Not going to end well?

The University of Michigan Consumer Inflation Expectations survey plunged this week to its lowest level on record.  Interesting, in that Brainard (as an example) implied last week that falling inflation expectations can have a negative feedback loop.  “We cannot rule out that stubbornly low inflation may be having an effect on inflation expectations.”  Bullard has made similar comments.

I don’t read much into the U of M surveys, but there is one thing in the confidence data that I do think is quite interesting.  I created a spread chart of Consumer Current Conditions vs Expectations (below).  The spread value is in the lower panel, last at 28.5.  I am just taking the data at face value; I did not do an in-depth study of components.  This chart below only goes back for 5 years, but I examined the data from the start, in the 1950’s.  Notice that CURRENT conditions are right at the high.  But EXPECTED conditions aren’t.  In fact, earlier this year, (due to the stock swoon, no doubt) the spread between the two hit a high of 29.1.  This is the highest level since August 2006, when oil was in the midst of an historic surge and the spread hit 35.8.  Interestingly at that time, the current conditions index was right around where it is now.

UM Cons Expectation

Using a three month MA of the spread, it’s at the highest level (27.5) since June 2007, right around when Bear Stearns’ mortgage funds failed.  There aren’t many readings of the three month MA above 26; my theory is that when future expectations are well below current conditions and the spread is high, it’s a pretty good indicator that things are going to go south.  Conversely, when the values are low, like in mid-2009 when both CURRENT and EXPECTED were in the high 60’s, things are likely to get better (can’t get any worse).

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The phrase, “This isn’t going to end well” is overused.  Most things don’t really just end in a big bang disaster, they deteriorate over time, sometimes faster and sometimes more slowly.  In 2008 of course, it seemed rapid because the twin wealth-loss effects of both real estate and equity values were extremely clear.  But the developed world is now undergoing the slow erosion of accumulated wealth through the decline of interest rate income.  Bond yields everywhere are simply too low to support forward living standards and the demand to borrow for new productive endeavors is not apparent.  For example, Morgan Stanley asked how companies were beating earnings estimates, and the majority pointed to expense cuts, rather than top line growth (spurred by new investments/projects).

It’s a slow drip, but can be debilitating over time.  We’re likely somewhere in the middle rather than near the “end”.  The crash in 2008 was an overt sign that things had gone wrong, and confidence in the system was at the nadir.  But now, with rates near zero, there are fewer ways to generate returns, and those come with asymmetric risks. One of the Fed’s goals in raising rates last year was probably to instill confidence that things were much improved and on an upward trajectory.  The long end isn’t buying it.  2/10 treasury spread remains pinned to the low at 90 bps, and the ten year yield closed at its lowest level since February, which in turn was the lowest since late 2012.

Over and over again I have seen charts with steady trends that are then shattered by a violent move that wipes out a large portion of former gains. I’ve always thought that the key is to try to sidestep those moves.  In terms of asymmetrical risks, central banks, through policies which force spread compression, remove the cushion that absorbs shocks.  The cartilage is gone, it’s now all bone on bone.  Many commentators have mentioned this risk in bonds….at these super low yields, if rates move up by a tiny amount then all the former income is wiped out and there’s the added kicker of a capital loss.  That’s why it resonates when former Dallas Fed President Richard Fisher says his rich friends are all hoarding cash.

As another example of asymmetry, look at the VIX index.  Portfolio managers are inclined to sell a bit of premium to squeeze out a few more bps of return, giving the VIX a downward bias.  But consider the last few weeks.  From May 10 to May 19 SPX pulled back from 2085 to almost 2025, 60 points.  This week, SPX pulled back from 2120 to 2090.  Over the first time frame, VIX went from a low of around 13.3 to 17.7.  Over the second time frame, a much shorter period with a much smaller absolute and percentage move, VIX went from sub-13 to 17.3.  A greater sense of risk is palpable.

The increased odds of Brexit are undoubtedly one of the reasons for this.  But China still represents another danger, as noted in this story from Reuters:

David Lipton, first deputy managing director of the IMF, warned in a speech to a group of economists in the southern city of Shenzhen that companies’ indebtedness is a “key fault line in the Chinese economy”.

“Company debt problems today can become systemic debt problems tomorrow. Systemic debt problems can lead to much lower economic growth, or a banking crisis. Or both,” Lipton said, according to a copy of his prepared remarks provided to Reuters.

Lipton said corporate debt in China stands at about 145 percent of gross domestic product, a high ratio. He singled out state-owned enterprises, which he said accounted for about 55 percent of corporate debt but only 22 percent of economic output, according to IMF estimates.

Note: US Corporate Debt to GDP is only around 50% (Corporate Debt is $8.28T according to this week’s Flow of Funds release).

There likely won’t be much drama associated with this week’s FOMC meeting.  Again the market is sending pretty clear signals that odds of tightening have diminished appreciably.  For example, all one-year Eurodollar calendar spreads made new lows.  The first ten one-yr spreads are between 19 and 22 bps.  Really flat and without curvature.  Other news this week includes Retail Sales Tuesday, expected +0.3/+0.4 and inflation data on Wednesday and Thursday.  (FOMC announcement and press conference on Wednesday afternoon).

Posted on June 13, 2016 at 5:21 am by alexmanzara · Permalink
In: Eurodollar Options

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