Eliminating Volatility from Inflation Measures

The FT covers statement's by the BoE's chief economist, Charles Bean, that the U.S. should not strip out food and energy from the inflation measure used to set policy:

The US Federal Reserve is wrong to focus on core measures of inflation that exclude energy prices, Charles Bean, chief economist at the Bank of England, has suggested. It should focus instead on headline inflation, which is much higher, he argued. Including energy and food costs, US consumer price inflation is running at an annual rate of 4.1 per cent, against 2.7 per cent for core inflation.

Mr Bean told the Fed's annual Jackson Hole symposium at the weekend that energy prices were rising for the same reason the price of many manufactured goods were falling: the rise of China and other emerging market economies. Since both price trends had a common cause, he said it makes little sense to focus "on measures of core inflation that strip out energy prices while not stripping out falling goods prices as well."

This debate gets brought up a lot by inflation hawks but I like his reasoning about China being the driver on both fronts. Also I was struck by the idea that while the U.S. eliminates food and energy from the top line to reduce volatility in the data, U.S. overnight rates have been quite volatile.

I guess this stuff is neither here nor there since the data including food and energy is still available and the bond market approves of the FOMC's view by keeping the inflation outlook low.

European Interest Rates

From the FT:

Hints by Jean-Claude Trichet, ECB president, and Otmar Issing, the bank's chief economist, that the possibility had increased of borrowing costs falling have contrasted with comments by several national central bank governors on the committee.
The differences highlight the dilemma faced by the ECB. Economic growth, lacklustre for the past four years, has slowed again, and politicians are increasing the pressure for a further cut in borrowing costs. But excess liquidity and oil price increases are sounding inflationary alarm bells.
The confusion puts pressure on the ECB to clarify its stance at its next rate setting meeting on July 7.

I wrote last week that I doubt U.S. interest rates will plunge like Japanese rates did in the 90's. I am much less convinced that the same can be said for Europe. The U.S. is in a much more attractive position to prevent deflation because lowering U.S. interest rates mostly punishes foreign lenders. Europe's higher savings rates make the ECB's decision tougher. In the end I think they will cut rates (maybe this fall) and I am guessing it will happen while the euro is rising rather than falling. I would also expect the ECB to follow any rate cuts by the U.S. Fed this time around too.

Marc Faber on Currencies, Commodities

From the Bloomberg:

Once the US economy deteriorates, the Fed "will go back to the old medicine, which is essentially to print money and the dollar will weaken again," Faber said in an interview with Bloomberg News yesterday. "Compared with the euro, the Asian currencies are very, very inexpensive."
...
``The foreign exchange market will anticipate this easing beforehand'' resulting in a drop in the dollar, said Faber, adding that he was a ``reluctant'' holder of dollars.

Some investors and traders disagree. Fifty-nine percent of the 54 strategists, investors and traders surveyed globally on May 20 said the dollar is poised for its longest winning streak against the euro since 2000 on expectations the U.S. currency's three-year bear market has ended.
...
Faber is also betting on gold because it has become cheaper compared with commodities such as crude oil.

Today, one ounce of gold, trading at $417.60, is worth about eight barrels of oil, according to Faber. In 1998, when oil fell to less than $11 per barrel, gold was trading at about $285 an ounce. That's equal to about 26 barrels of oil per ounce of gold.

``You should be long gold and short oil,'' Faber said. Commodity markets ``aren't particularly attractive.''

Hard to disagree with any of that. I would not hold dollars right now - even "reluctantly".

The EUR/JPY chart I put up just before the strong U.S. retail sales numbers still seems very relevant.

Equities, Bonds, and Inflation

I imagine we are making near term highs in the equity markets. Maybe slightly above here over the next 4 days and then a pullback. Maybe to 36.20 in the QQQQ. I am chucking out some of my longs with plans to kick the rest out tomorrow. Maybe we are into a topping process that leads to some good long term shorts but I would say it takes a couple of weeks and will be staying flat on equities and watching.

I am going to start building a long bond short in here. Going to go slow as it seems like the dollar might need to top out to create any real weakness.

I don't see this mornings inflation number as a problem and generally just see it lagging the PPI top. I don't see how that top can get taken out without a massive reversal in commodities. Those charts are disaster zones and probably need to base for 2 months. If I am wrong and that rally relaunches I would reconsider my view that inflation fears peaked in March and are headed lower.

Weakness Again

This is the 3rd day since last Wednesday that the sellers have surprised me a bit. I am now mostly flat and with some positions in commodity related names. I also went short housing stocks as a partial hedge to be long tradable goods against versus the U.S. housing market. The short is quite a bit smaller than the longs just because there are obviously some large hedging issues trying to use producers as a proxy for home prices (same problem but to a lesser extent on the commodity side). I will probably end up treating commodities and homes as two separate trades but for now I think it makes sense.

With the poor jobs showing again this morning I really see two scenarios for inflation and rates: One, weak growth reverses inflation trends and interest rates stop rising. And two, cost push inflation leads to higher interest rates slowing growth. I am leaning towards the second. In the first housing and commodities go down together but in the second my trade should make money on both sides.

Ready for the Jobs Report

Bill Cara summarized the odd strength in bonds in the face of some scary oil news. Also on oil I would point out the IEA recommendation to help panic consumers. Sounds like the rolling brown outs in California a few years back, but for cars. News like this has the potential to eventually undermine the anchoring of inflation expectations if and when it is affecting day-to-day living.

I first heard calls for $85 oil back in December, then again at the beginning of March. Then we had an OPEC meeting that basically indicated spot prices are now driven by estimated demand in Q4 and thereafter. With spot prices unhinged from the present details that market is ripe for speculators to push the price wherever they want. In judging the moves it is probably best to keep an eye on the far forward contracts rather than the front month.

Adding to the inflationary comeback yesterday, Merrill Lynch increased its price forecasts for copper, aluminum, nickel and zinc for the next three years. The industrial metals did not respond too dramatically but stocks like Phelps Dodge (PD) are now back wrestling with their breakdown point from Tuesday.

The dollar was steady to down and bonds rose on all this information. I don't think the jobs report will add to inflation pressures but instead will continue to be lackluster. This provides fuel for people like Roach who question whether the Fed will really fight inflation in the face of weak growth. That is a recipe for steepening.

Stocks look like they could stay strong no matter what the number but it kind of feels like the dollar wants to come back down a bit. We shall see.

Stocks get Whacked on Bond Selloff

Didn't really see that coming. It is hard for me to understand the weakness in stocks given the FOMC statement. Since they hit my "bullish" case (along with expectations), I hate to think what would have happened had they not.

My feeling is that bonds got caught very wrong footed following this AM's PPI. The sharp reversal easily broke new lows in 5s and 10s which left them little chance to recover. Stocks in all sectors got sold , being led lower by Citibank (C) and AIG (AIG). I still think there is a chance for an equity rally tomorrow but am generally surprised at the way the stock market fell apart today.

I am particularly surprised that gold, silver, and copper stocks all came off with the market. I realize the dollar rallied but there is a disconnect between inflation fears and commodity weakness.