Tuesday, September 21, 2010

Fed policy restarts the reflation trade

The FOMC's announcement today didn't reveal any signs of panic on the part of the Fed, but it did further open the door to another round of quantitative easing (aka QE2): "... the committee is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate." The market rationally interpreted this to be yet another sign that the Fed would rather err on the side of more inflation rather than less (or deflation). Predictably, measures of inflation expectations rose across the board. Gold has risen some $37/oz. so far this month, reaching yet another all-time high today. Gold is up against almost all currencies this month, but more so against the dollar, since it has fallen about 1.2% against a basket of major currencies.

TIPS are a reliable, if conservative, hedge against inflation, and TIPS yields/prices reached a new all-time low/high today. This is a direct reflection of investors' demands for inflation hedges, just as are record-high gold prices. Real yields on 10-yr TIPS have fallen 20 bps so far this month, while yields on 10-yr Treasuries are up 10 bps on the month; this translates into a 30 bps increase in average annual CPI expectations over the next 10 years. A more sensitive measure of inflation expectations, which is preferred by the Fed, is the 5-yr, 5-yr forward breakeven inflation rate; it has risen by over 50 bps so far this month, to a current 2.54%.

Other sectors of the bond market also reveal a recent increase in inflation expectations. As the chart above shows, the spread between 10- and 30-yr Treasury bond yields is now about as high as it has ever been (on a daily basis, we saw a record-high spread of 124 bps in early August). By insisting that short-term rates will remain low for a long time come what may, the Fed has helped 10-yr yields fall. But investors in 30-yr bonds have little or no reason to worry about what the funds rate will average over the next 10 years (a factor that does weigh heavily on the decision whether or not to buy the 10-yr), and they have decided that inflation risk outweighs carry concerns; as a result, 30-yr yields are up 25 bps on the month while 10-yr yields are up only 10 bps.

So we have now reached the point where the Fed's actions and its talk are definitely boosting reflationary expectations. By the same token, deflationary fears are declining. Monetary policy is "gaining traction," as economists are wont to say. Much as I hate the thought of higher inflation, I am not surprised to see equity prices up almost 9% so far this month. Reflation is good news for the equity market (and for high yield bonds) because a) it perforce reduces deflation risk, and b) it increases expected future cash flows without (so far) causing any significant rise in long-term interest rates.

My sense is that with the economy still on the mend—albeit slowly (i.e., modest growth of 3-4%, enough to bring down the unemployment rate in a very slow and painful fashion), and reflationary monetary policy gaining traction, we are now seeing a virtuous cycle kicking in that will at the very least act to help the economy grow. Consumers and businesses that have been hoarding massive amounts of money (as reflected in 12% decline in the velocity of M2 since the end of 2007) are now feeling increased pressures to unhoard some of that money, releasing it to be spent in a fashion that boosts nominal and real GDP. In the latter stages of this reflation process we would likely see an obvious buildup of inflation pressures, but for now this is of secondary concern.


John said...

The 'reflation trade' is bullish for the banks. Bank stocks have underperformed. The Fed is allowing them to reflate their balance sheets.

Something very similar occured during the 1990s. After the S&L debacle the banks had to raise capital (sound familiar?) and their stocks were lethargic for several quarters (hmmmmm). The Fed held rates low while banks were loath to lend. Credit quality slowly improved and as the economy recovered loan demand improved. The banks went on to record several years of increased earnings and early investors in bank stocks did extremely well...not just for a year or so, but for many years.

I was a working broker during those years and personally experienced the multi year bull market in bank stocks. I believe it is setting up to happen again. If you wait for the headlines you will not get the bargains. IMO high quality bank stocks are cheap. They will not stay that way. Suggestion: do some homework. There are low risk ways to participate if you seek them.

Those who think the world as we know it is about to end, please disregard this.

marmico said...

Those who think the world as we know it is about to end, please disregard this.

The world is not ending (well the Mayan calender says 2012) but I'll disregard you none the less. How many newsletters do you subscribe to in order to cut and paste gibberish?

The reflation trade, huh. No where to be seen.

Some reading material.

Benjamin said...

Excellent commentary by Scott Grannis. Even if I disagree, the intelligence and fairness in Grannis' demeanor and writing makes him a very enjoyable read. I always learn something. It helps to have an open mind, if you want to learn.

Inflation is dead, dead, dead, and we may already be in deflation, if you believe the findings of the Boskin Commission. I do, and so did Milton Friedman. Given the marvelous flexibility of the modern-day private sector, I suspect static CPI measurements are out-of-date before fielded.

I think interest rates are dead for a long, long time. They may even lag inflation--we may see negative interest rates for high-quality debt. The world is drowning in capital--even in this market, institutional investors plopped down $300 a sf for a downtown Los Angeles office tower yesterday, that had a good anchor tenant.
They sensed safety, and they paid big for it---otherwise they can sit on their money, and that does not impress clients, who are already sitting on heaps of money.

That means the Fed has the field wide open. They can run-and-gun, and feeble inflation will not tackle them (well, football season is upon us).

The Monetary Bulls needs to come to fore, and chase away the weakling Japan Wing of the Fed.

John said...


Thank you. I agree my last paragraph should not have been added. I will refrain from such in the future.

Benjamin said...

I am no fan of Paul Krugman, but I read his column. The guy is impressed with himself, but then he has some credentials.

Today, he had a point.

"The Fed Speaks

We’re failing in our mandate to deliver full employment; meanwhile, inflation is below target; therefore, we’ve decided to do nothing.

Oh, and why does the Fed keep saying that inflation expectations are stable?

Here’s the five-year breakeven rate, the difference in yields between ordinary 5-year bonds and inflation-protected bonds: (a graph here showing declining inflation expectations).

Last winter, the market briefly thought the Fed might hit its target inflation rate; since then it has been saying, in effect, that inflation will stay too low for a long time. And based on what we know about prolonged periods of economic weakness, the market is probably too optimistic."

He has a point. If inflation is dead and the economy feeble, why are we afraid of some monetary bullishness?

Buddy R Pacifico said...

From Scott's comments:

" Consumers and businesses that have been hoarding massive amounts of money (as reflected in 12% decline in the velocity of M2 since the end of 2007) are now feeling increased pressures to unhoard some of that money, releasing it to be spent in a fashion that boosts nominal and real GDP."

Microsoft has announced a 23% increase in its dividend becuase of pressure to reduce its cash hoard of an estimated $37 billion.

What is extremely interesting and enlightening is that funds for the dividends will come from issuing $6 billion in AAA debt. Why is that if the company is has over six times that in cash?

Interest rates for bonds are maybe the lowest they will ever get are one reason. The biggest reason is that so much of the cash is held in foreign affiliates and the tax consequences of bringing back to the U.S. are much to high.

The U.S. corporate tax rate averages about ten percent higher then other industrialised countries and is only exceeded by Japan. Veloicity of money will increase some by MSFT issuing debt but the real, massive and prolonged driver of velocity would be to lower the U.S. corp, tax rate to repatriate cash to the U.S.

BTW, It is estimated that U.S. corps. have a trillion dollars in cash and a significant percentage of that is overseas.

Scott Grannis said...

Buddy: excellent points. Even if MSFT sells debt to fund the increased dividend, the net result is that MSFT's desire to hold cash has dropped. This helps boost money velocity. This is most likely to continue and to build, and if the Fed is not watching carefully, it could become a source of inflation very quickly.

Public Library said...

More the like household penalty and mal-investment trade...

-Bank of Japan Masaaki Shirakawa argued among other things that “protracted low interest rates play an important role in preventing an economic downturn, but, at the same time, they tend to delay adjustment in excesses accumulated during the period of bubble expansion. In addition, they also tend to delay the rejuvenation of businesses.”

I think this is a very important point. By effectively taxing net depositors in the banking system (households) and using the proceeds to subsidize net borrowers (SOEs, large manufacturers, real estate developers, infrastructure investors, local and municipal governments, etc.), artificially low interest rates can prop up growth by increasing investment, but they do so by simultaneously encouraging overinvestment, especially in capacity, and discouraging household consumption. In China this process worsens the already horrendous domestic imbalance.

Buddy R Pacifico said...

Scott, thanks for your response. My premise concerning repatriation of oversears cash by corporations is to increase velocity of money and to grow the economy. I think this is a better approach then QE.

Here is link to short paper by Allen Sanai on how repatriated cash was used by corps after the most recent tax holiday. Two-thirds of the repatriated funds were used for U.S. capital purchases, U.S. hiring and U.S. based R&D.

Scott Grannis said...

I agree completely. We need to cut our corporate tax rate by at least as much as is needed to remain competitive with other countries. I would even argue that the corporate tax rate should be zero, since corporate taxes are ultimately passed on to the consumer anyway. It's a very inefficient way of taxing.

Family Man said...


Is the "currency war" (BOJ, FED, BoE)any worry for you.


Scott Grannis said...

The value of the dollar is a very important concern for me, since I think that is a good indicator of the effective stance of monetary policy, and a good leading indicator of the future direction of inflation. I don't like it when the dollar depreciates, especially when it is (as now) at the lower end of its historical valuation range.

Family Man said...


As for US quality banks I am in your camp. They are good antideflation play, as their current valuations (at least some of them) discounts deflationary environment which in market opinion translates into weakening profitability. Another words, deflation is in the price, so there could be a real and even worse deflation to get the banks drifting lower.