Markets May Get Some Relief; Economy? Not So Much

by: Michael Ashton

There is a very interesting development in inflation land: Deutsche Bank (NYSE:DB), which along with Credit Suisse (NYSE:CS) distanced themselves from less-innovative firms earlier this year when they issued ETN / ETF structures that allow an investor to invest in a long-breakeven position, has created a tradeable index that proxies core inflation.

Now, it isn't any mystery that you can create core inflation by taking headline inflation and stripping out energy (and, if you feel like torturing yourself with tiny futures positions, food) – for example, I presented a chart of 'implied core inflation' in the article linked here - so the DB product doesn't break any new theoretical ground. But it is a huge leap forward in that it allows more market participants to trade something that acts like core inflation in a direct way.

Why would an investor care about core inflation? Is it because he "doesn't care about buying gasoline and food"? No, an investor may wish to buy a core-inflation-linked bond for the same reason that a Fed governor wants to focus on core even though all prices matter: core inflation moves around less in the short run, but in the long run core and headline inflation move together. The chart below (Source: Bloomberg) shows the core CPI price index, and the headline CPI price index, normalized so that they were both 100 on December 31, 1979. Since then, prices have tripled, whether you are looking at headline or core. The difference in the compounded inflation rate? Core inflation has risen at a 3.471% inflation rate, while headline inflation has grown at 3.415%.

Click to enlarge

This is why central bankers want to focus on core – headline provides lots of noise but almost no signal. And it's the same reason that investors should prefer bonds linked to core inflation: you get virtually all of the long-term protection against inflation that you do with headline-inflation-linked bonds (like TIPS), but with much lower short-term volatility.

Now, Deutsche's index isn't truly core inflation, but a proxy thereof. It appears to be a decent proxy, but it is still a proxy (and we have some more theoretical / quantitative critiques that are beyond the scope of this column). And their product is a swap, not a bond (although it would not surprise me to see bonds linked to this index in the very near future). So it isn't perfect – but it is a huge step forward, and Deutsche Bank (and Allan Levin, the guy there who has the vision) deserves praise for actually innovating. Innovation tends to happen on the buy side-- and with smaller firms, not with big sell-side institutions-- and we should cheer it when we see it.

Now, back to actual markets: today the ECB is expected to announce a new program of buying periphery bonds when necessary. Actually, it is a bit more than expectation, since the plan was leaked yesterday. Supposedly, the ECB will announce that they are going to do "unlimited, sterilized bond buying" of securities three years and less in maturity.

The Euro was somewhat buoyed by this news. The idea is that big bond purchases will bring down sovereign yields, but sterilization of the purchases will mean that it isn't truly monetization and therefore not inflationary.

This seems ridiculous to me. I am not surprised at the idea that the ECB would conduct large purchases of bonds that no one else seems to want; they did quite a bit of that with Greece, after all. But I've lost track – are they still sterilizing the billions in bonds that they've already bought, as well as the two LTRO operations which they claimed to sterilize, but never explicitly did except through the expedient of paying interest on reserves to sop up the liquidity?

How are they going to sterilize more purchases? There are basically three straightforward ways for a central bank to remove liquidity from the market. We used to think that there were only two, because the only ways the central bank ever did it was to (a) conduct large reverse-repurchase operations in which the central bank lent bonds and borrowed cash, taking the cash temporarily out of the economy and (b) to sell bonds outright, to make a permanent reduction in reserves. Now we recognize a third option, although we're not sure how efficacious it is: (c) raising the interest rate on deposits of excess reserves at the central bank, so as to discourage the multiplication of those reserves.

But for the ECB's purchases to be effective in terms of their size, they will be far too large to use reverse-repos as a sterilization method; and it doesn't seem to make much sense to be selling bonds when they're buying other bonds, unless they want to try and push up the yields of countries like the Netherlands and Germany (which might not be politically too astute) at the same time that they're lowering the yields of Spain and Portugal. And they just cut the deposit rate to zero in July…are they going to raise it again?

I can understand the political cleverness of such an announcement, if the ECB makes it: make the bond buys "unlimited" to suggest that they can't be out-muscled, but also sterilized so it's not printing. But these can't both be true – because there is not unlimited capacity for sterilization. That plan can only work if, in fact, the ECB doesn't actually buy many bonds. In the past, they've tried to trick the market into rallying with "bazooka-like" comments so that they didn't actually have to do anything. To date, it has never worked. I doubt this will, either.

Back in the U.S., the wave of Employment data is about to hit. Thursday morning, Initial Claims (Consensus: 370k) will be released; about Claims the only thing I want to note is that while it is down considerably from the peak of the most-recent recession, it is only slightly below where it was at the peak of the last recession. Over the last 52 weeks, Claims have averaged 381k; in May of 2002 that average reached 419k. Also due out today is the ADP report (Consensus: 140k), which is expected to weaken slightly from last month's figure. On Friday, of course, the Payrolls report is expected to show a rise of 127k new jobs with the Unemployment Rate steady at 8.3%.

Some observers have made a lot of the fact that the Citigroup Economic Surprise index has risen from -65 or so in July to nearly flat now. But this is not a sign of improving economic conditions; it is a sign of improving economic forecasts. Remember that this index doesn't capture absolute levels, but the degree to which economists are missing. The current level is near flat because economists adapted their forecasts to the weak data, not because the data improved to catch up with the over-optimistic forecasts. I wouldn't draw much relief from that indicator.

Now, with the ECB and the Fed on the calendar over the next week, markets may well get some relief. But the economy, not so much, even if we do deserve it.