believe the answer is no.

First, it’s useful to put the recent weakness in perspective. Both gold and a broad basket of commodities are down roughly 10% over the past three months. While the losses represent a significant correction, they are in line with the performance of equity markets over the same time period. Even more importantly, here are three reasons for maintaining a strategic exposure to commodities.

1.) Diversification: Commodities typically behave differently from paper assets like stocks and bonds even as correlations between all risky assets have risen in recent years. In fact, based on historic relationships, it doesn’t take a large allocation to commodities – it typically takes less than 10% – to improve the risk-adjusted returns of a strategic portfolio.

2.) Inflation: Commodities tend to perform best when inflation is rising. As I mentioned last week, while I see little risk of double-digit inflation in the near-term, inflation is not completely dead. Core inflation in the United States is rising at 2.3% year over year, a 3 ½-year high. Given the US fiscal position and the unconventional nature of recent monetary policy, there is a non-trivial risk that we may see more than 2.3% inflation over the next decade. Over the long term, even modest inflation would erode purchasing power. Commodities can offer an effective hedge against this scenario.

3.) Potential tailwind from monetary policy: While commodities have suffered recently, the performance hasn’t been awful. The S&P Goldman Commodities Index is down roughly 5% year to date. Meanwhile, gold was up around 2% through the end of last week, returns that still compare favorably with most equity markets outside of the United States.

One reason for the resilience, as I’ve written before, is that commodities and gold generally benefit when real interest rates are negative. In such a rate environment, there’s no opportunity cost for holding commodities, and commodity returns tend to be higher. At least historically, the level of real interest rates has been far more important to commodity returns than either inflation or the dollar. In fact, over the past twenty years, the variation in real interest rates explains roughly 60% of the variation in the annual return of gold. To the extent the Fed, and most other major central banks, are determined to keep real rates negative for the foreseeable future, we’ll be in an environment supportive of commodities, particularly gold.

To be sure, commodity prices are likely to remain volatile – along with just about every other risky asset – in the near term as investors worry about the potential for a disorderly default by Greece impacting the global economy. However, for investors, especially those currently underweight commodities, now may very well be a good long-term buying opportunity (potential iShares solution: NYSEARCA: IAU).

Russ Koesterich, CFA is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog. You can find more of his posts here.

Source: Bloomberg

Past performance does not guarantee future results. Diversification and asset allocation may not protect against market risk.
iShares Gold Trust (“Trust”) has filed a registration statement (including a prospectus) with the SEC for the offering to which this communication relates. Before you invest, you should read the prospectus and other documents the Trust has filed with the SEC for more complete information about the issuer and this offering. You may get these documents for free by visiting www.iShares.com or EDGAR on the SEC website at www.sec.gov. Alternatively, the Trust will arrange to send you the prospectus if you request it by calling toll-free 1-800-474-2737.

Investing involves risk, including possible loss of principal. The iShares Gold Trust (“Trust”) is not an investment company registered under the Investment Company Act of 1940 or a commodity pool for purposes of the Commodity Exchange Act. Shares of the Trust are not subject to the same regulatory requirements as mutual funds. Because shares of the Trust are intended to reflect the price of the gold held by the Trust, the market price of the shares is subject to fluctuations similar to those affecting gold prices. Additionally, shares of the Trust are bought and sold at market price not at net asset value (“NAV”). Brokerage commissions will reduce returns.
Shares of the Trust are intended to reflect, at any given time, the market price of gold owned by the Trust at that time less the Trust’s expenses and liabilities. The price received upon the sale of the shares, which trade at market price, may be more or less than the value of the gold represented by them. If an investor sells the shares at a time when no active market for them exists, such lack of an active market will most likely adversely affect the price received for the shares. For a more complete discussion of the risk factors relative to the Trust, carefully read the prospectus.
Following an investment in shares of the Trust, several factors may have the effect of causing a decline in the prices of gold and a corresponding decline in the price of the shares. Among them: (i) Large sales by the official sector. A significant portion of the aggregate world gold holdings is owned by governments, central banks and related institutions. If one or more of these institutions decides to sell in amounts large enough to cause a decline in world gold prices, the price of the shares will be adversely affected. (ii) A significant increase in gold hedging activity by gold producers. Should there be an increase in the level of hedge activity of gold producing companies, it could cause a decline in world gold prices, adversely affecting the price of the shares. (iii) A significant change in the attitude of speculators and investors towards gold. Should the speculative community take a negative view towards gold, it could cause a decline in world gold prices, negatively impacting the price of the shares.
Shares of the iShares Gold Trust are not deposits or other obligations of or guaranteed by BlackRock, Inc., and its affiliates, and are not insured by the Federal deposit Insurance Corporation or any other governmental agency.
BlackRock Asset Management International Inc. (“BAMII”) is the sponsor of the Trust. BlackRock Investments, LLC (“BRIL”), assists in the promotion of the Trust. BAMII and BRIL are affiliates of BlackRock, Inc.

Tags: Amp, Commodities, Commodity Indices, Core Inflation, Correlations, Diversification, Fiscal Position, Goldman, Monetary Policy, Nbsp, Paper Assets, Purchasing Power, Resilience, Risk Adjusted Returns, Risky Assets, Same Time Period, Stocks And Bonds, Tailwind, Term Inflation, Three Months
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FOMC Engages in ‘Operation Twist,’ Another Unconventional Step

Thursday, September 22nd, 2011

This post is a guest contribution by Asha Bangalore, vice president and economist at The Northern Trust  Company.

The Fed left the federal funds rate unchanged, as expected, at 0.0-0.25%. The much awaited action called “Operation Twist” was part of the policy announcement. It was not an unanimous vote, three Fed Presidents — Richard Fisher of Dallas, Narayana Kocherlakota of Minneapolis and Charles Plosser of Philadelphia – who are concerned about inflation dissented. These three Fed officials opposed the FOMC’s August 9, 2011, decision that included an assurance of holding short-term interest rates near zero until mid-2013.

As per today’s announcement, the Fed will purchase $400 billion of Treasury securities with maturities of 6-30 years and finance this operation with sales of an equal amount of Treasuries with three years or less left on them. Operation Twist will not increase the current size of the Fed’s balance sheet. It is unlike the $600 billion program (known as QE2) which increased the size of the balance sheet to around $2.8 trillion and ended in June 2011. The objective of Operation Twist is to lift economic activity, that has slowed in the first-half of the year, by bringing about lower interest rates for home mortgages and business investment outlays. The FOMC included a surprise package – it will now reinvest early payment of mortgage securities back in debt issued by Fannie Mae and Freddie Mac.

The Fed continues to believe that “there are significant downside risks to the economic outlook, including strains in global financial markets.” The reference to global financial markets is new in the September statement and reflects the ongoing debt crisis in Euroland. The Fed anticipates a deceleration of inflation in the months ahead and continues to maintain that longer-term inflation expectations are stable.

In the Fed’s opinion, the rearrangement of it current portfolio “should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative.” However, if the unemployment rate fails to register a significant improvement, households who were not able to obtain a mortgage at already historically low rates (see Chart 1) are unlikely to pass strict underwriting standards that are in place now. The likely limited benefit of Operation Twist is the subject of the U.S. Economic Outlook of September 9, 2011. If this forecast is accurate and economic growth remains lackluster, Chairman Bernanke would most likely embark on QE3 in the early part of 2012.

Source: Asha Bangalore, Northern Trust – Daily Economic Commentary, September 21, 2011.

Tags: Charles Plosser, Debt Crisis, Downside Risks, Economic Outlook, Fannie Mae, Fannie Mae And Freddie Mac, Fed Officials, Federal Funds Rate, Global Financial Markets, Home Mortgages, Inflation Expectations, Mortgage Securities, Narayana, Northern Trust Company, Outlook, Policy Announcement, Qe2, Surprise Package, Term Inflation, Treasury Securities, Unanimous Vote
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2011 Outlook for Global Economies and Investment Strategies: Part 2 – David Rosenberg

Friday, July 22nd, 2011

Following up to the presentation by Gary Shilling at this year’s Strategic Investment Conference, we next move on to an old Zero Hedge favorite: David Rosenberg.

David Rosenberg

Chief Economist & Strategist
Gluskin Sheff + Associates, Toronto

Synopsis:

“Commodities Aside, Deflation Remains the Primary Trend”

David Rosenberg was unequivocal in his view that deflation is still the underlying trend, drawing the distinction between inflation due to fears of rising oil prices and the real forces that drive inflation. Core inflation is what drives the bond market, and there, he believes the underlying 1-2 year trend is down. “Take out the noise, and inflation is still comatose.” None of the economic factors point to sustainable inflation, yet rising inflation seems already priced into the markets as the majority view.

Rosenberg acknowledged the surge in oil and food prices (now 22% of US consumer spending), driven in part by speculative positions, and agreed this will show up temporarily in slightly higher goods inflation. Nevertheless, two thirds of the US economy is the service sector, which continues to show signs of deflation, even with rents hooking up (did it mean to say “looking”?).

“The labor market is what worries me! It will stop inflation in its own tracks.” Unit labor costs are the principal driver of long-term inflation. 1 in 7 Americans is un- or underemployed (U-6 Unemployment rate at record highs). Real wages are declining. Further deflationary pressure is building at the State and Local Government level as layoffs loom. With stimulus coming to an end, he expects cuts at the federal level as well.

In home prices, like Gary Shilling, Rosenberg predicts another 15-20% to the downside, while commercial real estate appears to be rolling over again to the downside as well.

Where’s the lending? The Fed’s Quantitative Easing is still sitting on bank balance sheets. This must get re-circulated into the economy to cause inflation. Meanwhile, the household sector is still paying down debt, as credit contraction continues. There is still no sign of a meaningful increase in the money multiplier or in the velocity of money as credit and wages stand in the way. For comparison, Rosenberg demonstrated how closely the US situation parallels that of Japan, and emphasized the sacrifices that Canada made to correct what was a more difficult situation.

Bonds: Rosenberg believes we’ll see rates at 2% before we see 4%. At these low levels of interest rates, the potential for capital gains in the bond markets is tremendous. “We’re in a post-bubble credit collapse. I’m bullish on long term rates. Getting the long bond yield down to 2% would be very stimulative for the economy.”

Commodities: He believes we are in a secular bull market, and expects there will be a correction in the short term, in both commodities and precious metals. With the prospect for the fed increasing interest rates “years away,” this bodes well for Gold according to Rosenberg. However, he believes we could see a brief counter-trend rally when QEII ends in June.

QEIII: He believes if the economy slips and unemployment goes back up, the Fed will further ease monetary policy. “Here we are, two years into the recovery, and we still face a 5 ½ % output gap. This has never happened before; usually the gap is zero by now.” Rosenberg is convinced we will see QEIII.

Full pdf of Rosenberg presentation can be found here. This is easily the most comprehensive David Rosenberg presentation put together to date.

Tags: Bank Balance, Canadian Market, Chief Economist, Commodities, Core Inflation, David Rosenberg, deflationary pressure, Economic Factors, Food prices, Gary Shilling, Global Economies, Government Level, Investment Conference, Investment Strategies, Majority View, Principal Driver, Record Highs, Rising Oil Prices, Sheff, State And Local Government, Term Inflation, Unemployment Rate
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Changes in the Inflation Rate Matter as Much to Investors as the Level

Sunday, March 27th, 2011

Changes in the Inflation Rate Matter as Much to Investors as the Level

by Bill Hester, CFA, Hussman Funds
March 2011

It is clear from February’s inflation data that there was a broad increase in price levels last month, especially for goods used during the early stages of production. The Producer Price Index rose 5.6 percent from its level a year earlier, up from 3.6 percent in January. On a month-to-month basis, the PPI rose 1.6 percent, doubling its recent pace. That increase was partially fueled by higher food prices, which makes up about a fifth of the overall PPI. Commodity prices tracked within the PPI Index rose 8 percent from a year ago, up from 5.6 percent last month.

Because of the price trends in food and energy, and the likely longer-term consequences of quantitative easing, investors and households are beginning to expect higher rates of inflation in the future. Implied inflation levels derived from the difference between 10-year nominal and real yields in the US have increased by 90 basis points since August. These recent yield levels suggest an annual inflation rate of about 2.5 percent.

Households are also expecting higher rates of inflation. Prices will rise by 4.6 percent over the next year, up from 2.2 percent in September, according to a poll by the University of Michigan. Over the next 5 to 10 years, inflation is expected to be 3.2 percent a year, versus 2.7 percent in September.

Those numbers – especially the longer-term inflation expectations – are not particularly high by historical standards. Nor are they high compared with the historical rate of inflation – which on a year-over-year basis has averaged 3.7 percent since 1950. This has left the Fed unfazed. In Chairman Bernanke’s recent testimony to Congress he suggested that any rise in price levels from commodity inflation would be “temporary and relatively modest.”

Another way to look at inflation expectations is to compare them with the trailing inflation rate over the most recent 12-month period. This is especially important for investors, because stock markets are sensitive to inflation rates rising quickly, even if the advance is from a low base (more on this below). Therefore, it’s important to measure inflation and inflation expectations compared with recent trends in trailing inflation.

The graph below shows the difference in inflation expectations and the Cleveland Fed’s median CPI rate. The Fed’s median CPI tracks the “core” CPI well, but because it’s not exposed to outliers it tends to be less volatile. The blue line in the graph below is based on year-ahead inflation expectations. The green line is based on inflation expectations over the next 5-10 years.

The graph shows that inflation expectations – relative to trailing inflation – have been generally well contained for 25 years. In the early 1980′s, inflation expectations collapsed quickly, slightly outpacing the decline in trailing inflation (bond investors were more suspicious, as yields were much slower to decline during this period). But since the mid 1980′s inflation expectations have generally been confined to about one percent above or below trailing measures of inflation.

Look at the recent spread. One-year expected inflation is now 3.6 percentage points above recent inflation. Longer-term inflation expectations are now 1.9 percentage points above recent inflation. Even if overall inflation expectations have not jumped to a level that concerns the Fed, it’s clear that inflation expectations relative to trailing levels of inflation have broken out of their long-term channel.

It will be important to monitor this spread between inflation expectations and trailing inflation. If the spread stays constant then as the trailing inflation rate rises, inflation expectations will increase to levels where the central bank would take notice. Last month, New York Fed President Bill Dudley said, “If inflation expectations were to become unanchored because Federal Reserve policy makers failed to communicate clearly, this would be a self-inflicted wound that would make our pursuit of the dual mandate of full employment and price stability more difficult.”

PPI Trend Levels

The topic of inflation tends to be a tool used by both sides of the debate about stock market performance. It’s argued that because corporations can pass on rising prices of raw goods to consumers, earnings will keep pace with inflation, so equities are a good hedge against inflation. It’s also argued that because the 1970′s was a terrible decade to own stocks, very high rates of inflation must be bad for equities. As in many discussions surrounding financial market topics, there is some truth in each of these arguments. But the full story tends not to lend itself to such broad generalizations. As John Hussman observed a few weeks ago, stocks can benefit from inflation once it is widely anticipated and well-reflected in valuations, but otherwise, stocks are not a very good inflation hedge in periods when inflation is rising.

Maybe one of the most underrated risks regarding inflation is the speed at which it is rising, even if that increase is off of a low base. It’s not high levels of inflation that precede important stock market declines, but instead how rapidly inflation is rising relative to its recent trend. And when you mix an overvalued market with rapidly rising inflation, bad outcomes tend to follow.

We can use the Producer Price Index to highlight this characteristic. The graph below shows each occurrence where inflation in the PPI Index was above 3 percent, the most recent PPI value was at least 60 percent above its 18-month moving average, and the cyclically-adjusted P/E ratio was above 16. For clarity, I’ve only displayed the first occurrence in any 12-month period. This set of conditions highlights periods where valuations were high (and therefore risk premiums are low) and producer inflation was rising at a fast pace relative to its recent trend.

It’s clear from the chart that periods following high P/E multiples and quickly rising rates of inflation haven’t worked out well for investors, on average. The worst instances came in December of 1965, three months prior to a 23 percent decline, in February 1973, a few weeks into a decline which would take stock markets down by half, in September 1987, and in September 1999 and October 2007, just prior to last decade’s two 50 percent-plus declines. The May 1989 instance was early, as the economy didn’t enter into a recession until the summer of 1990. But the market was mostly unchanged during this period, and would eventually fall by 20 percent. The one instance that was followed by gains came in July of 2003.

It’s important to note that I’m not suggesting this as an investment model in itself. For one, it lacks a re-entry signal. It also leaves out important measures of investor sentiment and internal market action. Because multiples were low and inflation measures were flattening out, there was no signal prior to the nearly 30 percent decline during the summer of 1982, which marked the end of a 17-year secular bear market. That said, for a metric that use a single economic statistic and valuation criteria, it has historically highlighted important oncoming risks.

Note that the warning signal above doesn’t demand high levels of inflation – just 3 percent, to indicate that some amount of inflation is already built into the economy. The most recent PPI inflation rate was 5.6 percent. All but one of the occurrence represented by the arrows above (the exception was in 2008) were at the same level or below the recent PPI inflation rate. The signals in 1966, 1968, 1987, and 2000 were all registered with a PPI under 3.5 percent.

The set of characteristics also doesn’t demand high levels of valuation. The graph below puts this into perspective. Above each of the arrows for the above criteria, I’ve noted the cyclically-adjusted P/E ratio (which smoothes real earnings out over the prior decade). The market has run into trouble with far lower multiples than current levels of valuation when early-stage inflation was rising quickly.

Of course, the stock-market bubble era of the late 1990′s through 2007 stands out. Valuations were higher at the peak in 2000 and again in 2007 than current levels, before stock prices declined. And the multiple was roughly the same prior to the 1966 decline. But the multiple was just 18 prior to the collapses in 1973 and 1987. Removing the valuation filter doesn’t change the above sample set materially, it just shifts signals around slightly. That’s because high levels of inflation relative to recent trends have often occurred in mature economic expansions, accompanied by high valuations – like those in 1973, 2001, and 2007 – just prior to the recessions that followed those signals.

In many ways QE2 has made the recent economic recovery much more divergent than most. Some metrics of this recovery resemble the characteristics of economy late in an expansion – including measures of production activity and increases in producer price indexes – while some components still resemble the characteristics of early-stage recoveries – like the number of net new jobs being added to the economy. When the PMI Index has been above 60 (it’s currently 61.4), the average unemployment rate has been 5.5 percent (it’s currently 8.9 percent). Price indexes are similarly stretched. When the PMI Price Index has been above 80 (it’s currently 82), the jobless rate has typically been 5.2 percent. So QE2 has produced a more “stagflationary” economic profile than is usually the case.

Higher prices are also increasing the pressures on households whose incomes continue to stagnate and who continue to struggle with debt loads. The imbalances within this recovery are likely going to represent the next obstacles to higher valuations – or maintaining current levels of elevated valuations – that investors confront. The divergences in the characteristics of this recovery will likely become even more visible as higher prices of raw goods work their way into measures of consumer inflation.

Consumer Inflation

The graph below applies nearly identical metrics to the slightly less volatile CPI Index. The arrows on this graph show where the year-over-year change in CPI was above 3%, the inflation level was 50 percent above its 18-month moving average, and the P/E ratio was above 16. Applying these criteria to changes in the CPI Index gives fewer signals – no signal was given prior to the 1969/1970 decline, the 1991 decline, nor prior to last year’s correction. Still, tracking CPI momentum has proved valuable by signaling what we can justifiably call the Four Big Ones: 1973, 1987, 2000, and 2007.

This time in the graph, I’ve plotted the levels of the year-over-year change in the CPI at the time of each signal. In this case, these are more instructive than the signals themselves. Investors don’t wait until inflation is rising at 15 percent a year to start aggressively selling overvalued equities. They don’t wait for 10 percent or 7 percent inflation, either. The highest level of inflation within this group of signals was 5.5 percent, prior to the bear market of 1973-1974. All of the other signals that preceded declines coincided with rates of consumer inflation somewhere between 3.2 and 4.3 percent. It’s the combination of high equity valuations and the acceleration in the rate of inflation – even if that increase is off of low levels – that has represented the most dangerous periods for risk taking.

In February, the CPI was up 2.1 percent from a year ago. This was up from an annual inflation rate of 1.6 percent in January. It’s well within reason to expect the rate of consumer inflation to rise above 3 percent over the next few months. A continuation of the recent trend would put year-over-year inflation above 3 percent by May. Keep in mind that the CPI Index hit its low in June 2010. So the year-over-year calculation will get a natural boost as the index moves higher over the next few months. If the CPI climbs above 3 percent by June, it will also almost certainly be more than 50 percent above its 18-month moving average. The CAPE Ratio is currently 24.

The start of a contraction in valuation multiples has historically come long before high levels of inflation. Rather, it’s inflation rising faster than its recent trend – sparking concerns of higher longer-term inflation – that increases risk aversion among investors. When these periods occur alongside high P/E ratios, the contraction in multiples has usually been substantial. Ben Bernanke recently told Congress that he is confident that the recent rise in the rate of inflation will be temporary, and that inflation expectations are unlikely to become unhinged. Stock investors must be able to share that belief and that forecast, because a change in longer-term inflation expectations – even from a low base – would increase stock market risks importantly.

Copyright © Hussman Funds

Tags: Annual Inflation Rate, Basis Points, Bernanke, Cfa, Commodity Prices, Food prices, Hester, Households, Hussman Funds, Inflation Data, Inflation Expectations, Level Changes, Ppi Index, Price Trends, Producer Price Index, Quantitative Easing, Rate Of Inflation, Term Consequences, Term Inflation, University Of Michigan
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Bizarre Bond Reaction, and Invading the Great White North (Rosenberg)

Thursday, January 27th, 2011

by David Rosenberg, Chief Investment Strategist, Gluskin Sheff

Breakfast with Dave, January 27, 2011 [PDF]

BIZARRE BOND REACTION

The bond market, for whatever reason, did not want to believe what it saw yesterday. First, the 5-year note auction went better than expected. No dice — the bondies still headed for the hills. Then the Fed, despite a moderate upgrade to its economic assessment in the post-meeting press release, stated that growth was still too tepid to generate any lasting improvement in the labour market and that core inflation risks were still squarely to the downside. To wit:

“The economic recovery is continuing, though at a rate that has been insufficient to bring about a significant improvement in labor market conditions.”

“Although commodity prices have risen, longer-term inflation expectations have remained stable, and measures of underlying inflation have been trending downward.”

Maybe the Treasury market thinks the Fed is behind on the inflation curve. If so, it will be as mistaken on this as it was in the summer of 2007 and spring of 2008. To be sure, the fiscal situation remains very fluid — the Congressional Budget Office just announced new deficit forecasts. The deficit-to-GDP ratio is expected to rise to 9.8% from 8.9% in 2010 (see below for more on the new CBO projections)

HERBERT OBAMA?

A long-standing colleague and reader sent this off to me yesterday and it blew me away. Read on:

Obama’s State of the Union:

“Two years after the worst recession most of us have ever known, the stock market has come roaring back. Corporate profits are up. The economy is growing again.”

Herbert Hoover, May 1st 1930, US Chamber of Commerce Meeting:

“While the crash only took place six months ago, I am convinced we have now passed the worst and with continued unity of effort we shall rapidly recover.”

Obama’s State of the Union:

“Thanks to the tax cuts we passed, Americans’ paychecks are a little bigger today. Every business can write off the full cost of the new investments they make this year. These steps, taken by Democrats and Republicans, will grow the economy and add to the more than one million private sector jobs created last year.”

Herbert Hoover, October 22, 1932, campaign speech in Detroit:

“It can be demonstrated that the tide has turned and that the gigantic forces of depression are today in retreat. Our measures and policies have demonstrated their effectiveness. They have preserved the American people from certain chaos. They have preserved a final fortress of stability in the world.”

Obama’s State of the Union:

“But now that the worst of the recession is over…”

Herbert Hoover, June 1930, to a delegation requesting a public works project:

“Gentlemen, you have come sixty days too late. The depression is over.”

Obama’s State of the Union:

“The steps we’ve taken over the last two years may have broken the back of this recession…”

Herbert Hoover, State of the Union, December 6, 1932:

“The unprecedented emergency measures enacted and policies adopted undoubtedly saved the country from economic disaster…”

INVADING THE GREAT WHITE NORTH

We’re not the only ones bullish on Canada. Coming on the heels of Target’s announcement to set up shop here, Walmart plans on opening 40 “supercenter” stores (with eight of these being brand-new stores) over the course of the next year. See the article in yesterday’s WSJ: Walmart Growth Signals Canada as a Hot Spot.

HOME SALES GOOD BUT MORE WEAKNESS COMING?

First the good news: Total new home sales spiked 17.5% MoM in December, eclipsing the 3.5% median expectation by economists. This takes the level of new housing sales up to 329k (annualized), the best we’ve seen since April 2010. Inventories slipped, leaving month’s supply at 6.9 months’, a welcome decline from the 12+ months’ reading in January 2009, signalling a more balanced market. We saw better price action as well, with prices jumping nearly 12% in December.

The bad news is when we dig further into the data, we were less jubilant over the numbers. The gain was led by a huge jump in new home sales in the West — up over 70% MoM in December. The non-seasonally adjusted numbers painted a worse picture — every region was flat in December, with the exception of the West. So all it took was a pop from 4,000 sales to the oh-so-grand total of 7,000 sales in December in one region, the West, to generate a national seasonally adjusted at an annual rate 17.5% surge in new housing activity. It should be said, we remain a bit skeptical of the December surge.

On top of that, the weekly Mortgage Bankers Association is painting a weak picture of sales going forward. Mortgage applications for purchase slipped 8.7% for the week of January 21, making it the fourth consecutive weekly drop. This means that so far January purchase applications are tracking nearly 9% lower than in December — and point to softer numbers ahead for home sales.

CBO’S DEFICIT PROJECTIONS A SEA OF RED

The Congressional Budget Office projected yesterday in its Budget and Economic Outlook a federal deficit of $1.48 trillion for 2011, or 9.8% of U.S. GDP — a sizeable increase from their previous forecast of 7% back in August. To put this in historical context, we’re back around the ratios last seen in 1945.

Looking further down the road, the CBO expects the deficit-to-GDP ratio to decline over the course of the next several years to 7% in 2012 and down to 4.3% in 2013, reducing gradually to average around 3.1% from 2014 to 2021.
Copyright (c) David Rosenberg, Gluskin Sheff

Tags: Bond Market, Canadian Market, Chief Investment Strategist, Commodity Prices, Congressional Budget Office, Core Inflation, Corporate Profits, David Rosenberg, Economic Assessment, Economic Recovery, Fiscal Situation, Gdp Ratio, Herbert Hoover, Inflation Expectations, Inflation Risks, Labour Market, Significant Improvement, Term Inflation, Treasury Market, Unity Of Effort, Us Chamber Of Commerce
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QE II Set To Sail, But How Soon?

Thursday, October 7th, 2010

QE II Set To Sail, But How Soon?

by Dr. Scott Brown, Chief Economist, Raymond James

October 4 – October 8, 2010

In its September 21 policy statement, the Federal Open Market Committee indicated that it was “prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.” The key part of that phrase is “if needed.” Growth and inflation are both too low for the Fed’s comfort, but are they low enough to force the Fed’s hand? In their public comments, senior Fed officials appear split, with some wanting to do more and others less. The most important development last week was a report that Fed policymakers are considering smaller-scale quantitative easing, which should be more palatable to the more cautious members of the FOMC.

“Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.” – FOMC statement, September 21

Most central banks have an inflation target. The Fed does not. The Fed has a dual mandate: maximum sustainable employment and price stability. In practice, the Fed believes that by keeping inflation low, economic growth will be better over the long run. However, the Fed does not view “price stability” as 0% inflation (as measured by the Consumer Price Index or PCE deflator). Rather, as former Fed Chairman Greenspan put it, price stability is “a situation in which households and businesses in making their saving and investment decisions can safely ignore the possibility of sustained, generalized price increase or decreases.” Comments from various Fed officials over the years have suggested an implicit comfort range of 1% to 2% in the PCE Price Index. The PCE Price Index ex-food & energy rose 1.4% over the 12 months ending in August. However, most other measures of core inflation have been trending below 1%.

Models of inflation are driven largely by a measure of excess capacity (an output gap or the unemployment rate) and inflation expectations (which act to anchor the underlying trend in inflation). As long as there is sufficient excess capacity, there will be downward pressure on inflation and over time, if actual inflation continues to trend below inflation expectations, inflation expectations should decline. Note that higher commodity prices generally do not have much of an impact at the consumer level – except for oil, which is more pervasive.

What will it take to get the Fed to pull the trigger? Most officials appear to be leaning in the direction of further quantitative easing, but it’s unclear when it will happen. The recent economic data have been consistent with a subpar rate of growth in the near term – positive, but well below the pace needed to absorb new people into the workforce and far below the rate we’d like to see at this point in the recovery. There’s nothing in the recent data to suggest that we’re in a double dip. However, growth is widely expected to remain soft for some time. There are still some serious headwinds (lingering problems in residential and commercial real estate, substantial budget shortfalls in state and local governments, uncertainty over tax policy, and a decreasing fiscal stimulus in 2011).

The likely effectiveness of further purchases of long-term securities is an item of debate among Fed officials. Large-scale purchases of Treasuries and mortgage-backed securities were critical during the financial crisis. However, further efforts are likely to be less effective now that conditions are more normal. Some Fed officials see problems as being more structural rather than cyclical, which would mean that policy stimulus would have less of an impact (recovery, in this case, would be largely a function of time). However, most view the current softness as cyclical (in which case, stimulus would be more meaningful).

The Wall Street Journal has reported that Fed officials are considering smaller-scale asset purchases. During the financial crisis, the Fed announced plans to purchase very large amounts of assets over many months. In contrast, the Fed may now adopt a more flexible strategy, announcing plans to purchase smaller amounts over shorter periods (a month or two). This is likely to make it easier to get those Fed officials sitting on the fence to go along – and the Fed could pull back if the pace of recovery were to pick up. The question then gets back to timing. All else equal, the Fed does not want to appear as being influenced by politics. The next FOMC decision is due on November 3, one day after the mid-term elections, but before the release of the October Employment Report.

Copyright (c) Raymond James

Tags: Central Banks, Chief Economist, Consumer Price Index, Deflator, Dual Mandate, Fed Chairman Greenspan, Fed Officials, Fed Policymakers, Federal Open Market Committee, Inflation Expectations, Inflation Target, Investment Decisions, Maximum Employment, oil, Open Market Committee, Price Stability, Qe Ii, Stable Inflation, Substantial Resource, Sustainable Employment, Term Inflation
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The Myopic Bond Market

Thursday, September 30th, 2010

It is axiomatic that investors in government bonds expect to earn a return in excess of inflation. Why invest in a bond if it does not increase the purchasing power of one’s capital? Hence, the current yield to maturity of a bond includes an expected real return element and a component for expected inflation. Since 1926, long-term U.S. government bonds have had an annualized return of 5.6% comprised of a real return of 2.6% and an inflation component of 3.0%.

As yields plunge ever lower, the bond market appears to be anticipating a protracted period of low inflation. Fears of outright deflation have escalated as the economic recovery slows swelling the burgeoning legion of bond purchasers and further depressing yields. In turn, lower yields reinforce the notion that future inflation rates will themselves be lower. This self-reinforcing cycle, however, begs the question – how successful has the bond market been in forecasting future inflation rates?

The answer is “not very”. As illustrated in the following graph, long-term government yields (in red) have almost consistently misestimated the subsequent long-term inflation rate (in green). During the late 1920′s and the mid-1970′s to 1990, the bond market chronically overestimated future inflation. This is evidenced by the fact that long-term bond yields were substantially in excess of the following 20-year inflation.

Conversely, from the early 1930′s until the early 1970′s, the bond market nearly always under-estimated subsequent inflation. In general, long-term bond yields were below the subsequent long-term inflation rate. Overall, the correlation between long-term bond yields and the subsequent long-term inflation was a negligible 0.20.

Mid-term bond yields also did a poor job of anticipating future inflation. The following graph illustrates how intermediate-term government yields (in red) failed to anticipate the subsequent five-year inflation rate (in green). As can be seen, intermediate-term bond yields tended to be either too high relative to the subsequent realized inflation rates (as occurred in the late 1920′s and the late 1970′s through to mid-2000′s) or too low (as occurred in the late 1930′s and 1940′s and the 1970′s).

The correlation between intermediate-term bond yields and the subsequent five-year inflation rate was a weak 0.27.

The bond market does a poor job of estimating future inflation rates over the mid to long-term. Hence, investors should have little comfort that today’s low yields properly anticipate future inflation over longer time frames or properly compensate them for the risk of potentially higher inflation further down the road.

In fact, historically, low bond yields have not provided investors with sufficient reward for the risk of unexpected higher inflation. This is illustrated in the following graph which compares the monthly long-term bond yields from January 1926 to September 1990 to the annualized real (i.e. inflation adjusted) return actually earned in long-term bonds over the subsequent twenty years.

Low long-term government bond yields such as the 3.4% yield today have typically resulted in either low or negative real returns for long-term bondholders. The only exception was the mid-1920′s when bond investors benefited from falling prices in the late 1920′s and early 1930′s as well as wartime price controls. Very low intermediate-term bond yields such as the 1.3% yield today have also resulted in either low or negative real returns over the subsequent five years (see Appendix I).

At today’s low yields, government bond investors are banking on a future of protracted low inflation or even outright deflation. They need to understand that, like Mr. Magoo, the bond market really doesn’t see clearly at a distance. Hence, although low inflation is the likely scenario over the several years, beyond that, the bond market has limited insight into mid to long-term inflation.

And the market is akin to Mr. Magoo in another respect. With yields so low today, it will also be prone to some nasty accidents in the future.

September 30, 2010

www.tacitacapital.com

Appendix I

Source: Data from Morningstar Ibbotson covering the period January 1926 to September 2005; calculations by Tacita Capital. 60-month real return is the actual annualized inflation-adjusted return on intermediate-term bonds compared to the bond yield in month one.

Tacita Capital Inc. (“Tacita”) is a private, independent family office and investment counselling firm that specializes in providing integrated wealth advisory and portfolio management services to families of affluence. We understand the challenges of affluence and apply the leading research and best practices of top financial academics and industry practitioners in assisting our clients to reach their goals.

Tacita research has been prepared without regard to the individual financial circumstances and objectives of persons who receive it and is not intended to replace individually tailored investment advice. The asset classes/securities/instruments/strategies discussed may not be suitable for all investors and certain investors may not be eligible to purchase or participate in some or all of them. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. Tacita recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial advisor.

Tacita research is prepared for informational purposes. Neither the information nor any opinion expressed constitutes a solicitation by Tacita for the purchase or sale of any securities or financial products. This research is not intended to provide tax, legal, or accounting advice and readers are advised to seek out qualified professionals that provide advice on these issues for their individual circumstances.

Tacita research is based on public information. Tacita makes every effort to use reliable, comprehensive information, but we make no representation that it is accurate or complete.  We have no obligation to inform any parties when opinions, estimates or information in Tacita research changes.

All investments involve risk including loss of principal. The value of and income from investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. There may be time limitations on the exercise of options or other rights in securities transactions.  Past performance is not necessarily a guide to future performance.  Estimates of future performance are based on assumptions that may not be realized. Management fees and expenses are associated with investing.

Tags: Annualized Return, Bond Market, Bond Yields, Correlation, Current Yield, Deflation, Early 1970, Economic Recovery, Graph, Inflation Component, Inflation Fears, Inflation Rate, Inflation Rates, Notion, Poor Job, Purchasing Power, Term Bond, Term Inflation, U S Government Bonds, Yield To Maturity
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Bernanke Presents Fed’s Options and Indicates Deflation Not a Significant Risk

Tuesday, August 31st, 2010

August 27, 2010

Chairman Bernanke kicked off the annual symposium in Jackson Hole with a blueprint for the future course of monetary policy. In his opinion, “the recovery of output and employment in the United States has slowed in recent months, to a pace somewhat weaker than most FOMC participants projected earlier this year.” (The central tendency of the Fed’s forecast in July for 2010 is 3.0% to 3.5%). He also noted that “despite the weaker data seen recently, the preconditions for a pickup in growth in 2011 appear to remain in place.”

Bernanke listed four options the Fed has in its arsenal with the costs and benefits of each alternative. First, the Fed can purchase longer term securities and increase the size of the balance sheet. However, Mr. Bernanke indicated that this strategy works best during times of “financial stress.” He also added that large purchases of additional securities would leave the public less confident about the Fed’s ability to manage a smooth exit. The reduction of confidence would translate into an “undesired increase in inflation expectations.” Bernanke stressed that the Fed has developed several tools to ensure a smooth exit and Fed officials have spoken extensively about these tools to moderate concerns of the public. Second, Mr. Bernanke noted that the Fed could communicate to investors that it “anticipates keeping the target for the federal funds rate low for a longer period than is currently priced in the markets.” The main drawback of this tool is that it may be a challenge to convey the FOMC’s intentions with precision. Third, the Fed could reduce interest rates it pays on excess reserves (currently 25 bps). Bernanke sees this route as fraught with the potential of reducing liquidity of the federal funds market. Fourth, he mentioned a controversial solution – announcing a medium term inflation target that is above a level consistent with price stability. Bernanke considers this option inappropriate for the United States and sees it suitable in situations of an extended period of deflation. He supported this opinion with the fact that inflation and inflation expectations are within a range of price stability in the United States and would not require this strategy. Given these opinions about the alternatives the Fed has, it appears that purchases of securities will probably prevail, if necessary.

Bernanke’s description of the circumstances under which the Fed would consider further easing of monetary policy is the crux of the speech. These remarks offer guidance pertaining to the course of near term monetary policy:

“First, the FOMC will strongly resist deviations from price stability in the downward direction. Falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation. It is worthwhile to note that, if deflation risks were to increase, the benefit-cost tradeoffs of some of our policy tools could become significantly more favorable.

Second, regardless of the risks of deflation, the FOMC will do all that it can to ensure continuation of the economic recovery. Consistent with our mandate, the Federal Reserve is committed to promoting growth in employment and reducing resource slack more generally. Because a further significant weakening in the economic outlook would likely be associated with further disinflation, in the current environment there is little or no potential conflict between the goals of supporting growth and employment and of maintaining price stability.”

Real GDP Growth Slows in Q2, Second-Half Likely to Mimic This Trend

Real GDP of the U.S. economy grew at annual rate of 1.6% in the second quarter, revised down from the advance estimate of 2.4%. The upward revision of imports to a 32.4% increase from the earlier estimate of a 28.8% gain was the major reason for the downward revision, in addition to a smaller accumulation of inventories ($63.2 billion vs. $75.7 billion in the advance estimate) and a nearly flat reading of outlays on non-residential structures (+0.4% vs. +5.2%). Partly offsetting positive contributions came from upward revisions of consumer spending (+2.0% vs. +1.6% in the advance report) and equipment and software spending (+24.9% vs. +21.9% in advance estimate).

Corporate profits increased 4.6% in the second quarter vs. a 10.6% gain in the first quarter. Domestic non-financial industries (+8.1%) made the larger contribution to corporate profits in the second quarter, while profits of the financial industry inched down 0.1% and profits from abroad rose 1.4%.

A tepid increase in real GDP is projected for the second-half of the year, putting the Q4-to-Q4 increase at 2.2% after a nearly flat reading in 2009. Bernanke indicated that the Fed stands ready to provide additional financial accommodation to maintain the pace of economic activity, if necessary (See remarks about Bernanke’s speech above).

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.

Copyright (c) Northern Trust

Tags: Arsenal, Balance Sheet, Blueprint, Bps, Central Tendency, Drawback, Excess Reserves, Fed Officials, Federal Funds Rate, Financial Stress, Fomc, Inflation Expectations, Inflation Target, interest rates, Jackson Hole, liquidity, Monetary Policy, Preconditions, Price Stability, Term Inflation
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The Economy and Bond Market Diary (July 19, 2010)

Monday, July 19th, 2010

The Economy and Bond Market Diary (July 19, 2010)

Treasury bonds rallied this week as the low inflation theme was underscored with very benign inflation data. The 10-year Treasury closed the week below 3 percent and the 2-year Treasury hit a new low.

Economic data was also weak overall, making the near-term inflation story less viable. The chart below shows that the University of Michigan Consumer Confidence Survey fell sharply, reflecting pessimism regarding employment and income growth, and it suggests expectations of sluggish consumer spending going forward.

Strengths

• Industrial production continued to move higher, rising 0.1 percent. On a year-over-year basis, industrial production continues to accelerate. It has risen 8.2 percent and shows continued expansion in the manufacturing sector.
• Initial jobless claims for the week ended July 9 decreased by 29,000 to 429,000, the lowest level since August 2008.
• Both the Consumer Price Index and the Producer Price Index indicated benign inflation this week, which allows the Federal Reserve plenty of room to maneuver.

Weaknesses

• The University of Michigan Consumer Confidence Survey hit the lowest level since August 2009, highlighting the fragile nature of the economic recovery.
• June retail sales fell 0.5 percent, confirming the weak confidence data.
• China’s GDP slowed to 10.3 percent in the second quarter, below expectations and indicating that recent tightening moves by the government are already having an impact.

Opportunities

• Inflation is unlikely to be a problem for some time. This gives central bankers and other policymakers around the world room for expansive policies.

Threats

• The risk of austerity measures going too far and significantly diminishing economic growth is a real risk.

Tags: 10 Year Treasury, Austerity Measures, Bond Market, Chart Below Shows, Confidence Data, Confidence Survey, Consumer Price Index, Economic Data, Economic Recovery, Fragile Nature, Inflation Data, Initial Jobless Claims, Manufacturing Sector, Market Diary, Michigan Consumer Confidence, Pessimism, Producer Price Index, Term Inflation, Treasury Bonds, University Of Michigan Consumer Confidence
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