From "Deflationary misery" to "inflation pain" the Fed's story over last decade

The long narratives are often quite different from short-term reality. Remember the post-GFC period when our greatest fear was deflationary misery. There was deep discussion on the pain, potential and actual, from deflation. The Fed, other central banks and academics spent countless hours discussing the issue of being policy constrained at the lower bound. The view from MMT advocates stated that inflation could never be a problem because it was so easy to constrain relative to deflation. The was little acceptance of the view that deflation is not always bad.

There is now no perceived deflation misery but real inflation pain for everyone. Businesses are facing pricing confusion and the potential for profit squeezes if they are unable to pass through price increases from good or labor increases. Labor is seeing real wages decline. Wages are going up, but the increases are not uniform, nor do they offset the short-term inflation spikes.

A common theme is that the Fed was not prepared for deflation risks and is not prepared for inflation pain. Using a precautionary view, it is believed that waiting will prove to be an effective response. Caution is good, but like any complex system there is uncertainty on the response time to policy so that overcompensation is real. The Fed actions today may not have an impact for nine months. Forward guidance and announcement effects attempt to reduce policy lags, but they still exist.

The overall investment them is that clear and present danger will likely be addressed quickly but anything short of a large shock will be addressed slowly and lead to real and financial trends. Caution can lead to policy errors. 

Beware of the Confirmatory Bias

“Contrary to the rules of philosophers of science, who advise testing hypotheses by trying to refute them, people seek data that are likely to be compatible with the beliefs they currently hold. The confirmatory bias [of our minds] favors uncritical acceptance of suggestions and exaggerations of the likelihood of extreme and improbable events . . . [our minds are] not prone to doubt. It suppresses ambiguity and spontaneously constructs stories that are as coherent as possible.”

“...evidence is that we are born prepared to make intentional attributions.” 

- Thinking Fast and Slow Daniel Kahneman

Most investors just look for data that confirm our current opinions. If we think the Fed will increase rates x times in 2020, we look for data that confirm our view of the world. If we believe that an oil price shock will generate a recession, we look for data to confirm that narrative. It is in our nature. The argument may be true, but that does not mean we should immediately accept it. 

The only way to move away from this confirmatory bias is to look for contradictory information to our current beliefs. If we cannot find any contradictory information, we are not looking hard enough. There is always another narrative to fit a set of facts. If you cannot find it, find a person that has an alternative view and ask for their logic. Don't ask someone to play the role of the devil's advocate. That does not work. Truly look for alternative views or data. Just beware of the confirmatory bias.

See:

Does your investment committee have a Devil's Advocate?

The value of dissent with investment committees - You want troublemakers; not devil's advocates

Bond dealers reduce exposure of corporate debt

What are bond dealers doing with their inventory? Tracking inventory is a helpful tool for getting flow sentiment on markets. If there is an increase in dealer inventories, it is a sign that the dealer community may believe that prices are going higher; otherwise, the dealers will not hold the bonds in their portfolio. If hedged with Treasuries, there is the expectation that spreads will tighten. Dealers may be stuck with inventory they cannot get rid of which will lead to excesses in their inventory levels but since bond dealers, especially for corporates, are not required to make markets, we generally find that bond inventories tell us something about the direction in prices.  

The chart above is from weekly inventory information collected by the NY Fed from primary dealers. Like the futures commitment of traders, it may not provide useful information every week, but it does confirm and provide insight at extremes.  The chart shows a combination of both investment grade and high yield bonds held in inventory. All bond exposures have fallen from January highs. Long exposures have especially fallen while shorter maturities have increased slightly. 

The inventory changes are consistent with the spread widening we have seen in both investment and high yield bonds. Given the current market uncertainty, we expect that the current inventory trends to continue. 

 

Value advantage from Buffett - Always try and incorporate value, if possible, in your decisions

 ‘‘Long ago, Ben Graham taught me that price is what you pay but value is what you get. Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.’’ - Warren Buffett

This Buffett quote has been heard by many, but it is important to remember even if you are a trader who focuses trend, momentum or carry. Value can be a tailwind or a headwind and if possible, you would like to have it serve as trade enhancer. All else being equal, buy cheap and avoid rich assets. Investing in trends moving higher for a cheap commodity will always be better than a trend higher of a rich commodity. 

Now, there may be doubt about where there is value in the market. Goods can be marked down or on sale and still be rich, so valuation is not easy to determine. Unfortunately, value is a moving target. It may not change every day, but, regardless of price, value today may not be value next month or next year.   

In the case of most trend-followers, there is no sense for what is value so the question of buying cheap is avoided; however, if there is reason to believe that a commodity is rich or cheap, then use that information to create an advantage. Nevertheless, the harder it is to determine the difference between price and value, the more likely there is an advantage with following trends. Without good valuations, the focus must be on movement of price.