Goal oriented monetary policy and hidden sources of volatility, discussed at the US Monetary Policy Forum last Friday, sparked articles in the New York Times, the Financial Times and the Wall Street Journal over the weekend. With investors seeking income in bond and money markets while nervously watching for when Fed policy will shift to higher interest rates, the discussions offer some interesting hints.

In the last year or so the Fed repeated that it wants inflation at 2% and will not raise interest rates until the unemployment is under 6.5%.  The unemployment rate is now a tenth of a percent away from the target but arguments that it is sending misleading signals are widespread. Inflation, as measured by the Fed’s preferred gauge of the deflator on personal consumption expenditures, is well below is its goal. In one presentation Charles Evans, president of the Chicago Fed, proposed that an explicit function could be used to show the trade-off between the inflation and unemployment targets.  He suggested that Fed policy would minimize the loss function:

V=(Inflation – 2%)² + (unemployment – 5.5)²

The farther unemployment is from its target or the farther inflation is from its target of 2%. The 5.5% unemployment is the Fed’s forecast for 2016; there is no agreed target for unemployment.  This is an improvement over the Taylor rule which chooses the Fed funds rate based on inflation.  The Evans approach gives an explicit goal and shows the trade-off between the Fed’s dual – but sometimes conflicting – mandates of inflation and employment. In the spirit that a picture is worth 10,000 words, the chart (from Evans’ speech at the conference, available at the Chicago Fed’s web site) gives the target.

One other comment by Charles Evans is worth mentioning: the inflation objective is two sided: being below 2% is as bad as being above 2%.  If getting closer to the bull’s eye in the diagram means pushing inflation over 2% to get a larger reduction in unemployment, that would be part of the approach.  There were times in the past, such as 1979-1982, when high unemployment was seen as the necessary price to pay for low inflation.

The turmoil experienced last summer after the Fed first hinted at tapering is now termed a market tantrum.  One of the papers presented at the Forum explored what might cause the kind of turmoil seen last summer and what might be done to prevent it.   Unlike the financial crisis, the problems would not be caused by banks or excessive debt. Rather, a combination of a long period of low interest rates, the resulting search for yield and competition among fixed income mutual funds can conspire to create volatile fast moving markets. The key ideas revolve around the way mutual funds and other asset managers react which makes interest rate movements and markets asymmetric: when rates fall the reactions are slow and measured, when they rise the response is accelerate by positive feedback.

The story – stylized here – goes like this: The Fed cuts interest to extremely low levels to support the economy.  Investors and fund managers search for yield, extend maturities, reach for lower credit quality and shift assets from short term floating rate money market funds to bonds, bond funds and similar investments.  Mutual funds compete for investors’ assets and a key component of the competition is performance, especially in the search for yield.  When the Fed hints that rates may rise, a “musical chairs” or “rush to the exits” mentality seizes the mutual funds – no one wants to be the last one out of bonds as the prices fall and their performance collapses.  The preferred strategy in this game is getting out first. This rush, (or run in the traditional banking lingo) accelerates the market shift. Further, rising rates and falling prices encourages investors to withdraw money from the same mutual funds, pushing rates further up. All this is modeled and described in more detail, in the paper presented at the Forum.

The puzzle for monetary policy is how to tame this possible run on the market.  Never using low interest rates to support the economy is not the answer. Maybe more transparent policy would help.  One conclusion is that bank regulations would have no effect have no effect on these tantrums.

This morning’s Financial Times revisits the argument that smaller funds generally have a performance advantage over larger funds.  One contention advanced in favor of this view is that as funds grow, they “have” to hold more large-cap stocks, and that this large-cap weighting hurts overall performance: “Outperformance in large-cap companies is harder to achieve because they are more efficiently priced.”

Not exactly.  Increasing a fund’s weighting in large caps actually produces two distinct effects which should not be conflated.  The more important of the two is an allocation effect: if large caps, as an asset class, do less well than mid- or small caps, then increasing a portfolio’s exposure to the large-cap segment of the market is likely to diminish its performance over time.  In this absolute performance sense, the argument against large caps is well-established; the Fama-French study of 1992 is probably its most famous, but by no means its only, exposition.

But adding large-cap stocks also produces what we might call a relative performance or selection effect; if it’s easier to generate excess returns (“alpha”) in small-cap stocks than in large, then performance might suffer for that reason as well.  That’s the argument of the FT‘s source, and on first blush it’s plausible.  It’s certainly true, e.g., that research coverage is tilted toward larger companies.  And the dispersion of mid- and small-cap stocks is greater than that of  large caps, which tells us that the opportunities for alpha-generating stock selection diminish as we go up the capitalization scale.

But higher dispersion, and the scarcity of research coverage, imply only that the likelihood of misvaluation is higher among smaller companies.  There’s no reason to assume that the likelihood of undervaluation is higher for small caps than large caps, and without that presumption the case for active management of small-cap stocks withers.  Logically, of course, the average component of any index can’t be either over- or under-valued relative to the index’s valuation level — there is, in other words, no net supply of alpha.  And the empirical data demonstrate that generating excess returns relative to an appropriate index is just as difficult for small- cap managers as it is for large.

Size matters because small- and mid-cap stocks, over time, tend to outperform large caps.  But when it comes to stock selection, the average small- or mid-cap investor, like his large-cap counterpart, would benefit from a passive approach.

Complete transcripts of the Fed’s policy meetings and conference calls are published with a five year lag. Last week the central bank released the transcripts from 2008, probably one of the more interesting years to “hear” word for word what the members of the FOMC were saying.  The release was almost to the day the five year anniversary of the signing of the American Recovery and Reinvestment Act – better known as Obama’s stimulus — on February 17^th 2009.  These two events are generating discussion of both monetary and fiscal policy over the last few years along with a lot of Monday morning quarter-backing.

If journalism is instant history, then journalism with a five year lag is certainly not history written with sufficient time to digest events and gain perspective.  Recent comments about both the Fed and the fiscal stimulus reflect current policy debates more than anything else. The comments also demonstrate that most of us have forgotten how dark the economy and the markets looked as Lehman collapsed and Congress rejected the first attempt to pass legislation to address the crisis. While acknowledging that we don’t yet understand everything that happened to the economy or why, it is still possible to draw a few conclusions with some possible pointers should such things happen again.

On the fiscal policy side, leaving aside the claims that fiscal policy doesn’t work, that it would have worked if it had been larger or that it did work because without we would have had a second Great Depression, a little bit of data:  The US stock market bottomed out and turned up on March 9^th 2009, about three weeks after the stimulus bill became law. US real (inflation adjusted) GDP quarter to quarter at annual rates were -8.3% in 2008:4, -5.4% in 2009:1, -0.4 in 2009:2 and +1.3% in 2009:3.  Job losses bottomed in the first quarter of 2009 and were positive by the end of the year.  In the numbers, the fiscal stimulus worked.  There was a very deep recession but no second Great Depression.  It is too early to give fiscal policy and the stimulus law a final grade, but it certainly passed and made a large positive contribution.

The Fed transcripts run about 1500 pages including meetings, phone calls and supporting documents.  The number of commentators who have read through all the documents is probably very small (and does not include me).  From the selections reported and repeated in the media and among blogs, one hears of moments of great insight as well as surprise, shock and sometimes scant comprehension of what was happening.  A few things that were learned, and shouldn’t be forgotten, include: what absolutely can’t happen sometimes does, it is difficult to forget or eliminate yesterday’s fears (such as inflation) and just because something hasn’t been done before is not a reason to not do it.  In the end the Fed recognized the liquidity had vanished, that the solvency of many major institutions was being questioned and that no one would accept any risk. The central bank took steps to address these issues with the focus on liquidity and risk by pushing interest rates to zero and flooding the market with liquidity. The resulting rise in asset prices helped address some of the solvency problems. Inflation, five years later, is lower now than it was iat the beginning of 2008.  Through the comments echoed in the media both Chairpersons – Ben Bernanke and Janet Yellen – come across as having understood the problems as quickly as anyone while maintaining a sense of perspective and humor.

It is a familiar concept that commodities have provided inflation protection as discussed in a recent post about a discussion I had with Bluford Putnam, Managing Director and Chief Economist, of our partner, CME Group, to discuss why inflation is likely to appear this year.

I have also discussed how much inflation protection has been provided in a special video on commodities and inflation from our Index Matters Series with Bob Greer of PIMCO and Boris Shrayer (formerly) from Morgan Stanley.

Inflation and commodities generally move together as shown in the chart below:

Source: S&P Dow Jones Indices and ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt
Data from Jan 2004 to Dec 2013.  Past performance is not an indication of future results.
This chart reflects hypothetical historical performance. Please note that any information
prior to the launch of the index is considered hypothetical historical performance (backtesting).
Backtested performance is not actual performance and there are a number of inherent limitations
associated with backtested performance, including the fact that backtested calculations are
generally prepared with the benefit of hindsight.

However, in light of the inflation announcement from Feb 20, 2014 that stated US inflation ticked up in January 2014, I have received some questions from investors around the world regarding whether the commodity indices protect them from local inflation.  The answer is that it depends but for most of the countries in the table below, the answer is yes.  As I have explained inflation beta in prior posts, the results can be interpreted as, “if there was a 1% change in CPI, then there was an x% change in the index”.

In the table below, the country CPI is compared to both a global flagship, the S&P GSCI, and an international flagship the S&P WCI.  Notice generally the inflation beta is higher from the international benchmark, the S&P WCI.  Also notice for some countries like South Africa and Mexico, there may not be the local inflation protection one might get from other countries. This is not completely surprising given that some countries have local price controls despite the global nature of commodities, discussed in this post including discussions with the CME Group, ICE and NYSE-LIFFE.

For any investor who has chosen lean hogs as the commodity to invest in 2014, s/he is as “happy as a pig in the index“. The S&P GSCI Lean Hogs are the 3rd best performing commodity in the index YTD, up 16.3%, before the roll.  Even after the roll, the lean hogs are the 5th best performing commodity in the S&P GSCI and the best performing commodity in its sector, livestock. Now the  S&P GSCI Lean Hogs is just 4.5% short of reaching its all-time index level high which occurred in March 2011.  

Rising expectations that cash hog supplies will tighten soon and an increase in wholesale-pork prices have supported the lean hogs in the index. Packers were willing to pay higher prices to insure their immediate slaughter needs (known as convenience yield) were covered as they attempt to catch up production in the wake of weather-induced closures and delays (known as expectational variance or supply shocks). Summer hog contracts remain strong on the expectation Porcine Epidemic Diarrhea virus (PEDv), which is fatal to baby pigs, will cut the U.S. hog herd.

Average monthly returns between Jan-Feb of 2014 of 7.9% are the highest of any first two months since 1999. Further, the average monthly summer backwardation in 2013 of 4.2% was the highest since 2001 and has been increasing since 2010, when it was just 1.9%.  Also in history, only in 14 of 39 years have we seen  backwardation in February and we haven’t seen three years in a row with a backwardated February, like we see now, since 1978-80. 

In the summer months of June-Sept, during the years of backwardation in February, the average monthly total return of lean hogs was 117 basis points higher than in all the years taken together. If this pattern continues with tight supplies of lean hogs, there could be a hot roll this summer. Though one might be cautious given the history of abundance in March.

See in the charts below the data showing historical average returns, backwardation and contango.

Source: S&P Dow Jones Indices and/or its affiliates. Data from Jan 1973 to Feb 2014. Past performance is not an indication of future results. This chart reflects hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with backtested performance.