Tuesday, September 28, 2010

Marching Toward More QE

What started as a hint in Bernanke's Jackson Hole speech a few weeks ago and was seconded by a more overt hint to that effect in the latest FOMC statement, seems to have taken the form, in the Treasury market's mind, of an almost unstoppable march toward more quantitative easing by the Fed. Today's front page article in The Wall Street Journal, along with the sharp decline in the Conference Board's consumer confidence index for September, seemed to have added an air of a near inevitability to the prospect of additional purchases of Treasuries by the Fed in the foreseeable future.

The obvious question that this dynamic generates is whether there is anything, at this point, that can derail this outcome.

With the various economic reports in recent days having failed to provide any glimmer of hope that economic activity is gearing up, the possible "cicrcuit-breakers" are dwindling fast. With Friday's ISM likely to show, if anything, a modest retreat from its 56.7 level in August, the only potential piece of economic data that would allow the Fed to take a step back and wait a little longer, appears to be the September employment report. While putting forward hard and fast rules here as to what nonfarm payroll number would be required to put the Fed's apparent plans on hold is a tricky task, it is not unreasonable to argue that a gain in private payrolls by more than 125K in September (to be released on October 8) might give the Fed some room to take a small step back. (Such a reference number is not outlandish, as just in July- in the midst of the current soft patch- private payrolls turned out a gain of 107K). Then, the behavior of the September core CPI could take an unexpectedly pivotal role in the final decision. With the core index currently running at 0.9% year-on-year, a gain of 0.2% in the series for the month could help expand the Fed's breathing space- at least for a while.

Anthony Karydakis

Thursday, September 23, 2010

Nominal Treasuries and TIPS: A Diverging Inflation Outlook?

As of next week, I will be returning to the financial industry, while maintaining some of my teaching responsibilities at Stern. Every effort will be made to maintain a pace of approximately two new postings each week, although, on rare occasions, that standard may not be fully met.- AK

One of the most intriguing market reactions to the FOMC's signal last week that additional purchases of Treasuries may be in store is the strong rally in TIPS, which has fully kept up with that in nominal long-term Treasuries. This has helped sustain the strength that TIPS have demonstrated since the beginning of the month, and which has led to a rebound of the break-evens in the 10-year sector by about 30 basis points.

That nominal Treasuries have rallied in the aftermath of the Fed's announcement is hardly surprising, although we felt that it contained a bit of a "jumping the gun" element (http://economistscorner.blogspot.com/2010/09/fomc-statement-litle-closer-but-not.html). Still, the enhanced prospect of potentially sizable purchases that would likely remain concentrated in the long end of the market, can explain the resumption of the rally that had suffered a modest setback earlier in the month.

The impressive vigor of the rally in the TIPS market (which would almost certainly be excluded from any Fed asset purchase program) can only be attributed to the part in the FOMC statement that expresses the policymakers' discomfort with the rate of core inflation running below the Fed's medium-term objective, of presumably closer to 2%. Another way of putting it is that TIPS became suddenly more attractive because the Fed signaled that they may provide more liquidity to the system via quantitative easing to fend off any deflation risk- and possibly reflate the economy.

Something though does not quite sit right with the above interpretation of the strength of the TIPS market. If TIPS are rallying because the Fed's anticipated second round of quantitative easing will cause more inflation (therefore making TIPS appealing), why don't nominal Treasuries see that perceived threat of higher inflation, and have, instead, rallied as well by a roughly comparative amount?

The only plausible explanation here is that Treasuries have evidently made the assessment that the extra demand for long-term securities by the Fed will squarely outweigh the setback that such maturities would otherwise be suffering as a result of any heightened inflation fears. This is, in our opinion, a somewhat heroic proposition, as patterns of market behavior over the medium-term have almost invariably shown that concerns about inflation tend to be a more reliable and potent driver of nominal long-term yields than supply-related considerations.

The above analysis does not imply that the widening of the TIPS break-evens since the beginning of September will be reversed. In fact, that push may continue, albeit in a somewhat choppy manner. However, such a move would more likely be fueled by a slow retreat of the most intense deflation concerns that would allow TIPS to maintain a firm underlying bid consistent with the tacit view of 1.75-2.0% inflation over the long-term. At the same time, Treasuries may remain close to a standstill, pulled in opposite directions by that same inflation prospect and positive- although, still not guaranteed to materialize- supply considerations.

Anthony Karydakis

Tuesday, September 21, 2010

The FOMC Statement: A Litle Closer But Not There Yet

The FOMC statement this afternoon (http://www.federalreserve.gov/newsevents/press/monetary/20100921a.htm) contained a little bit for everyone. To those who have been increasingly agitating for another meaningful round of quantitative easing, the statement offered the seemingly reassuring language that the Committee" will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed". At the same time, there was not even an attempt to present the contours of the criteria that will be used to make that determination, an omission that reveals traces of ambivalence, or unpreparedness, within the FOMC about such action.

The Fed's hesitation to be more specific, or assertive in its intention to implement additional quantitative easing is probably the result of both its natural reluctance to promise, or commit to, a specific outcome but also the product of its continuing soul-searching as to where that route makes fully sense on a risk-reward basis. For an additional round of material quantitative easing, an increase in the size of the Fed's portfolio by a number in the vicinity of $1 trillion is probably what the Fed is looking at, with no guarantee that such an injection will actually be pivotal in jump starting the anemic recovery. At the same time, by taking that route, the Fed will be dramatically increasing the magnitude of its own headaches in handling successfully the exit strategy when the time ultimately comes (because, at some point, it will!). The issue of whether creating that substantial additional risk that will be left lurking around the corner is a worthwhile endeavor for the Fed is arguably unsettled in the policymakers' own mind at this point.

A reasonable conclusion, based on the above, would be that additional quantitative easing of some significance is not yet a done deal, particularly in view of some publicly expressed resistance to such measures by some Fed officials. However, the Treasury market's nearly euphoric reaction to the announcement strongly suggests that the consensus interpretation is that it is only a matter of time until the Fed proceeds with such action- it is as if the "when" is the only issue to be settled and no longer the "if".

This is a risky proposition. By adopting that interpretation, the market is exposing itself to the prospect that the tone of the various economic reports stabilizes in the coming weeks (signs of which have actually appeared recently) and this provides the Fed with more breathing space to wait longer before any decision about more quantitative easing is put in place. The odds that such action will in the end be taken have risen somewhat in the wake of the FOMC's statement today, but they are not nearly as close to a foregone conclusion as today's price action in the Treasury market implies.

Anthony Karydakis

Thursday, September 9, 2010

Next Week's Busy Economic Calendar

Due to a vacation overseas, there will be no new articles posted until the week of September 20th.

The moderate back up in Treasury yields caused by the more resilient-than-expected labor market report last Friday has essentially put the market in an "on hold" mode, awaiting further cues as to which way to go next. The particularly light economic calendar this week also left Treasuries more sensitive to supply, with the maneuvering around the 3-, 10-, and 30-year auctions representing the main drive of price action so far. A somewhat underwhelming Beige Book on Wednesday and a 27,000 decline in initial jobless claims were not potent enough information to provide prices with any momentum in either direction

This state of relative inertia has the potential to change next week, as the economic calendar is packed with major releases, usually known for their market-moving potential. At the same time, the absence of any new coupon supply almost guarantees that the economic data will be in the driver's seat of next week's price action, with a reasonable prospect that will help the market break out of this week's stalemate.

At the top of the list of such key reports next week are August's retail sales on Tuesday, the September Empire Fed and Philly Fed manufacturing surveys on Wednesday and Thursday respectively, and CPI (August) along with the University of Michigan Consumer Sentiment (September) index on Friday.

Following some inconsistent performance in the last few months, retail sales should show a moderate gain of about 0.5%, with only a slightly smaller gain in the ex-autos component. The overall number should benefit from better-than-expected "back-to-school" sales for the month and will probably underscore the fact that, contrary to concerns expressed recently, the consumer is not quite as moribund as feared. We view personal spending as still on track to post a gain in the 2-2 1/4% range (annualized) in Q3.

The two manufacturing surveys could be pivotal in setting market tone next week, not only because of the usually considerable degree of attention they command but also due to their dramatic drop in the last three months- which is particularly true for the Philly Fed (-7.7 in August compared to 21.4 in May). Both indexes should show a rebound by about 10 points or so, providing reassurance that their sharp weakening earlier in the summer was mostly caused by auto-related and other unspecified distortions and were not the precursor of an ominous, broad-based slowing in manufacturing.

A gain of 0.1% in the core CPI for August (+0.2% overall) would leave that closely watched measure of inflation at +0.9% on a year-on-year basis for the fifth consecutive month. This, although not ground-breaking material as such, should be viewed as mildly reassuring that the disinflationary dynamic is not picking up steam and that core inflation may stand a good chance of stabilizing at a fairly safe distance from the dreaded zero mark in the context of an ongoing economic recovery.

Although, on balance, the overall tone of next week's economic reports should feel consistent with a recovery that continues to plow ahead at an admittedly unimpressive pace but is showing no signs of fizzling dangerously. However, the behavior of the Treasury market, as has often been attested to in the last year or so, is not always a linear function of the specific economic reports, as other parameters often can interfere with that relationship. For example, headlines associated with the sovereign debt situation in Europe that seem to be making their way back up to the spotlight in the last few weeks, can, depending on the degree of surprises that the data hold, have a significant role to play. So, all things considered, it is safer to argue that next week has the potential to offer more exciting (see, noisy) price action in the Treasury market but offers no promises of a decisive directional move.

Anthony Karydakis

Friday, September 3, 2010

The Employment Picture Brightens Up, Suddenly

The August employment report provides irrefutable evidence that the economic recovery is alive and well, moving forward at a reasonable enough clip to put "double dip"-related concerns to rest.

Not only did private payrolls rise by a moderate 67,000 last month but significant upward revisions to the prior two months in the overall numbers by a cumulative 123,000 jobs suddenly paint a more resilient labor market picture than previously thought.

The 54,000 decline in the headline payroll number for August is inconsequential, as it reflects the distortion caused by the layoffs in census workers for the month (-114,000).

Since last December's low, the private sector has created a total of 763,000 jobs in the first eight months of the year, meaning an average of 95,000 jobs a month. While the number is definitely short of where it ultimately should be (probably in the 200,000+ range), it is still respectable for an economic recovery the sustainability of which has often been called into question recently. The message here is that, despite the much-publicized defensive attitude by companies, the private sector is moving ahead with a pace of hiring that, while cautious, still indicates an irreversible forward momentum in economic growth.

Health care employment was up 28,000 in August, as the sector remains a steady source of job creation in private payrolls, having averaged about 20,000 a month so far in 2010. Construction employment was up 19,000 (reflecting in part the return to work of 10,000 striking workers in July), while manufacturing jobs fell 27,000 due to a sharp decline in motor vehicle production (the result of a different pattern this year for the industry's retooling process during the summer months).

The average workweek for all employees- a key predictor of future hiring- was unchanged at 34.2 hours in August, remaining at the high end of its range for the year.

Comparable gains in both the size of the civilian labor force and employment in the household survey (154,000 and 139,000 respectively) caused an uptick in the unemployment rate to 9.6%, which is right in the middle of the 9.5-9.7% range that has prevailed for the series since May. The stalled unemployment rate in the last several months reflects both the still moderate pace of private payroll growth and the unwinding of the Census workers.

By throwing cold water to the more pessimistic views of the economy expressed by some in the last few months, today's report represents a significant blow- at least for the time being- to the Treasury market's seemingly irrepressible summer rally, as it deflates expectations about additional quantitative easing by the Fed and helps tame the most intense concerns about the deflation risk. In fact, on that last front, one of the more low-key elements of the report, average hourly earnings for all employees, showed a solid gain of 0.3% in August, which translates into a 1.7% gain on a year-on-year basis. With wage increases holding up at a moderate pace, the deflation story becomes a little more difficult to rationalize.

Anthony Karydakis