Unintended Inventory
I took an economics class from Robert Eisner, a nationally distinguished professor who was an expert on Keynes. About the only thing I remember from college (it was a long time ago) is this: Investment doesn’t necessarily equal intended investment. This idea is at the heart of Keynesianism. Previously, if unsold product built up, classical economists thought that rates would decline, investment would be spurred, hiring would pick-up and inventories would be worked down to intended levels. Self-correcting. In Keynes’ model, cause and effect of various actions were viewed differently; he concluded that in the classical model, unemployment would not necessarily get back to previous levels, especially in a liquidity trap, hence government spending could be used to fill the gap. I know I’ve muddled the story, but the main point is that we often mistake cause and effect; attribute a particular market action to something that might just be correlation, not causation. Our internal model doesn’t allow for a quirk that might give perennially bad results. Has the dollar declined because Core PCE inflation has declined this year? Has the yield curve flattened to near multi-year lows because the Fed is too tight? If the Fed is tight then why is the dollar declining? Is the dollar falling BECAUSE the curve is flattening?
In terms of unintended inventory, I recall a floor story told to me in great detail by a front month euro$ pit broker, in the days when the near month contracts MOVED, long before electronic trading. This was also prior to dual trading rules, so he traded his own account as well as filling orders, and it was in the time before 0.5 bp price increments. He was short in a rising market and yelling out an offer: “3000 at 8; 3000 at 8.” Good size in those days; most people would think he was representing a ‘desk order’ but in this case he was trying to personally hold the market down (also in the days of pre-spoofing rules). Once again, “3000 at 8!” and a local just looked over, said ‘buy ‘em’ and never even glanced back at the broker, just looked down, carded the trade up, and bid 8 to follow. “Buy ‘em”….that’s the whole order. The narrator said all the air was just sucked out of his body at that moment. A visceral case of unintended inventory.
One would think in our current world of computer networks and just-in-time methods of product delivery, there could almost never be an unintended inventory issue. Yet I saw a few articles that suggested Hurricane Harvey, with its widespread destruction, went a long way in ‘solving’ the auto industry’s inventory problem. [Estimates of 500k cars damaged; cash-for-clunkers in 2009 led to 700k vehicles traded in]. Sure, there will be re-building to spark growth, but there has also been a huge loss in wages, in production, in sales. What will the net effect be?
“The public has been conditioned by frequent natural disasters to think that nobody has to eat the losses, so that in effect loss doesn’t exist, just as the nation’s central bank has engineered the belief that risk no longer exists in the management of capital.” (Howard Kuntsler).
In tying together the idea of inventory and management of capital, I would guess that many investors don’t have much sense of how much ‘short vol’ is in their inventory, and little idea of the total magnitude of capital committed to the trade. But we do see that items of limited supply, like bitcoin, can ramp up in price quite powerfully.
This week, Core PCE yoy price index was released at only 1.4%. It has declined steadily this year, having started at 1.8%. It’s now way below the Fed’s 2% target. Also this week, the dollar index (DXY) made a new low for the year. Many measures of the yield curve flattened to new lows. 2/10 treasury spread closed below 80 bps on Thursday (having been as high as 136 post-election). Red/gold euro$ pack spread (2yr forward vs 5 yr forward) was 100 bps in January, but closed 52 on Thursday. Red/green euro$ pack spread (2yr frd vs 3yr frd) is below 17 bps. All of these spreads are nearing the lows of 2016, before the election of Trump gave hope that stimulus measures would boost wages and infrastructure. The pre-election lows in 2016 were the flattest the curve has been since 2007/2008, when yields were high and the crisis was starting. Currently, one-year Eurodollar calendar spreads are all below 25 bps; the market is not pricing forward tightening of more than one hike in any given year.
So we’re back to cause and effect. Is the government perceived as impotent regarding stimulus at the same time that the Fed has removed a small measure of accommodation, thereby causing inflation to decline, which is flattening the curve due to a lack of inflation premium? Is the USD simply responding to the curve, weakening as the curve flattens? Will the weaker dollar eventually spark inflation in USD denominated goods, or is the flip side more ominous, that strength in the euro will slow down progress made in the Eurozone? As Treasury Secretary Mnuchin said this week, a weaker dollar is somewhat better for US trade. Everyone wants a weaker currency so someone else can buy their products.
The interest rate market and the dollar seem to be telling us that the economy isn’t all that great and perhaps a slowdown is in the cards. The short term curve is saying that Fed tightening isn’t necessary and indeed may lead to a negative outcome. The dollar is softening because it won’t be underpinned by higher rates. Stocks are firm because, in a slow growth/low inflation economy, investors are drawn to large cap tech stocks as they almost appear to have the safety and liquidity characteristics of bonds. Which market will give a true signal of change?
We’re in a month where government influence will be on display, center stage (for better or worse). Congress is back to tackle the debt ceiling and budget. The Fed meets in two and a half weeks and may initiate the balance sheet adjustment plan. Most importantly, we may see a more forceful reaction to N Korea’s sixth nuclear test, a hydrogen bomb.
My internal model tells me that 3 day weekends sometimes correspond to trend changes. (Is that vague enough?) I will note that on Friday many interest rate contracts made new high prints for the year and then reversed, with outside ranges and lower closes. That’s a signal that buying in rate futures has been shut off, but given the geopolitical back-drop, a safe haven bid can quickly dominate all else. Dec Gold settled at a new high on the year, and at $1330, is up over $110 from the low set in July.
