Economic Sophisms

I always try to compare movements in stock and commodity markets against market inflation forecasts and exchange rates.  Doing so helps one to narrow down the plausible set of causation.  Maybe the biggest error that people make when they start out in markets or in economic question in general is “Reasoning from Price Changes”, I did this now and then until Sumner brought my mind to it.  The idea behind considering many parts of the Walrasian black box (by looking at a range of assets prices and other economic developments) is that markets don’t just move by themselves.  Oil for example doesn’t just become cheaper or dearer on its own, it responds to changes in supply, demand, regulation and expectations thereof.

An important tool to understanding what lies behind movements in big macroeconomically determined financial aggregates like…bond prices, national share indices and commodities is the TIPS spread or market inflation expectations in the U.S.  If the TIPS spread falls, that means expectations of the future level of the U.S. CPI are falling, which probably means spending expectations in the U.S. are falling too.  Here is a plot of the TIPS spread over the last few years

There is an unfathomable mass of information within this plot. The pith of the last three years of economic doom and then malaise are described within the fractally generated jags of that thin black line.  Inflation indexed bonds like TIPS and the equivalent spreads for Germany, Japan, Great Britain and France are probably my single favorite assets to track.  These markets respond almost entirely to changes in expected monetary policy[see Note 1 at the end] and as a result they tell us much about what is moving other markets.  If oil falls a lot (say 3%) and the TIPS spread is also down “a lot” (say maybe 10-15 basis points)  then I will reckon that oil is weak because expectations of future nominal spending are falling, which is in turn due to investors reasoning that monetary policy over the next 5 years is probabilistically tighter.  If oil moves a lot and the TIPS spread is unchanged, then the oil market is most likely responding to expectations of supply changes in either oil production or the “AS curve” of the global macroeconomy.  There are no stable correlations in financial markets though, markets move for so many reasons and the structure of the economy in constant flux that such comparisons are always crude and prone to misinterpretation.  This is why you need to hire people like me to interpret those movements.

The following plots show 10 day backward looking moving correlations of the change in the TIPS spread and the percentage change in either the S&P 500 or the WTI oil benchmark price.

Clearly the correlation is unstable and subject to rapid change, which is exactly what you would expect.  That said, there aren’t  many periods with a strong negative correlation.  Those spans of mild negative correlation might be due to say, oil supply fears spilling into the CPI and also creating expectations of wrongheaded Fed tightening in response to high oil prices. You couldn’t draw this from the very messy graph, but my experience following markets tells me that in periods with little supply side information, movements in inflation expectations explain a lot of market behavior. The March 2009 to present market rally seemed to be link to the recovery of the TIPS spread.

One of the reasons I am not too worried about the current softness in asset markets is because markets seem to be following TIPS spreads and moving inversely to the USD/EUR rate.  That means the Fed could turn things around whenever it wants.  My view is that above all, markets are worried about how the FED will react to future liquidity shortages.  This is why the FED should adopt a level targeting policy or intervene in the indexed bond market rather than conduct these cumbersome and politically risky QE sprees.  What the Fed should do is beside the point though, I am confident they wont let TIPS spreads fall below say 1.5% again, which suggests that as long as markets are falling because of fears of tight money, that the downside risk is contained.

Markets are down a fair amount today, inflation expectations are down too at around 2.08% over the next 5 years.  If markets are moving on inflation expectations, that means that a bet on most asset classes today is an implicit bet on what central banks (foremost the Fed) are liable to do.  I am growing ever more confident that Greece will default, leave the Euro or both.  I am also increasingly worried about Italy, which has enormous debts, terrible demographics and while it is a lovely place, has less business being in the EMU than even Spain.  This makes me want to sell some equities, move into gold and long dated U.S. treasuries.  Hopefully the Greek government will hurry up and accept reality, ignore the IMF and the Germans and default.  We are really in uncharted territory now.  Never before has a capitalistic currency union disassembled itself back to national currencies, it will be both nerve wracking and exciting to watch.  Vast fortunes will be made and lost.  My bet is that Central Banks wont mess up 2008 style, as long as the ECB keeps nominal spending up in Germany and France, and the Fed does the same in the U.S., I don’t see why a haircut on all PIIGS bonds (including Italy) need cause a major recession.

[Note 1: The 5 and 10 year spreads usually referenced shouldn't be dramatically affected by things like sales tax changes due to the long window. Measurement errors shouldnt be a problem either as long as the systematic component of CPI measurement error is fairly stable over time]

There are reasonable rumors that Greece is making plans to leave the EMU and reintroduce its own currency.  The Euro is down on this news, indeed much of this risk was likely priced in (note the growing spread between the Swedish Krona and Swiss Franc which usually mirror the Euro).  From a certain perspective this is strange, Greece is tiny, hell even Portugal, Ireland and Spain are fairly small as a whole, and there is thusfar little risk of Spain leaving.  If Greece and Ireland leave the EMU, does that leave the EMU stronger, if slightly smaller?

In my view, the way to understand the weakening Euro is to note that today and Euro is not a Euro.  If a Euro were a Euro, one would be confident that a year from now it would still be a Euro and managed by the ECB.  Instead, one cannot be 100% or even 85% sure that all of one’s Euro’s will remain so a year from now.  Each Euro in circulation carries an unknowable but non trivial risk that it will be converted into an Irish Pound or Greek Drachma and subsequently lose much of its value.  This is because there is no easy way to convert all Euro base money and assets within Ireland or Greece into domestic currency.  The Euro was intentionally designed to be permanet so that it would be costly for states to return to their pre Euro currency. A Cortezsian Burn the Ships strategy.  No one knows exactly how the process would work, but there is a risk that some fraction of Euro’s are simply declaired to be Irish or Greek currency.

This means that people are less willing to hold Euros, or at least they should be, and thus currency traders have bid down the price of the Euro in terms of other currency.  If Greece and Ireland leave the Euro, one should make plans to go long the Euro; because once this uncertainty is removed the currency should quickly move back above 1.5 USD/EUR. [For the record, this is for entertainment purposes and does not consititute financial advice.  If you listen to anything I say you will lose all of your money and then some, so (American's especially) please don't sue me.]

There are of course many contingencies to this scenario.  But my aim here is to describe the underlying mechanism. The biggest risk to this scenario is that if either country announces a Euro exit, the currency will fall hard as markets try to digest the implications of whatever conversion mechanism is announced.  This will automatically tighten monetary policy in other countries, especially the U.S. and Japan as capital flees Euros and goes to these safe assets.  It is impossible to know beforehand how strong this effect will be and there is a chance that it could derail the tepid U.S. and Japanese recoveries if not offset by new Dollars and Yen.

It is useless to speculate as to how the BOJ would react, but they are a minor player compared with the FED anyway (Keep in mind that through the RMB-USD peg the FED partially sets China’s monetary policy).  Bernanke is as Friedman put it ”a very able man” and my gut feeling is that he won’t mess up again 2008 style.  He has more allies on the FOMC now feels better about how QE affects markets. With growth in nominal wages and core inflation low in the U.S., he should have the cover to meet the increased demand for dollars with new cash injections.  If he doesn’t though things could get ugly.

So I wouldn’t want to own Euros today, I would rather be in long dated U.S. bonds.  If Greece/Ireland leave the EMU, I would probably want to sell those bonds shortly after and then either buy a leveraged USD/EUR ETF or a short U.S. bond ETF.

Oil was down nearly 9% today and has gone from $113 at the start of the week to $99 at the end of trading today.  So is the high oil price a “bubble”?

Before I tackle this, let me define bubble-a term of which I feel ill.   For my own sake, a bubble means an inefficiently high price.  A price not incorporating most freely available knowledge.  A price which is completely out of line with any reasonable forecast of discounted future prices, medium run supply and demand conditions.  Bubbles inevitably collapse when enough brave speculators discover the supply/demand discrepancy.  Not all quickly falling prices are bubbles.  If China invades Taiwan tomorrow and Acer shares fall, Acer was not a bubble.  If Toyota shares fall because of the earth quake, Toyota was not a bubble.

If someone tells you that market X was a bubble, ask if you might see their brokerage records because they should be rich from trading on their superior foresight.  If they aren’t, pay them no heed. When conditions change, prices should change, and conditions are constantly changing.  Right now markets are forecasting slightly weaker nominal spending growth.  You can see this in other commodities, stocks and my personal favorite, the TIPS spread.  If oil falls because central banks put the economy on a near starvation diet with tight money, then no, oil was not a bubble.

The 5 year TIPS spread (a rough market CPI inflation forecast for the U.S.) is at 2.35%.  This is down from around 2.60% early last week.  My story is that markets saw the bad employment number, and combined that with expectations of tighter money in the EMU, China and political challenges to a third round of QE from Bernanke and concluded that nominal spending is likely to come in a bit weaker than previously reckoned.   If nominal spending is weaker,  the economy will do badly and the dollar will appreciate.  If the economy does badly, oil falls. Oil is not going down because of a strong dollar, the changes in oil prices are far too big to be simply due to movements in exchange rates.  Rather oil and the dollar are moving in opposite directions because money is becoming tighter and expectations of nominal spending are falling.  Even slight changes in demand can dramatically change the price of oil, cut expected global growth by….1% and the price can fall a lot.

If the drop in oil prices were entirely due to poor discounting by markets, then we should see fairly stable TIPS spreads and if anything rising equities.

The markets are smart.  They know that Bernanke will need to see a few months of flat or very low (say .5% yearly rate) headline CPI inflation before he will have the political cover to do what is right, to do more QE or charge negative interest on reserves.  The ECB would rather see a recession and PIIGS default than 4% headline inflation.  The PBC has a genuine need to tighten Chinese money and the BOJ is doubtless already working on plans to undo the latests cash injections so that they can keep to mild deflation and a strengthening yen (why they do this, I do not know). Things can get a whole lot worse before anything will be done, we are at the mercy of the AS curve.

My plan is to lighten up on my oil service shares a bit and probably buy back in a few weeks.  My own expectations is that oil prices will probably stay above $85 for WTI.  If the economy ever recovers oil will be…I don’t know know…dear.