What Mr. Market giveth, he also taketh away. That was mostly true for this month, as the chart below documents. The high-flying asset classes were generally the ones that suffered the most in May, as of yesterday’s closing prices.
The primary exception was commodities. A high-flying asset of late, by any measure, but one that also led the pack in producing what was otherwise in short supply in May: robust positive returns.
Our measure of commodities is the PIMCO Commodity Real Return Strategy fund, which tracks the Dow Jones-AIG Commodity Index. By this gauge, May was in fact merry, with the mutual fund advancing 1.95% for the month.
On the opposite end of the performance spectrum is the sharp loss for emerging markets stocks, which retreated by 12.6% this month through yesterday, measured here by the iShares MSCI Emerging Markets ETF. But even that deep cut has yet to knock the asset class from its perch as the best performer over the past year. Emerging markets equities may be suffering these days, but in the race over the past 12 months they’re still far and away the top dog.
The question, of course, is what comes next, and on that score there is always far less clarity compared with dissecting what’s just passed. In any case, perhaps this is a timely moment for a strategically minded investor to ask if momentum has legs in bear as well as bull markets.

Asset class proxies: Vanguard REIT Index VIPER, iShares Russell 2000, iShares MSCI Emerging Markets, MSCI EAFE, S&P 500 SPDR, Vanguard High-Yield Corporate, PIMCO EM Bond, Morningstar Short Gov’t Category, PIMCO Foreign Bond, iShares Lehman Aggregate Bond, Vanguard Inflation Protected Securities, PIMCO Commodity Real Return Strategy.

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Mr. Market has been wearing optimism on his sleeve when it comes to estimating the future path of inflation by way of the spread between nominal and inflation-indexed Treasuries with 10-year maturities. But the optimism that has been fashionable this season past may fall out of favor this summer as inflation fears heat up.
As of last week’s close, the nominal yield on a 10-year Treasury was 5.06%, according to the databank maintained by the U.S. Treasury. The 10-year inflation-indexed Treasury (or 10-year TIPS, as everyone likes to call them) ended the week at 2.44%. The spread between the two was 2.62% (5.06 less 2.44). In other words, Mr. Market’s forecast of inflation is 2.62%, as the chart below illustrates.

How high is 2.62% as an inflation forecast? Arguably, not high enough, even though it represents the upper range based on the last three years, and up about 30 basis points from 2005’s close. But on one level, at least, 2.62% as an inflation expectation appears more than a little dovish. We come to the conclusion by pointing out that 2.62% is considerably below the 3.5% current annual pace of increase in consumer prices.

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In order to know what is going to happen, one must know what has happened.
Nicolo Machiavelli
The “conundrum” of low bond yields in the face of rising inflation and a robust economy may be yesterday’s news, but a consensus on the causes remains elusive. Indeed, one of the more common explanations–foreign central bank buying, particularly from those in Asia–wasn’t the cause after all, according to a new research paper by economists at two Fed banks, which we’ll get to in a minute.
But first, it’s worth noting that the ignorance could be a problem for monetary policy in the future. If the forces behind the conundrum aren’t understood, those forces may yet come back to bite Bernanke’s Fed. How can you manage something you don’t understand? The answer, of course, is that you can’t. And if you can’t understand the forces affecting monetary policy, the risks are higher that your policy could run amuck and dispense effects into the economy that are unnecessary or even dangerous in the pursuit of a stable and low-inflation, a stable currency, and so on.
It’s hardly comforting to know that former Fed head Alan Greenspan chose the word “conundrum” to describe the capacity for long yields to stay low when the central bank tried to engineer a higher price of money. The idea that a mysterious but powerful force is rewriting market rules for the global economy should give both investors and central bankers pause.
What you don’t know can hurt you when it comes to deploying monetary policy. That starts with allowing inflationary forces to take root when one might suppose otherwise. Another skulking threat might be the nurturing of speculative bubbles when the Fed intends nothing of the kind.
There is no shortage of opinions about why long rates–which are set by the marketplace–stayed so low for so long, much to the Fed’s consternation. Fed Chairman Bernanke, before he reached his current exalted position, opined as a Fed governor that a “global savings glut” was the source of the conundrum. A more ambitious explanation came from Christopher Probyn, chief economist for SsgA, who last year wrote that the low yields were a byproduct of a “confluence of forces, including the transparency of monetary policy, contained inflationary expectations, pension reform, foreign central bank demand for U.S. securities, a new government deficit financing strategy, and the shift to floating rate debt.” Perhaps he should have simply blamed the global economy.
But is it really that simple (or complicated)? Not necessarily. Consider a more modest analysis of what’s going on, which comes by way of a new research paper penned by economists at the San Francisco and Dallas Fed banks. In fact,
The Bond Yield Conundrum from a Macro-Finance Perspective is notable for what it doesn’t find: easy explanations.
Although the paper’s models document that the low yields of 2004 and 2005 were “unusual,” the variable showing the most explanatory relevance, albeit a small one, “is declines in the (short-run implied) volatility of long-term Treasury yields…. Even so, at best, almost two-thirds of the conundrum remains unexplained.”
The most-provocative part of the paper’s conclusions is what it didn’t find, namely, that foreign central bank buying of Treasuries explains the abnormal persistence of low yields in 2004 and 2005. “Large-scale purchases of long-term Treasuries by foreign central
banks,” the authors write, “has essentially no explanatory power for the conundrum episode.”
The paper concludes by putting a positive spin on the mystery. “The resolution of these “conundrum” episodes, in the U.S. and abroad, presents a rich frontier for future research.” Somehow, we suspect that Bernanke and company will have a slightly different reaction.

Today’s upward revision in the pace of growth in first-quarter GDP shows the economy expanding at its fastest rate in more than two years. That should give the Federal Reserve something to talk about as it ponders what to do at its next monetary policy meeting on June 28-29.
Bernanke and company keep reminding that they need more data to make an informed decision on the next move (if any) on interest rates. By that standard, can we assume that the Fed is now one step closer to putting the pause on pause and raising Fed funds next month?
Last month, when the first guess of 1Q GDP was dispatched (the “advance” estimate, as it’s known), we were told that the economy grew by a robust annualized 4.8%. Today, we learn that GDP was rolling along at a materially faster pace: 5.3%. The “primary” reasons for the upgrade, the Bureau of Economic Statistics says, was a higher increase in inventories and stronger exports that initially estimated.
In any case, an economy growing by 5.3% is an economy that’s expanding at a rate that exceeds the current Fed funds rate by more than a trivial gap. Perhaps it’s time to rethink if the central bank’s monetary policy is at or near a state of neutrality. Even if the Fed were to elevate rates by 25 basis points come the end of June–as it’s been doing at every FOMC meeting since June 2004–Fed funds would still be trailing GDP’s pace for the first three months of this year.
But as any dismal scientist will tell you, GDP reports–even upwardly revised ones–are yesterday’s news, or, more precisely, the previous quarter’s news. The question is whether the obviously strong first quarter momentum will spill over into the second quarter and (dare we ask it?) the third quarter? On that all-important question the jury is out, at least when it comes to trying to forge a consensus. And since the first guess at second-quarter GDP doesn’t arrive until July 29, the opportunities for conjecture are wide open on matters economic.

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What good is transparency if the future’s unclear? Not much if you’re turning over stones in the bond market in search of clues about what’s coming.
Fed Chairman Ben Bernanke has been warning that the central bank is more or less making monetary policy on the fly these days. As new numbers on the economy come in, the Fed will adjust its monetary prescription accordingly. Gee, thanks.
If it’s not already obvious that ours is a great moment of transition, Bernanke reminded everyone of this fact in his testimony yesterday to the Senate Banking Committee. On the subject of the next interest-rate meeting on June 28-29, he advised that “we have about a month to go before the next FOMC meeting and a lot of data between now and then. We will be watching that data very carefully,” reports Reuters. In other words, the Fed may hike rates but perhaps it won’t.

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Everything’s down, but discriminating among equity sectors still has its merits. In fact, one could reason that selectivity becomes that much more critical if the downturn in the stock market is more than just a temporary setback. Genius is a bull market, an observation that’s delivered no small advantage in recent years. But an eye for finding pearls among swine may be due for a comeback as a favored investment skill.
As you might expect, the broad-based selling of late has dispensed varying degrees of red ink across the ten major sectors that comprise the S&P 500, as the chart below illustrates. So far in May, information technology has suffered the biggest loss, tumbling 7% this month through last night’s close, according to Standard & Poor’s. The relatively conservative utilities, by contrast, have been pinched the least, posting a stumble of just two-tenths-of-one-percent. Overall, the stock market (measured by the S&P 500) has shed 2.5% in May.

In the search for investment justice, some may look for signs that the highest flyers of the large-cap equity sectors so far this year have taken the toughest punishment this month. But the record is mixed on that score. Indeed, the worst-performing sector (information tech) in May is also the big loser year to date through yesterday. Meanwhile, the second-biggest year-to-date winner–industrials–has endured one of the milder sell offs so far this month.
Justice, such as it is, is most obvious among the energy stocks. As the leading performing sector in 2006, energy has taken one of the sharper tumbles in May, falling 5.7% so far this month.

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It’s passé, out-of-favor, irrelevant, and just plain dull. But its rate of increase has shifted higher. Is anybody watching? Does anybody care?
Not necessarily. Money supply elicits yawns these days. It’s been a generation since the days when the release of the latest money supply numbers every Thursday from the Fed attracted widespread attention. Even when the central bank stopped publishing its broadest measure of money supply–the so-called M3 series–a few months back, there was a collective yawn from the financial world.
At the risk of putting readers to sleep, The Capital Spectator nonetheless continues to monitor money supply in the perhaps mistaken belief that something relevant may emerge from the analysis. That includes our belief that maybe, just maybe, there’s a link between inflation and money supply.
For those of you still reading, it may be of interest to note that seasonally adjusted M2 money supply (the broadest measure of money supply currently published…last we checked) seems to have acquired a habit this year of consistently growing at a rate above 4%. The last time that happened with any consistency was back in late-2004 and early 2005.
To cite the latest example, in last Thursday’s money supply report, M2 advanced by 4.4% over its year-earlier level. Although that’s down from the recent peak of 5.0%, it’s materially higher than the rate that prevailed in last two months of 2005.
In other words, dear reader, the pace of M2 expansion seems to have found a higher plateau, as the chart below reveals, which shows the rolling 52-week rate of change for seasonally adjusted M2 through May 8. Whether this higher plateau is destined to be long-running, or the start of even greater rates of ascendancy, remain to be seen. But for the moment, there’s reason to ponder the implications, the risks, or (for the skeptics) if any of this matters.

Inflation returned to the market’s collective consciousness this week, as detailed in the April report on consumer prices. But yesterday came more signs that an economic slowdown may in the offing as well, by way of the Conference Board’s index of leading indicators and a surge in jobless claims for last week.
Adding to the perception that a downshift in growth is taking root are fresh comments from Fed Chairman Ben Bernanke, who yesterday observed that the real estate market is cooling. “It looks to be a very orderly and moderate kind of cooling at this point,” he explained via CNNMoney.com, but a cooling nonetheless.
It’s no secret that some dismal scientists have been predicting a softening in the economy’s momentum for the second half of this year and beyond. That view has been under pressure of late thanks to a string of economic reports that suggest the economy’s still bubbling. But yesterday’s numbers give a bit more credence to the forces of pessimism.
If a slowdown is coming, it may arrive just as inflationary pressures are gaining momentum. In that case, does that mean that stagflation is just around the corner?

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When Mr. Market speaks, investors may or may not listen. But when he shouts, almost everyone pays attention.
Mr. Market was definitely shouting yesterday. The S&P 500, every institutional investor’s favorite equity benchmark, collapsed on Wednesday, losing nearly 1.7%. That’s the biggest one-day percentage retreat in recent memory. The proximate cause was yesterday’s April report on consumer prices. Suffice to say, the report was received with less than enthusiasm on Wall Street.
And for good reason. As we wrote yesterday, there’s more than enough reason to worry that inflationary pressures are building a head of steam. Until yesterday, there was widespread agreement that the inflation has been “contained,” to use one of the Fed’s favorite words for communicating recently to the masses that there’s everything’s under control on the matter of price trends.
Perhaps it’s time to rethink that assumption, to judge by the April’s CPI numbers. To recap the news that convinced traders to dump stocks and bonds (the 10-year Treasury yield rose to 5.15% yesterday, the highest in four years), the core CPI pace of change jumped to a higher level, running at 0.3% in April, the second month at that level. Meanwhile, top-line CPI is rising at an even faster rate. With both core and top-line CPIs signaling trouble ahead, it’s getting easier to favor cash if only because expectations are growing that higher interest rates are still the path of least resistance.
To be sure, it remains to be seen if April proves to be a turning point on the inflation front. There have been scares about pricing pressures before, only to watch the threat evaporate in the optimism of a renewed bull market in stocks and bonds. Will it be different this time? In search of an answer, we took a closer look at yesterday’s CPI numbers. If this is in fact the turning point, it’s time to acquaint ourselves with the particulars of the transition. As usual, energy was the leading source of upward pricing pressure last month, rising by five times as much compared with consumer prices overall, as the chart below reveals.

For perspective, we also ran the numbers on a trend basis, and once again found energy to be the big weasel in the statistical henhouse of late, as you can see below.

It’s all about inflation again, and so it promises to be a long, anxious wait until next month’s CPI update confirms or denies April’s warning.