Monday, December 17, 2007
Well, well well. Macro Man was offline on Friday afternoon, engaged in one of those "rich food and expensive claret" luncheons, but it looks like he missed a doozy. He's now the proud owner of a new £20 pound note, courtesy of the high CPI inflation print. The reaction of risk asset markets was pretty apt, given that the price rise was pretty broad-based. Headline, core, food, energy....it's all going up. And not just in the US of course! Just this month, Macro Man has already highlighted multi-year highs in CPI inflation in both Europe and China. The same, it almost need not be said, holds true in countries as diverse as Singapore and South Africa. Indeed, it seems as if there's only two kinds of countries that aren't experiencing multiyear highs in inflation: erstwhile hyperinflationary economies (Brazil, Russia, Turkey) who have a recent legacy of maxi-devaluation of the currency, and Japan. The question of what ails Japan is worthy of its own post, or indeed its own blog; suffice to say that the country is back in the doldrums. More interesting is the implication for other markets.
This week, for example, sees a round of liquidity auctions from the "Gang of Five"- the Fed, ECB, BOE, BOC, and SNB. This is the first shot in the banks' attempt at a microeconomic solution to the money market crisis. Yet the Fed, BOE, and BOC have already begun pursuing macroeconomic solutions via cuts in the benchmark interest rate.
The question which was always going to arise from such an effort is now pushing to the forefront of markets' agendas: how much can CBs ease when inflation appears to be a legitimate problem? One answer is "as much as they want", but that of course ignores the lessons of the 1970's. It seems pretty clear that the Fed's been dragged kicking and screaming into the last two easings, and it's not an unreasonable assumption to say that the bar will be set even higher for further monetary stimulus int he near-term. If, indeed, one can even think of the near-term; the next Fed meeting isn't until the end of January.
In the near term, then, adverse price may well have tied the hands of the Fed (and pretty clearly, the ECB), if not other central banks. There would appear to be little chance of CBs getting "ahead of the curve" as envisaged by most market participants. The upshot, then, is that risky assets are unliely to be on the receiving end of the warm bath of liquidity that has prompted the last couple of forays to the topside.
From a tactical perpective, therefore, the outlook for risky assets would appear to be somewhat unfavourable. Yet nominal bonds are not exactly screaming "buy me!" either. True, 10 year yields have risen almost 0.40% over the last couple of weeks. Yet they've failed to keep up with y/y CPI, and on that basis yields are now negative. Errr......no thanks.
So what to do? Risk assets look set to at least explore further downside, yet nominal bonds currently pay you nowt in real terms. Perhaps it's time to look at Macro man's old friend, TIPS. Not only do they provide the safety of government securities, but they also insure one's portfolio against further adverse price moves. Moreover, there is a seasonal component to TIPS that is worth considering, as the inflation compensation is calculated off of the non-seasonally adjusted CPI index.
Basically, Q1 generally sees a sharp rise in the NSA index, presumably due to new year's mark ups and administered price rises. The table below sets out the seasonality; the NSA index has never failed to rise at least 1% in Q1 this decade, with the rise exceeding 1.5% in each of the last four years. Indeed, in six of the last 11 years, the Q1 rise in the NSA index exceeded that of the subsequent three quarters combined! Put it all together and, for the next couple of months, TIPS look like just about the best long-side bet going. Macro Man will therefore bid 104 for another $25 million of the issue that he already owns. If done, he may well look to sell a bit of crude oil to hedge against a commodity price implosion.
Finally, we're approaching levels in EUR/USD where it is safe to conclude that The Economist cover curse has struck again. Macro Man is trying very hard not to read too much into price action. While the rally in the dollar could well reflect a repricing of the Fed, a downgrade of expectations elsewhere, a repatriation of USD by American firms looking to shore up balance sheets, or a bet of valuation, the reality is that currency markets appear to be following the script observed elsewhere, e.g. he who plays, loses.