Inflationary Expectations are Rising

Recently the Fed affirmed its worries about rising inflation. If you want to read a good article about this, click here. And today the Producer Price Index (PPI) report for March was released (click for article). How can we examine inflationary expectations without waiting until a CPI, PPI, or GDP deflator report is released? The answer is to examine the ratio of TIP prices (Treasury Inflation-Protected Securities) to nominal bond prices. I have found it useful to use the ratio of 20+ year bonds. In StockCharts.com, the symbols for these are TIP and TLT. So, to examine the ratio, use TIP:TLT. Also, switch to viewing this as a line graph and remove moving averages, etc. but keep the RSI (use 9 periods). The resulting chart is given below (click on the image to enlarge it).

A critical technical formation has appeared with this ratio: a double bottom. Recall from Stikki Stock Charts that a double bottom is a reversal pattern. This price ratio has failed to break below a support level twice, which often (BUT NOT ALWAYS) signals an upward move is forthcoming. According to technical analysis, it is possible to determine a likely upside price target assuming a reversal does occur. To do this, form a neckline connecting prior recent peaks (i.e., resistance). In the present example this is at 1.148. Subtract from this the value of the bottom, which is 1.121, which I will round to 1.12. Then add this difference to the neckline value to arrive at the price target:

TARGET Change = Neckline - Bottom
= 1.148 - 1.12 = 0.028
TARGET VALUE = Neckline + Target Change
= 1.148 + 0.028 = 1.176

So, should this double bottom play out as a reversal, we would expect to see the ration TIP:TLT rise to around 1.176. The graph contains this information with a horizontal line drawn at this value. Notice anything interesting? The price target move us almost exactly to a prior level of support from June of 2006!

How likely is it that we will actually reach 1.176? Note from the RSI that it is not yet overbought, so there is room to move up. It is not far from the overbought reading of 70, however, so there will likely be a short-term downward move before that target would actually be reached. I suggest that you consider a support for the upside rally of a value of 50 for the RSI. As long as the RSI(9) remains at or above 50, don't rule out the possibility of reaching the upside target.

Employment Report -- March

Yesterday the March employment report was released. To the surprise of many (including me), payroll employment rose by 180,000 over the February total. This was far above the consensus estimate of around 130,000. Ironically, there was no effect whatsoever upon the stock market. Of course, that's because the markets were closed the day the report was released. So, Monday should start off with a bang, as traders have had the entire weekend to think about their reaction to the report.

Part of the reason for a larger-than-expected employment gain was that when the February survey was undertaken there was a snow storm, which prevented some persons from getting to work during that week. THE EMPLOYMENT SURVEY IS CONDUCTED DURING THE WEEK THAT INCLUDES THE 12TH OF EACH MONTH. So, comparing to a month with snow storms leads to some distortions. February likely understated employment, and March, comparing to February, overstated employment strength. While the employment data are seasonally adjusted (a statistical smoothing that takes into account events that happen "normally" at the same point each year), atypical events -- like February's snow storm, often cause seasonal adjustment distortions. A very readable article describing seasonal adjustment in on the online syllabus. Access it here.

So, while we have to wait until Monday to see how the employment report will affect the stock and bond markets, there was a great deal of discussion about the report overall and its likely asset market effects on television Friday. One question that is emerging about "good news" is whether the stock market will react positively or negatively at the present time. Why? Because "good news" may signal the increased likelihood of Fed tightening. And, we saw earlier in the semester, that rising interest rates are bad for stock prices (often referred to as a "head wind"). But, a stronger economy means profit strength in the future, which is a plus for stock prices. So, which effect will predominate with investors? Stay tuned, we'll see. Here's a Friday article that discusses this. Let's see how accurate it proves to be.

Along with employment, the monthly labor market report also has information on the unemployment rate, which fell unexpectedly from 4.6% to 4.4%, placing us at full employment, an average hourly wage growth. Often this is taken to be an inflation indicator, but it really isn't that good at signaling future inflation (here's an article discussing that). Actual wage growth was 0.3%, the expected amount, so there is not likely to be any reaction to that aspect of the report. As I stated in class, there are composition effects to wage change, determined by the types of jobs that are added in a given month. If lots of "high wage" jobs are added, the wage gain will be substantial. If largely "low wage" jobs are added, the opposite occurs.

So, what is happening to inflation expectations? Has the employment report changed anything? I have shown a way to observe this using StockCharts.com and TIPS prices relative to bond prices. For extra credit, graph this ratio (which we have discussed in class before) using daily data (make it a line graph). Annotate this with comments, print it and add a paragraph of discussion, and hand this in at the beginning of class on Tuesday. I will not accept anything after the beginning of class.

So, Monday morning promises to be very interesting for the stock, bond, and currency markets. It would be very good practice for you to think of what "should" happen, based on economic theory.