That was the week that was – April 1, 2016

Markets – US equities versus bonds

It’s been good for US equities as the S&P has further consolidated its post-March FOMC meeting bounce. Apparent monetary dovishness has boosted confidence. The US$ has also weakened back to the lower end of its recent trading range and equities in particular like that.

The confidence in equities is something of a contrast with the bond markets. They don’t see the dovishness from the FOMC as that bullish.

Tuesday saw a big hit to shorter term rate expectations due to weaker than expected PCE Price Inflation, especially the famous Core PCE PI. Plus we saw big negative revisions in January’s actual PCE growth (both deflated, “real”, and actual, “nominal”) not accompanied by any strong move in February growth to compensate.

Equities should have been concerned by the weak real and nominal spending figures, but this may have been offset by the expected future benefits of a weakening currency and lowering of rate rise expectations. Expectations of FOMC rate rises fell back over the week to suggest one and one hike only in 2016, in November. Two-year benchmark yields fell back to just 72bps and ten year yields to 177bps. The yield curve maintained the same level of steepness but got more pessimistic about nominal growth across the curve.

We prefer to go with the bond markets on this one and expect their fear of lowflation to win out over equities optimism. Equities are likely to give back the recent rally and fall back to the bottom of the trading range, but not crash. The dollar will likely rally back up again.

Topic of the week

Although we discussed the PCE figures in DataWatch earlier in the week, the rumbling on of the inflation hawks is really remarkably stupid. They obsess about PCE Price Inflation so much that they forget that the important piece of data is actually the PCE itself. In most discussions they even lazily drop the “PI” (Price Inflation) and chatter on and on about PCE and Core PCE versus Core CPI and CPI, as if the actual data was irrelevant. Madness.

They prefer to go on and on about the array of exotic derivatives of the price indexes such as the really useless “trimmed mean” PCE and CPI. Apparently trimming off the outliers amongst the different elements of price indexes improves the quality of the figure. This is insane.

Inflation, if it is measurable at all, has to be for all goods and services. Cutting out some elements because they show rises too far from the average of all items will definitely not produce a reliable figure for the inflation element of nominal growth. Yet many institutions, including some of the US regional central banks piously feed this mania, searching for some “true” underlying inflation. None seem to spend any time on worrying about quality adjustments or spending patterns in the internet age.

As nominal growth is the right goal for a central bank, it has to be the actual nominal PCE, actual expenditure that is the most interesting number. I have tried to engage with some of these hawks on the issue and they are just too blind or too ignorant of any monetary economics other than the “inflation is bad” school of thought. It is not clear how they know. The evidence is very clear that the “bad” hyperinflationary 1970s were far superior for real growth than the “good” lowflationary 2010s.

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Perhaps we are reacting too harshly on these inflation hawks. They seem to have little influence on bond markets, the ultimate guardians of inflationary expectations. Although market implied inflation expectations have rebounded somewhat they are still well below 2%. And these are expectations for CPI not the PCE PI that the Fed says it targets. The latter runs about 0.5% below CPI so the inflation expectations for the Fed’s target are running at only 1.2%.

Even defenders of the concept of the measurability of inflation believe that CPI overstates “true” inflation by 0.8-0.9%. So market-implied expectations of “true” inflation are less than 1%.

The odd thing is that the Federal Reserve is impressed, or is it scared, by these inflation hawks and most often seems just as hawkish, despite clear evidence from the bond market that there is little or no inflation.

You don’t have to go to the length of calculating implied inflation using TIPS, just look at the benchmark ten-year bond yield drooping along at 1.8%. Even this is a high figure versus some major competitor countries like Germany where it is 0.2% or Japan where it is negative.

Markets worry about this bias to hawkishness at the Fed and it keeps a break on easier monetary policy and thus on nominal growth, and thus on real growth. There just isn’t enough monetary growth to ensure good degrees of price flexibility between growing and declining sectors. Enforcing a one size fits all is not good policy.

Data

We have already discussed the PCE both in our DataWatch section and just now. The crash the PCE release caused in the Atlanta Fed GDPNow 1Q16 forecast shows just how important is the actual PCE data, and not the price index. Most of the inflation hawks are too blind to see this rather obvious fact.

Friday’s monthly jobs and wage data for March did not measurably affect the 1Q16 GDPNow forecast. The unemployment rate crept up, mostly due to a small increase in the labour force participation rate. Wage growth was very dull.

A comical piece of work from the San Francisco Fed trying to justify its sister Atlanta Fed’s “Wage Growth Tracker” that shows that adjusted for mix effects there is apparently some better wage growth. But new entrants to the labour force are on far lower wages than those exiting. So, big deal. Adjusted to exclude bad stuff, most data is good … and vice versa. We are concerned with the whole economy not just bits of it, that is what Aggregate Demand means.

After a somewhat surprising mini “surge” in average hourly wages towards the end of last year that got both inflation hawks wringing the hands, the FOMC raising rates, the longer term “Philips Curve is dead” trend has reasserted itself. Nominal wages cannot accelerate while base money growth and NGDP growth are so dull.

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Base money has not been too good over the last few weeks and this very dull trend continues. It is beginning to look as if the average of 2015 for base money of around $4tn has been broken and a new, lower, level of around $3.8tn established. A 5% cut may not seem much but it will be very bad for nominal GDP growth prospects.

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Next week we get to see the services PMI’s, both the bi-monthly one from Markit and the “official” one from the ISM. Some regional Fed surveys showed a bit of a rebound in March so it will be interesting to see what they say. They are far better leading indicators, or even coincident indicators, of the state of the economy than lagging jobs data or consumer confidence, based on their job prospects.

There may well be a bit of recovery from very poor recent surveys of the service sector, but we do not expect it to last many months.

The cacophony of inflation hawks and, importantly, the market’s belief that the Fed will listen to those hawks will ensure the market thinks the Fed will become a bit more biased towards tightening if any run of good news does occur, and so putting a stop to it.

Janet Yellen recently emphasised that market beliefs about the Fed’s reaction function acts as a buffer against shocks.

Sadly, this can equally apply to positive news as well as to negative news. When the news is good, the Fed’s use of mistaken Philips Curve economic models means the market will take it as bad news unless the Fed makes clear they have abandoned those models. So good news on the services sector surveys may well be the classic “good news is bad news” event. It’s so hard for the market to tell what the Fed thinks when it is relying on such a broken rudder – especially when it doesn’t even realise the rudder is broken![/vc_column_text][vc_empty_space height=”32px”][vc_column_text]

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