Bonds Spinning In Place

The Fed told us to relax, watch the data mix and reevaluate in six weeks. The market, doing its reflexive best, reacts to every bit of data as a new trend even, at times, a new business cycle. Sometimes the market travels to several different cycles in one day.

The only one position to take with some confidence, and the one the market keeps drifting back to, is what we call the "Poole Scenario" (see table below). Basically it has the Fed easing some 25 to 50 basis points by the middle of next year because growth has slowed enough for long enough to reduce inflation risk. It will either be that or on hold (Unless the data suggest a too weak economy and then we get the ease in January. No ease in January and you can kiss the recession scenario goodbye.) The shift in pricing to Poole means about a 15bp rise in 2 year yields. Fed keeps the funds rates at 5.25%, 40 odd basis point rise in the yield on a 2-year Treasury. Small shift to a tightening bias for midyear (my personal favorite) and 2 year yield rises 52bps.

You pay your money and take your chances. Understand the risk and you can better evaluate the expected return.

As of day's end Friday, the market is giving only a cumulative 16% chance of an ease by Mar and then builds to certainty for the first 25bp cut at the Jun 28 meeting. At the edge of the Poole.

The street economists who gave us consumer calamity for 06 are, being a shameless bunch, still out there pitching doom and gloom or at least a weaker forecast than the Fed's. Like a stopped clock they will eventually be right, but not anytime soon. Certainly not as long as credit remains as plentiful as it is.

Teeing It Up For January

Today's FOMC statement went about as far as they could go in signalling that their forecast might not work out as expected. Here is the key paragraph and the only part of the statement that changed from the previous one (bold and italics mine):

Economic growth has slowed over the course of the year, partly reflecting a substantial cooling of the housing market. Although recent indicators have been mixed, the economy seems likely to expand at a moderate pace on balance over coming quarters.

The paragraph in the Oct 25 statement was:

Economic growth has slowed over the course of the year, partly reflecting a cooling of the housing market. Going forward, the economy seems likely to expand at a moderate pace.

If the Fed came out and said "economy is weaker than expected" they would be expected to ease. Shy of an ease, they gave a nod to the current influx of data. They did it with "substantial" and "recent indicators have been mixed". As for the look forward, its a moderate pace "on balance".

Everything else in the statement stayed the same, including the firming bias. Not much choice given the evidence is mixed and that any true hint of an ease begs the question, why wait?

Will they ease in January? Data dependent, of course. As I wrote earlier, I don't think they will nor do I think they should. But this slight nod is a enough of a crack in their outlook to tee up the possibility.

Initial market reaction has 2 and 3yr paper rallying, with most of that rally in the red Euros. The odds skew for an ease increases as 2007 goes on.

If they don't go in Jan, odds of them going later in the year on are not good. First off, it would confirm that Q4 was where the Fed expects it would be, not where the eco bears calling for recession expect the economy to land. Secondly, the odds of an ease later in the year diminish because the U.S. economy is "adapt and grow". The longer funds stay at this level the greater the probability of reaccelerating growth.

At the very least, the Fed has given us the holiday gift of a bone to gnaw on until January 31.

Why The Fed Debates While We Wait

Economies run on credit. No one knows that more than a central bank. While we look at the mind-numbing number of statistics regarding economic activity and try to make strong conclusions out of weak data, as the revisions underscore, the willingness to lend stands out as a gauge of where the people who control capital feel like spending their money.

You can decry ever narrowing corporate spreads in the bond market, junk and investment grade alike, as the result of too much global liquidity chasing yield (isn't that ultimately inflation). But the lending standards of banks are subject only to senior management's desire not to have profits later damaged by increases to loan loss reserves.

In that spirit, I offer the chart below as evidence that credit standards remain well below the levels of "saying no, we are staying in cash" that create the credit crunches that create recession.



If anything, the chart tells me that the Fed sees nothing but an economy set to adapt and grow past this housing slump. Credit ultimately creates inflation. That may be tougher to see in a goods market flooded with imports from low wage nations with cheap currencies, but it does show up in services and asset prices. Not the stuff of CPI but the stuff of increased wage demands.

Will comment post the FOMC statement, which I suspect will be newsworthy in its tilt towards neutral and give the market the requisite set up for a January ease. Chart above says the ease won't come. And as I have written before, if the ease doesn't take place in January, the "adapt and grow" economy fueled by plentiful credit will not give the Fed the opportunity to ease for quite some time.

Tomorrow Fed Gets Taken For A Ride, Markets Hang On To The Bumper

Poole told us one data point doesn't make a difference. Kohn told us it can and minds can be changed in just a few days or weeks. The difference between the two rests on one distinction -- is it a single data point or one that fills in the last bits of a puzzle? Tomorrow morning's employment data is a filler that should reduce the number of two-handed economists at the Fed. The policy road map to March becomes more clear 8:30 tommorrow morning.

The headline numbers will be Nov employment and the revisions to Oct. Expectations for Nov is 75,000 to 100,000. As for the Oct revision, no one knows what to expect. Employment growth lags real growth, so those with opinions that matter to policy will examine hours worked for its leading possibilities.

Forget for the moment the probabilities in the market, as they are only the average of everyone's best guess given what everyone knows at the moment and that moment changes tomorrow morning.

Using some twisted logic based on recent Fed chatter, the road forward lays out this way. First, a strong or consensus number (consensus being the economists at the Fed) means the Dec statement looks remarkably like the October statement. Since we know, from Beckner, that there is alot of resistance to jumping in and dropping funds without a forewarning, a repeat of Oct in Dec means that Jan is the time for the statement shift and likelihood of an ease rolls out to Mar. In my opinion, if it rolls to Mar it rolls off the table.

A weaker number and the other one-handed view point comes in and shifts the statement or even, if weak enough, sets up an ease. To shift and not ease the FOMC has to let people know everything is fine, maybe not as fine as we thought, but not not fine enough to do anything right now.

As for the market and current pricing, here is what we know. The prices are all wrong as far as what terminal values will be. Fed goes or not, its 0 or 1 not 35%. Fed goes 50, not 25, if it goes. Prices will not end up at a 40% probability.

Bernanke, Poole, et al have told us that this will be a data driven Fed. The Fed goes for a ride tomorrow.

Why Not Ease In Dec? Kohn Tells Us Why They Could

In remarks by Vice Chairman Donald L. Kohn at the Fourth Conference of the International Research Forum on Monetary Policy on December 1, Kohn gave out the rationale for moving to a neutral bias at the Dec meeting or even ease. Here is, in my humble opinion, the critical paragraphs (as always, italics and bolds are mine):

"An important source of our uncertainty about the recent past and the current state of the economy is that economic data typically come in with a considerable lag and are subject to substantial measurement errors and revision. . . . academic economists may still not fully appreciate the degree to which measurement uncertainty bedevils policymaking. These difficulties are especially pronounced at times like the present. . . .

Consider our estimates of real economic activity. These estimates often change markedly with the receipt of just a few more days or weeks of data."

WOW!!!!!!!!!!!!!!!!! Estimates can change markedly with a few more days or weeks of data? Less than 10 days to the FOMC for Dec with Nov employment smack in the middle. And Poole told us one data point doesn't matter. It matters if it completes a picture drawn from all the other data.

How does Mr. Kohn deal with this uncertainty?

"Given that uncertainty is pervasive, how should central banks deal with it? . . . . cost-effective ways to support both the development of more accurate and timely data . . . . using data in a nuanced manner--. . . . being cautious about the weight placed on short run movements. . . . . such efforts can take policymakers only so far. . . . risk is unavoidable, and central banks need to conduct policy in a manner that takes account of uncertainty in its various forms, as they strive to maximize public welfare."

Later in the talk:

". . . gradualism and model averaging may not be appropriate in all circumstances. . . . may be necessary for monetary policy to respond to what might be called "tail events," . . . choosing policy settings to minimize the maximum possible loss across different models of the economy, in contrast to . . . . minimize the average loss across models. . . . policymakers may at times base policy settings on especially pernicious risks has an important ring of truth."

Kohn goes on to say:

". . . central banks now strive to conduct policy in a predictable (albeit flexible) manner that is consistent with their stated objectives. On occasion, however, the goal of predictability may conflict with the concept of risk management, particularly when risk management requires taking steps to deal with an unusual or unprecedented risk. "

So if the data come in weak in the next few days, how does Kohn plan to conduct himself at the FOMC meeting:

". . . . heterogeneous viewpoints expressed by my fellow Committee members are intellectually stimulating and that they spur me to improve my own thinking about the economy and about the best course for monetary policy."

This from a man who two months ago wondered why the market was so certain that the Fed would be easing in 2007 and cautioned against shorting the Fed's resolve against inflation. Like Keynes and any rational person, and Kohn is certainly rational, new information changes his mind.

Where does that leave us now that the divine prophet of the Greenbook has told us that its tough to run policy from the data? Given Bernanke's remarks (see previous post) and remarks from others, a netural bias is in the bag.

The question before the FOMC is this: If the economy seems weaker than they expect, why would they wait until January 31 to ease? They wouldn't. This is why all the talk has been a mix of maybe things are softening with everything is runnning according to plan and the "We are fighting inflation" credibility mantra.

Without the positive talk, the FOMC is in that "why wait and ease now" bind. On the one hand, on the other hand, so we wait some more but give an acknowledgment that the economy may be a tad worse than expected. No wonder Truman wanted a "one-handed economist".

From a market perspective, the answer is pretty simple, buy the Dec Eurodollar futures outright. (Remember this is my opinion, not a recommendation to do anything other than to think about how the market is priced, the appropriate trading or investment opportunity for you is for you to decide) It is trading at 94.66 when 94.63 is "Fed on hold". The market's odds of Jan ease is around 20%. Or you can buy some out-of-the-money calls on Dec Euros or calls on Feb Fed funds (Jan/Feb spread doesn't work if they ease before the Jan 31 get together).

The FOMC might just ease in Dec or before the Jan meeting. As I wrote back in the summer, its "white knuckle time" for Bernanke.

Fed Moves To A Balancing Act

The Fed has reached its own conundrum . . . . move to a neutral bias without scaring equities or the FX markets. If they came out today and said the economy was weakening more than anticipated by what logic would they wait and not ease right now? By the same token, they are really afraid of inflation expectations getting out of line, in part because there is so much liquidity in the system and the credit creation process continues to hum along. So the Fedspeak is to talk tough on inflation, talk up the economy, and then shift to a neutral bias in mid December because things do seem to be unraveling a bit. The markets, however, can see through the tough talk all the way to a 4.75% funds rate -- at least.

Offering up the verbal strategy, we got remarks by Michael H. Moskow, President and Chief Executive Officer, Federal Reserve Bank of Chicago at the Carthage Business and Professional Coalition Luncheon Meeting at Carthage College in Wisconsin. If nothing else Moskow remains consistent in his view. He said:

". . . . my current assessment is that the risk of inflation remaining too high is greater than the risk of growth being too low. . . . some additional firming of policy may yet be necessary to bring inflation back to a range consistent with price stability in a reasonable period of time. But that decision will depend on how the incoming data affect the outlook."

As for the market's reaction, the probability for an ease in Jan is now up to 25%, halfway to the 50/50 or even 75/25 odds post the Dec 12 meeting. That Jan/Feb Fed funds spread went out today at -5, the other day it was trading -1.5/-2. The March odds are up to 47%, 64% by May, etc.

While I am convinced of the Dec shift, I remain on the sidelines regarding January. Regardless of my view, the Fed is creating for itself the same problem fiscal policy created in 60s -- the notion that they can fine tune policy to match growth and keep the train moving. It turned out wrong on the fiscal end, not sure it will turn out any better for the monetarists now at the Fed.

No rules. Only judgement of knowing where the economy really is, where it is going, and what is the proper rate in that environment. Those guys must be pretty smart.

Bernanke Bias Shifts To Neutral; First Step To An Ease

Today's remarks by Chairman Ben S. Bernanke before the National Italian American Foundation in New York on "The Economic Outlook" told the audience that the bias shifts to neutral in the statement following the Dec 12 FOMC meeting. Beckner, a member of the Fed's favorite scribes, told us that the shift to netural is necessary before the Fed eases. It doesn't mean ease, the data has to conform, but the odds go to 50/50.

The link I give is to the audio/visual of the talk, courtesy of Bloomberg. Hearing the two paragraphs reprinted below is much more powerful. The italics and bolding are mine.

"Over the next year or so, the economy appears likely to expand at a moderate rate, close to or modestly below the economy's long-run sustainable pace. Core inflation is expected to slow gradually from its recent level, reflecting the reduced impetus from high prices of energy and other commodities, contained inflation expectations, and perhaps further reductions in the rate of increase of shelter costs and some easing in the pressures on capital and labor resources. However, substantial uncertainties surround this baseline forecast. The Federal Open Market Committee (FOMC), the committee that sets monetary policy, will continue to monitor the incoming data closely. In its latest statement, the FOMC reiterated its view that the upside risks to inflation are the predominant risks to the forecast and indicated that it is prepared to take action to address inflation if developments warrant.

As I have just noted, the pace of economic activity has moderated over the course of the year. According to the latest estimates by the U.S. Department of Commerce, real gross domestic product (GDP) increased at an annual rate of 2.6 percent in the second quarter of 2006 and at a rate of only 1.6 percent in the third quarter. These figures are down noticeably from the 3-1/2 percent average pace of growth of the preceding two years. We will receive an updated estimate of third-quarter GDP growth tomorrow. At this juncture, information about economic activity in the fourth quarter is limited, and the range of plausible outcomes remains wide. But the indicators in hand suggest that real GDP growth this quarter is likely to be in the same general range that it was in the second and third quarters."

Here is how I heard it: Bernanke says the economy has moderated, inflation risks have gone down BUT "substantial uncertainies surround this baseline forecast". In our last statement we told you that inflation was the big risk. Now, as I was saying, the economy has moderated, growth is down substantially from where it was, and it looks like the current quarter will come in at the same pace as the previous two BUT current information is limited so "plausible outcomes remain wide".

One mention of inflation, lots about the slowdown, and a pointed reference to the uncertainty of the coming quarter. When you expect the quarter to come in at the low pace of the previous two, seems to me the uncertainty lies with greater weakness rather than strength.

The market, in its infinite wisdom is placing the odds of an ease in Jan at around 10%. Bernanke just told us its 50/50. If the market shifts to those odds, the Jan/Feb funds spread I wrote about yesterday makes 12 on a 2 tic investment (caveats everyone, no guarantees, it might not be for you, and this is only explanatory not a direct recommendation, etc, etc, etc).

All is possible as far as the economy is concerned. After all, if the Fed thought the economy was going to weaken further they would ease now not in January. They certainly wouldn't wait till March. By Jan 31 they will know Q4 and Jan sales, which have become quite important. There is nothing earth shattering to learn in the following 6 weeks that lead into the Mar meeting.

The December shift to a neutral bias is necessary for the ease. From then on, the decks are clear for the data to lead the Fed.

Fed and Market Dancing Together For The Holidays

The Fed acts, the market reacts, the Fed reviews what the market does and speaks about it, the market reacts, perhaps something else in the world takes place, the market acts, the Fed reacts, the market reacts again, and the interest rate world converges to a single point. There is no arbitrary measure or guidepost to establish whether the point is too high or too low, for the short-term or the long haul. We just know that market and Fed have reached a conclusion that this is where rates should be for now. This is monetary policy today.

It would be nice to know why 5.25% is, as Poole noted in some q&a, "mildly restrictive" and how the FOMC came to that conclusion. We do know from that comment that once the economy slows to the point that inflation risk has lessened, rates will be pulled back to neutral. Before all that, the Fed will let us know whether the expectation in the market place for an ease is right or not.

Some insight to all this was given in remarks by Governor Kevin M. Warsh at the New York Stock Exchange, New York, New York on November 21, 2006 entitled "Financial Markets and the Federal Reserve"

"Today, I will discuss the role of financial markets in effective monetary, regulatory, and supervisory policy making by the Federal Reserve. In particular, I will discuss the potential for markets to inform the Fed's policy judgments--even as our policies also affect markets."

A good start. Later in his talk;

"Markets affect monetary policy predominantly through the information provided by asset prices. . . . At least as important, these prices also can provide some insight into the uncertainty surrounding likely outcomes. Monetary policy makers can use economic models and statistical techniques to extract the views of market participants about these key macroeconomic variables.

Let me cite a few simple examples of how we interpret asset prices. Through open market operations, the FOMC sets the target federal funds rate, . . . Interest rates for periods extending beyond that very short horizon, however, are established by market participants rather than the FOMC, although members of the Committee may be able to influence these longer-term rates somewhat through what is affectionately described as "open mouth operations." In this way, market-based interest rates reflect primarily the path investors expect for monetary policy. That expected path is of keen interest to us as policymakers."

Next, Warsh does my work for me by saying;

"Prices on federal funds futures and Eurodollar futures suggest that market participants expect the FOMC to cut the target federal funds rate about 50 basis points during 2007, a view consistent with expectations of a "soft landing." At the same time, market-based options prices on these interest rate futures indicate that implied volatilities are quite low, suggesting a surprising degree of certainty regarding policy expectations. Taken at face value, market participants appear to be reasonably certain of a benign outcome for both economic growth and inflation. In contrast, my own judgmental forecast includes a wider range of possible outcomes than is implicit in these market-based measures."

Now comes something interesting;

" . . . .Our own policies and actions affect market prices. As a result, when we look to financial markets for information, the information we seek may be shaped in part by our own views. The more that "market information" reflects our own actions, the less it is useful as a source of independent information to inform our policy judgments.

We need to be alert to this "mirror problem," in which markets can cease to provide independent information on current and prospective financial and economic developments. In the extreme case, financial markets keenly follow the Federal Reserve, the Federal Reserve is equally attuned to the latest financial quotes, and fundamentals of the economy are obscured. Under such circumstances, asset prices might teach us only about our skills as communicators. Fortunately, the prospect for profits--the critical underpinning of all markets--mitigates this problem."

Perhaps this is why Poole, after his talk to actuaries in Delaware, answered a question on the level of long-term yields with a question of why the bond market is a pessimist and equities an optimist.

Warsh, once again:

"Market-based information is surely important in determining good monetary policy. This does not mean, however, that the Fed's goal is to align its views with those of the markets or that it wants the markets' views to match its own. Instead, policymakers benefit greatly by listening to views expressed in markets that are at least somewhat independent of FOMC communications. We can further enhance the role of markets by enriching our understanding of the interplay between communication policies of central banks and market prices. Good communication by the Fed should help members of the FOMC interpret market prices. Unnecessary market uncertainty or misinterpretation of our assessments will only muddy the waters."

They will be making the waters still in the coming days as Feds speak and the November data start rolling in. Don't expect worried comments about the economy, but listen to what they are not saying. They have not said the market is wrong and they have not said anything about raising the funds rate. They have said the economy is cooling, housing isn't creating a recession, and inflation is cooling off nicely. Beckner, one of the Fed's chosen scribes, writes that the FOMC will shift its missive in the meeting prior to the ease.

What the market has priced in, and the Fed isn't telling us that the market is wrong, is an easing bias that starts with 10% chance of a 25bp cut in Jan, 30% for Mar, 30% for May, 40% for Jun and 40% for August (in round numbers). Since this all adds up to more than 100%, 50bp is in for next year -- see Warsh's comments above.

The odds of an ease have to rise as the year progresses, since the Fed has told us they will be easing but not when. The longer the time period, the greater the chance of capturing the ease. My guess, however, is that the ease, if it comes, comes in January. They will know everything they need to know. Watch the data, listen to the comments, read the Dec FOMC statement. The combination tells us Jan definitively.

The Jan/Feb spread in Fed funds futures closed today at 2. Earn 25 if the Fed goes, lose 2 if they don't. A pretty good risk/reward since Jan has the highest probability of getting Fed action and every other probability in 07 is contingent on what happens then. And given how policy is run, we will know Jan within the next 10 days or less.

Market Snaps Back Into Line

Yesterday's market was totally out of whack given the direction of data and Fedspeak. Forget Moskow's assertions to the otherwise, after all the Fed always wants us to know that they are vigiliant in their vigilance against the virus of rising inflation expectations. Poole has noted that a reason downturns in the economy aren't as deep or protracted is that the Fed eases and eases alot once it sees the economy heading south. This week, Poole let us know that the FOMC is ready to ease and ease alot if the data swing in that direction. Consequently, bets in the market today are a bet on data, not the Fed. The policy we know -- stay put or ease. As for the direction of the data? Its all a guess -- an educated guess perhaps, but still a guess.

Since today's swing was big enough, I have reproduced the Stan Jonas table of probabilities for your reference.

Bonds Weaken With The Data . . . . . ?????

Earlier this week Poole let us know that everything is going according to plan and the funds rate is neither too hot nor too cold. Yet, he implies and has implied that the Fed eases and eases alot if the wheels are coming off. If the Fed thought that was happening don't expect it to be telegraphed like the march to 5.25%. They will just ease. After all, if they say they are worried it must be really bad. There is a limit to transparency in communications. January seems like perfect timing between enough data and enough suprise.

The market, in its infinite wisdom, ignores the softness that permeated the data this week and instead focused on the FOMC minutes. Minutes from a meeting that took place three weeks ago and made note of the important information coming out between then and the Dec meeting. Shouldn't Poole's comments these past several days have more impact than the minutes?

Apparently not. A week ago, the Mar 07 Eurodollar contract was priced to a 26% chance of an ease and now sits at 14%. Odds of a move in Jan is down to 6%. The Mar contract is interesting because it contains an expectation of what will have happened in Jan and what it thinks the market will think what will happen in the 3 months to follow. Below is how the probabilities shake out as of today's close (courtesy of Stan Jonas) and the impact of a shift in expectations on prices and yields. The later in the year we go, the odds of an ease move higher -- so says the market.

The pricing is skewed the wrong way, from my perspective. Odds of an ease in January is really quite high -- if the eco bears get the kind of 4th quarter economy they expect. The Fed will be sifting through 4th quarter data that are coming on the heels of a weak 3rd quarter. The cumulative impact of 5.25% funds will be obvious. On the other hand, if the Fed holds in Jan, that 4th quarter bounce the FOMC expects will have occurred. If we get the bounce, that market-determined cumulative probability of an ease in the spring and again later in the year will likely swing to a bias to tighten.

Right now, the 2-year has 23 basis points of risk should the probabilities swing back to 0% (on hold). On the other hand, a Jan ease gives the 2-year a 40 basis point rally. Pick your bias, know your risk, the tale will be told by Jan. And maybe, just maybe, hinted at in the Dec statement. Stay tuned.

Close To An Ease . . . . .But Based On What Policy?

After Bill Poole's talk "U.S. Labor Input in Coming Years" to the Chartered Financial Analysts Society of Philadelphia, the most interesting answer he gave was to the question on long term rates. Rather than take the conundrum path he jumped onto the yield curve. And rather than play the trader's growth expectations vs the Fed's, as he did several months ago, he contrasted the bond market's view (eco bears) with the equity market's (eco bulls). He doesn't understand why there is a difference in opinion, so the only thing to do is to wait. Wait and then what? If the equity market moves to share the bond market's view on things does the Fed ease? Poole's comments suggest to me they might.

In the Q&A to reporters, Bloomberg news headlines are (in my order): "inflation expectations are well controlled", "price movements tend to lag general economy", "can't rule out slower growth behind oil-price drop", "outlook for Fed policy is roughly symetrical" and "don't want to hold onto tight policy too long"

There you have it. Stop trading on employment data, retail sales or inflation indexes, so advises the President of the St. Louis Fed, one data point won't move the Fed and the value of the information in the first release is suspect to say the least. Watch the equity market instead.

If you are so certain that the Fed will ease, why bet on March? CBOT Fed funds digitals are trading at an 8%/11% chance of an ease in January with a tightening at, inexplicably, 4%/9%. Put up $11 to make $100 if the Fed eases, great odds in my view. Poole is telling you that the Fed is ready to ease if the data break that way or equity traders give up on the prospect for good earnings.

The Christmas selling season is upon us. By the end of January the current weakening trend in the data will be known as a blip or something more meaningful. They won't wait till March. And if they don't ease in January, why believe they ease in the Spring?

By the way, what is monetary policy? Not the object, the management.

We know and have confidence in the goal -- long-term price stability. But by what basis do they know what funds rate is right? Can they be certain that targetting 2% in the short term doesn't foster higher or lower inflation down the road? What benchmark best gauges policy, since we live in a series of short-term periods that only sees price stability looking backwards?

The other day Bernanke tells us that in this hi-tech, global world without borders, money is no longer a reliable indicator for monetary policy. Today, Poole tells us that labor can no longer be a reliable guidepost for policy.

Okay, I give up, what should we be looking at?

Market Wants Spring Break -- The Coming Week Will Tell

The market is hellbent on believing that by June of next year the first 25 will have been lopped off the funds rate. The Fed, erstwhile managers of market opinion, will let the market know whether to hold to this view on Tuesday. Poole gives a 12:30 talk in Philadelphia and then, as if he arranged a second chance for the market to get it right, he is to speak on Thursday at a CATO conference on the Fed. Other members of the Fed tribe will be out on the hustings as well, but Poole has been the best at setting the market straight.

Tuesday is also the date for the release of October PPI and Retail Sales. The October number will be used as an indicator of Christmas sales, as it comes on the heels of lower gas prices and some softening in consumer optimism. CPI is reported on Thursday.

Data plus the Fed means market volatility. Table below outlines the risks entailed. Market is pretty much set at the Poole scenario (things work out as we expect and we will give 25 back). But if we move back to 0%, there is 34 basis points of risk in the 2-year. To be forewarned . . . . . .

Money & Interest Rates ....Whose Money? Whose Interest Rates? What Policy?

Today's remarks by Chairman Bernanke at the Fourth ECB Central Banking Conference, Frankfurt, Germany entitled "Monetary Aggregates and Monetary Policy at the Federal Reserve: A Historical Perspective" gives light to the difficulty of a rules based monetary policy, or at least that the rules have changed. The upshot of his remarks:

"As I have already suggested, the rapid pace of financial innovation in the United States has been an important reason for the instability of the relationships between monetary aggregates and other macroeconomic variables.14 In response to regulatory changes and technological progress, U.S. banks have created new kinds of accounts and added features to existing accounts. More broadly, payments technologies and practices have changed substantially over the past few decades, and innovations (such as Internet banking) continue. As a result, patterns of usage of different types of transactions accounts have at times shifted rapidly and unpredictably.

Various special factors have also contributed to the observed instability. For example, between one-half and two-thirds of U.S. currency is held abroad. As a consequence, cross-border currency flows, which can be estimated only imprecisely, may lead to sharp changes in currency outstanding and in the monetary base that are largely unrelated to domestic conditions.15, 16"

As if to underscore this point, we got John Authers' Short View Column in today's Financial Times on "Tracking Bank of Japan"(subscription needed). Here he writes about the role of the yen-carry trade, the Japanese Central Bank and global liquidity.

"The question arises because much money is now riding on what is known as the “yen carry trade” – borrowing money in yen, where the BoJ’s base rates are still only 0.25 per cent, and placing it in a much higher yielding currency, such as the New Zealand and Australian dollars.

You lose money only if the yen suddenly appreciates. That could quickly wipe out all your gains. But the weight of money making this bet has helped to keep the yen relatively cheap. Volatility, which hurts the carry trade, has also been remarkably low. It may also have contributed to excess liquidity – or a “bubble” to some – elsewhere in world markets, by providing a source of cheap money.

Tim Lee of pi Economics says carry trades are “at the heart” of the “current bizarre economic cycle”, and that “carry trade mania is a key factor in the weak yen”. Stephen Jen of Morgan Stanley argues that the evidence does not support this, and points out that of all global cross-border loans, only 5 per cent are yen-denominated.

But there is circumstantial evidence that the yen carry trade matters a lot. During the sharp world equity market correction in May this year, traders complained of a liquidity crunch. That correction coincided directly with a sharp appreciation of the yen, which moved in days from Y118 to Y110 to the dollar. This temporarily removed the carry trade. Liquidity has returned, and equities rallied once more, as the yen has slipped back towards Y120. This is consistent with the belief that the yen carry trade is the source of a global liquidity bubble.

The BoJ has reason to dislike carry trade activity. If next week’s Japanese GDP figures are as bad as some expect, then it may be difficult for the BoJ to raise rates straight away. But it is well to pay a lot of attention: little or no risk of a tightening by the end of the year is priced into the market. Judging by May’s experience, a surprise from the BoJ could knock over a lot of dominoes."

So, what is U.S. monetary policy?

The globalization of money and credit has apparently confined policy to divining a rate that sustains the Fed's anti-inflation credibility yet maintains growth while letting everyone in on the plan. Policy has gone from a gold standard to monetary growth targets to "trust me, we know the right rate". The groundwork for this trust in today's Fed comes from when Volcker reestablished central bank credibility by essentially setting reserve growth and then allowing the market to decide the level of Fed funds. Believing we know the right rate to meet growth and inflation targets, especially in a world of free flowing capital and goods, is the kind of hubris that got us to needing Volcker in the first place.

Dems Win, Fed Concern -- Rolling Back Globalization?

The concern is not so much because Democrats are anti free trade, but because of the issue of income inequality. Class issues drive Democratic politics and policies. With the control of Congress and the start of the 2008 election campaign, you can bet that globalization and its effect on income distribution is front and center in the political landscape.

Why is the Fed talking about this? After all, income distribution is not in their policy agenda. Let's wind the calendar of events backwards to get a sense of the where and why of Fed concern.

We start with the November 6 speech by Janet Yellen, President of the San Francisco Fed, on "Income Inequality In The United States"

"However, there are signs that rising inequality is intensifying resistance to globalization, impairing social cohesion, and could, ultimately, undermine American democracy."

Lets go back to October 12, when Governor Mishkin gave a talk at Baruch College entitled "Globalization: A Force For Good?" From that speech:

"I will conclude by saying that those who oppose any and all globalization have it completely backward: Protectionism, not globalization, is the enemy. It is true that, by itself, globalization in both finance and trade is not enough to ensure economic development and that economies must position themselves to handle foreign capital flows. But as I said, to be against globalization as such is most assuredly to be against poor people, and this is presumably not the position antiglobalizers want to take. Developing countries cannot get rich unless they globalize in both trade and finance. Making financial flows truly worldwide and creating robust, efficient financial markets in developing countries is not optional: It needs to be the focus of the next great globalization."

Let's role back to Chairman Bernancke's talk at Jackson Hole, "Global Economic Intergration: What's New and What's Not?" on August 25 From that speech:

"The final item on my list of what is new about the current episode is that international capital markets have become substantially more mature. Although the net capital flows of a century ago, measured relative to global output, are comparable to those of the present, gross flows today are much larger. Moreover, capital flows now take many more forms than in the past . . . Today, international investors hold an array of debt instruments, equities, and derivatives, including claims on a broad range of sectors . . ."

Bernanke concludes with:

"Further progress in global economic integration should not be taken for granted, however. Geopolitical concerns, including international tensions and the risks of terrorism, already constrain the pace of worldwide economic integration and may do so even more in the future. And, as in the past, the social and political opposition to openness can be strong. Although this opposition has many sources, I have suggested that much of it arises because changes in the patterns of production are likely to threaten the livelihoods of some workers and the profits of some firms, even when these changes lead to greater productivity and output overall. . . . The challenge for policymakers is to ensure that the benefits of global economic integration are sufficiently widely shared . . . the effort is well worth making, as the potential benefits of increased global economic integration are large indeed."

Where is this interest in the topic coming from? In June of this year, an excellent book was published, "Polarized America: The Dance of Ideology and Unequal Riches" by Nolan McCarty, Keith T. Poole and Howard Rosenthal. It crystallized the political problem of income inequality.

It didn't take much to see, as Yellen did explicitly, that people see globalization as a key factor hollowing out the middle class. At the same time, it didn't take much imagination during these past few months to believe that the Democrats would regain some legislative power and bring the income issue to forefront.

Here is the abstract from the paper that predates the book:

"Since the early 1970s, American society has undergone two important parallel transformations, one political and one economic. Following a period with mild partisan divisions, post-1970s politics is increasingly characterized by an ideologically polarized party system. Similarly, the 1970s mark an end to several decades of increasing economic equality and the beginning of a trend towards greater inequality of wealth and income. While the literature on comparative political economy has focused on the links between economic inequality and political conflict, the relationship between these trends in the United States remains essentially unexplored. We explore the relationship between voter partisanship and income from 1956 to 1996. We find that over this period of time partisanship has become more stratified by income. We argue that this trend is the consequence both of polarization of the parties on economic issues and increased economic inequality"

The Fed is concerned, from my perspective, because any trade legislation that, going forward, has the impact of diminshing global capital flows will be particularly problematic for the U.S. First off, it would be a problem for financing the current account deficit and for financing the rolling over of the accumulated debt. Second, and I believe more important to the Fed, is the financing of social security.

The the social security trust fund has been using its current surplus to fund the current budget deficit by buying non-marketable Treasurys. Once the trust fund has to start paying out from the surplus it has been designed to build (talk to Greenspan, he helped design it), the fund will have to redeem these securities it accumulated to the Treasury in exchange for cash to make the required payments. Where will Treasury get the cash? By issuing debt that would be an addition to any debt raised to finance the budget deficit at that time. Any wonder why Greenspan in the 90s was so focused on maintaining budget surpluses?

If foreign flows aren't flowing at that time, the interest rate adjustment will not be pleasant.

Inflation anyone?

Tomorrow I go back to markets and probabilities and Fed action. I thought today should be about politics and economic policy and the long game.

Fed Fixes Market Focus . . . . . .Again

The monthly cycle to bring the market savants back to reality has begun. The Fed, again playing the role of responsible adult, is letting everyone know that the economy isn't tanking, the Fed isn't easing, and the risk of inflation is greater than that of a recession. The program to redjust attitudes and pricing began with the Beckner article on Friday (see my previous post) and Moskow's talk in Chicago this morning. Tonight (10pm est), Yellen speaks. Before the parade is over Poole will pop up to put the final coda on all of this.

The market, stubbornly holding to the view that its take on the economy is more correct than the Fed's (sometimes it is, this time it isn't), used Friday to push out the first ease to June. Apparently an ease delayed is not an ease to be denied. If anyone was really thinking, they might conclude that the tough Fed talk is masking an easy policy that is going to have to tighten late next year -- not ease. On that point, follow below through the highlights (as I picked them) from the Michael Moskow, President of the Chicago Fed, speech this morning to the Chicagoland Chamber of Commerce on the U.S. Economic Outlook.

Since so many are focused on a 5.25% funds rate demolishing the housing market and, in turn, the source of consumer spending, here is the Fed's take:

"A significant part, though, was due to developments in the housing sector. Residential investment has fallen 7-1/2 percent year-to-date, and in the third quarter it shaved 1.1 percentage points off of GDP growth. Additionally, home prices have been rising more slowly and by some measures have even declined. These developments raise important questions for the economy as a whole: Will there be further declines in housing markets? And will the current and any further declines in housing lead to more general economic weakness? . . . .

. . . . Nonetheless, with underlying housing demand growing 3 percent per year, the large gains in residential investment—which averaged 8-1/2 percent per year between 2001 and 2005—clearly could not continue indefinitely. Moreover, housing demand may slow to less than 3 percent, as demographics point to slower growth in household formation. As a result, we at the Chicago Fed expect some further weakness in residential construction.

.. . . . Currently, we do not see the slowing in housing markets spilling over into a more prolonged period of weakness in the U.S. economy overall. On balance, the 95 percent of the economy outside of housing remains on good footing. Employment has been increasing near its long-run sustainable pace. Productivity trends remain solid. Recent declines in oil prices should give household budgets a boost. Economic growth in other countries should increase demand for our exports. And current financial conditions are not very restrictive by historical norms."

Please note the phrase that I bolded and italicized. FINANCIAL CONDITIONS ARE NOT VERY RESTRICTIVE BY HISTORICAL NORMS. Ok then, if that is the case and the economy is expanding, what is the inflation view? From today's speech:

"Still, there is a risk that core inflation could run above 2 percent for some time. We could be wrong about reduced pressures from resource constraints, or we could see further cost shocks. And perhaps most importantly, if actual inflation continues at high levels, it could cause inflation expectations to run too high. If firms and workers expect inflation to be high, they will want to compensate by raising prices and wages or building in plans for automatic increases. In this way, high inflation expectations can lead to persistently high actual inflation."

Therefore, the conclusion on policy:

"Taking all of the factors on growth and inflation into account, my current assessment is that the risk of inflation remaining too high is greater than the risk of growth being too low. Thus, some additional firming of policy may yet be necessary to bring inflation back to a range consistent with price stability in a reasonable period of time. But that decision will depend on how the incoming data affect the outlook."

The Fed speaks, the market should listen. As for investors, 25bp in risk in the two-year Treasury if the market just goes back to pricing 0% odds of the Fed doing anything.

If, at the January meeting, the Fed holds because Christmas was good and the algebra of GDP growth makes for a stronger 4th quarter, those back Euros will be trading to a tightening instead. Just an opinion, but remember Moskow told us growth is fine and policy isn't particularly restrictive. Folks, the longer they stay on hold the less restrictive policy becomes. The nature of this economy is adapt and grow not shock and fold.

Employing Some Good Sense; The Fed Weighs In Just In Case We Missed The Point (Some Still Do)

Today's employment data and revisions snapped the market back to reality. The economy isn't falling off a cliff and the Fed is still on hold. Today's sharp move in bond prices underscores my oft made point: Investor risk lies not in fundamentals but in the volatility of opinion of what the Fed is thinking it should do next. Yesterday the market priced a 20% chance of an ease in January. Today its zero.

So much market opinion comes from savants proclaiming an inevitable recession because a 5.25% fund rate will dry up home equity lines as a source for spending. Here's a novel idea to these seers who take ceterus paribus to the extreme -- how about employment and income growth contributing to consumer well-being? Here is another novel thought, there is plenty room for the share of capital to flow back to labor before inflation becomes a problem, as this chart aptly illustrates:



In case you think this is the rant of an aging socialist, here are some words from today's Stephen Beckner article on what the Fed thinks of the data:

"The Fed is not alarmed by climbing labor costs at this stage. Officials have been expecting some increase in wages in the belief that they were due to "catch up" to past productivity gains which until recently served mainly to swell profits.. . . . .

. . . .It's possible that rising labor costs will just be part of a return to more historical norms on the labor share and the profit share, but that's not guaranteed," a senior Fed source said. "It's a rising cost pressure. It won't necessarily feed into inflation, but it's something that has to be taken into account."

That room for catch-up comes from the sharp dip in the blue line since 2000.

As for the ease potential priced into the Eurodollar contracts, beginning with Mar 07, understand what inflation the Fed is concerned about. They are not focused on price swings in energy and other commodities. That is the stuff that makes free market economies free. They instead focus on a broader increase in costs that gives truth to the Friedman view that inflation is a monetary phenomenon. This recovery sits on top of a mountain of liquidity. Hence the following from the same article:

"Comments by Fed sources suggest that, while labor compensation pressures are not worrisome enough in the current economic context to force a resumption of policy firming anytime soon, they are enough of a concern, together with other considerations, to reduce chances of Fed easing......

Echoing the FOMC minutes, a Fed official said, "trend might be a little lower than in recent years, in part because of slower productivity growth, in part because of slower labor force growth. Our bottom line expectation is not for a big output gap being opened up by slowing growth -- maybe something small."

"So that by itself isn't going to be a very strong disinflationary force," the official continued. "I don't think we can necessarily expect slower growth by itself to bring inflation down very rapidly from where it's been.""

Once again, if there is no ease in January why expect an ease by July? And if those back Eurodollar contracts return to pricing "no ease", there is a 25 basis point risk in the two-year (yesterday it was 40). Understand the risk to understand the reward.

I leave with where the market has priced the odds (they still believe 100% that there is a 25bp ease by next summer).

Where Market Is Now -- The 170% Solution

It has been a week for bullish sentiment as far as bonds are concerned. The probability pricing for a Fed ease, diminished only a couple weeks ago by Fed speakers and then rekindled by the FOMC statement (go figure), has moved to a full flame-on frenzy based on ISM and other assorted just released data. Not even the first shot across the party boat's bow, Dallas Fed Chairman's chat today at the New York Association of Business Economists, could take the punch bowl away from this celebration of impending economic gloom (bond people are natural pessimists, if they were optimists they would've gone into equities).

Rather than opine on Mr. Fisher's comments and try to establish what is really meant by inflation (see my blog on the subject), I figured it was prudent to wait till after the big number is out tomorrow morning.

So in the interest of the public interest, or at least those that read my blog, I offer the table of market probabilities -- as compiled by my partner Stan Jonas.



Note that the Thursday column shows a cumulative probability of a 170% chance of a Fed ease by Aug 07. Meaning 25bp is baked in and there is a 70% chance for the next 50bp. Which, in our terms is pretty much 100%.

Once again, if the data continue to support the negative view on growth the Fed will ease in January (where the market is pricing in only a 1 in 5 chance of an ease) by 25b or even 50bp. Why anyone thinks they will wait til Mar is beyond me.

If the data stabilize, disappointing the gloomy ones, and the market prices to the "on hold" scenario (JHLD column), the two-year backs up approximately 40bp. Will that happen? No one knows for certain, but things always seem worse than they are when the economy is in the midst of a downshift. Still, it is always helpful to know the risk you are taking from what you are buying.

Rubin In The Times, Betting Against The Dollar

In today's New York Times the Economix column by David Leonhardt carries the title "A Gamble Bound to Win, Eventually". Its about Robert Rubin, now characterized as the "eminence grise at Citigroup", having lost money betting against the dollar. He isn't the only one to have wagered and lost on this bet. Of course the equally large book taking these bets wagered and won.

This from the article (the he is Rubin):

But when he talks about the dollar, you can see how hard it is, even for somebody with his self-assurance, to remain confident in the face of a failed prediction. “I think I was right, probabilistically,” he said recently, sitting in his Citigroup office overlooking Park Avenue. “But I don’t know. I really don’t. I don’t think anyone does. It’s also possible that none of this could happen. It’s possible that for reasons none of us can see that this will work itself out in a very copacetic way.”

Why bet against the dollar in the first place? The article explains:

The simplest way to explain the problem is to say that the United States has been living beyond its means.

Both the federal government and American families have been spending more money than they take in, leaving both in debt. To close the gap between our resources and our spending habits, we have borrowed from abroad. It’s the only option.

The net amount of money leaving the United States — that is, the amount of money we need to borrow back to support our lifestyle — has soared to $800 billion a year. “It’s just stunning,” said Kenneth S. Rogoff, former chief economist of the International Monetary Fund. “It’s unprecedented.”

As for how it can resolve itself, well it can be quick and dislocating or slow and relatively painless. One scenario noted in the column caught my attention:

The other possibility is that an unexpected event — a spike in oil prices, say — could cause foreign investors to cut their dollar purchases sharply, bringing all sorts of economic havoc.

Huh?

Oil is priced in dollars. A spike raises global demand for dollars and then transfers all of it to OPEC. Petrodollar recycling ensues. Trust me on this one, they don't burn the dollars. They buy lots of things that are priced in dollars -- not all of which is sold by U.S. producers. By the way, know who the world's largest exporter is, in absolute terms? The United States, by a landslide.

The reason so many notables were wrong on the dollar, and this isn't to say that at some point they won't be right, is only one side of the equation is being examined. In other words, they are not open to the possibility that they have cause and effect reversed.

The demand for dollars is NOT something totally in our control. As the global currency, lots of people buy and sell dollars because of their own domestic needs and concerns and not because pricing of U.S. dollar assets are attractive. In fact, as I wrote about yesterday, the Warnock paper on the impact of dollar flows on U.S. interest ratees suggested that flows dropped the yield on ten-year Treasurys by about 90 basis points. Why would foreign capital keep following?

Herein lies the tale, from my perspective. We have, in some ways, become like any other emerging economy where foreign capital flows in and distorts domestic pricing and, in turn, domestic activity. It is not quite that bad, although 90bp is alot when you consider it took 4 Fed meetings to raise the funds rate 100 basis points, since the demand for dollars might reflect activity elsewhere in the world with little relevance to whether U.S. asseets are attractive. But the domestic impact is the same, regardless.

Rather that wring our hands about the profligacy of Amercian consumers and the Federal government, a worthy topic for another time, collective wisdom should focus on how to insulate asset prices here from being distorted by foreign flows. A distortion that, in turn, distorts domestic activity. Ideas?

International Capital Flows Alter U.S. Interest Rates

Thought it worth taking a brief trip away from Fed probabilities now that the market has reached a frenzied expectation that Fed eases arrive March 07. Not much to say about a frenzy except wait for facts to confuse the issue. The market rally does, of course, ease financial conditions and thereby mitigate the impact of 5.25% Fed funds. Market professionals also know that foreign capital flows have kept market interest rates low. Academe has caught up.

"International Capital Flows and U.S. Interest Rates (NBER Working Paper No. 12560)by Francis and Veronica Warnock conclude that the impact has been significant:

"Foreign official purchases of U.S. government bonds have an economically large and statistically significant impact on long-term interest rates. Federal Reserve credibility, as evidenced by dramatic reductions in both long-term inflation expectations and the volatility of long rates, contributed much to the decline of long rates in the 1990s. More recently, however, foreign flows have become important. Controlling for various factors given by a standard macroeconomic model, we estimate that had there been no foreign official flows into U.S. government bonds over the past year, the 10-year Treasury yield would currently be 90 basis points higher. Our results are robust to a number of alternative specifications."

There is also the ongoing expectation that we will need to keep interest rates high and the dollar strong in order to bribe foreign investors to keep buying our debt (finally an export in which we appear to have the greatest comparative advantage). We are at their mercy, so goes the common wisdom which always concludes with "How long can this go on?" Here's an answer -- "As long as the rest of the world wants to over save and under invest." And how long is that? Until it becomes politically necessary for a change. In other words, there is no answer.

Reds Rally, But Its Really All About Jan

GDP data come out and tell us what the Fed knew two days ago. Two days ago the Fed came out and told us the slowdown is done and its moderate growth from here on out. Market comes out and rallies the late 07 and early 08 Euros. Dec 06 Euros priced at 94.62 means no Fed action in Q1. So the market prices a weaker economy than the Fed expects, but expects the Fed not to see or react to what the market sees until the middle of next year -- at the earliest. You can't make this stuff up.

The Jan meeting will tell the tale. IF the Q4 data are as weak or weaker than Q3, Fed eases right then and there -- they are not going to wait til Mar, May or Jul. Poole told us, no moderation on the downside if the wheels are coming off the economic bus. IF the Fed holds in Jan, it means that their forecast of moderate growth unfolded as expected. Should that be the case, do you think all that ease priced into the red and green Euros holds?

Right now, market is pricing a 10% or so chance of an ease in Jan while looking for 60 basis points through 2007. One interpretation is 60% chance of 100 basis points in eases. Another way to parse it is certainty on 50bp and 40% on the next 25. Either way, the eases are loaded into the warm weather months. Seems to me, if you believe the economy is weaker than the Fed is letting on, always a possibility, cheaper to buy the call on Jan and hedge it up with cheap puts in Sep 07 or Dec 07. As always, these are ideas best discussed with people who understand your financial situation and no guarantees are being made or implied.

Let's confuse the GDP growth story with some facts.

Having a weak quarter during an expansion is, by itself, not unusual. We all like to think in trend terms, but there is very little correlation in real growth from quarter to quarter. There is a lot of basic algebra determining the next quarter based on the current one. High number raises odds of lower one in the next period, and visa versa. It can get a bit more detailed, such as using the monthly pattern, but suffice it to say that for the 4th quarter to look weaker, lots of activity has to weaken further since housing doesn't drop another 17% -- unless we want to take down all the growth from inventory liquidation. Which is always possible, as is the likely reversal of that strange growth number for auto production.

Every quarter has its "special factors" that, over time, are forgotten as we examine past patterns of real growth. The chart below shows the pattern of quarter to quarter growth during the 90s expansion. The variability and how strong quarters follow weak ones, etc. are clearly evident.



As for my comment about getting a weak quarter during an expansion, you can see that in the chart above and in this histogram below. The graph counts out the number of quarters registering growth rates in different buckets during expansions (as defined by the NBER) beginning with 1960. Note that 21% of the quarters had growth rates of less than 3% and of those 40% was less than 2%. Point here is that while there is a clear central tendency, as one might expect, there is also a clear dispersion that makes straight line forecasting from one quarter's growth rate a tricky business.



Lastly, the 3Q numbers are weak exactly where the Fed expected them -- in residential housing. The capital spending and consumption data say that the drop in housing hasn't spilt over. The Fed's outlook is that the worst in housing is over. Accepting that plus lower mortgage rates, lower gas prices, higher confidence numbers, and ongoing credit creation, why can't Q4 turn out as the Fed expects -- moderate (under 3%) real growth? From here, it looks like the Fed holds again in Jan (Dec on hold is a foregone conclusion). Given that, why do those back Euros keep getting richer?

How The Market Read The Fed

My interpretation of the FOMC Statement is that the Fed believes the economy has past its low so its moderate growth ahead. Moderate keeps the Fed from tightening. Growth means they hold if their forecast comes true and tighten if it doesn't. The likelihood of an ease drops off because when you expect growth you have dismissed housing as a factor that could pull the economy to recession.

Opinions make betting pools and markets interesting. Fed fund futures and Eurodollar futures are alot like betting pools. Given that preamble, the table below, lifted as usual from my colleague Stan Jonas, closes the day at these levels of probability and risk



The Wed column is the close of business, all the others are where the market would be for that array of odds. Wed close is not a bearish view, but clearly a bullish one. Markets now expect no change till the summertime ease.

How the market pulled this one out of its collective hat is beyond me. The natural predisposition for the economy is to adapt and grow. As time goes on, the 5.25% funds rate will have increasingly less impact. The market believes the opposite.

We will both be wrong, of that I am sure. For if there is one thing I do know, it is that there is big thing out there we all don't know that will change everyone's mind.

What Was Said

A quick view of the FOMC Statement shows an important shift in FOMC thinking and its view of the economy.

First off, there is the opening line:

"Economic growth has slowed over the course of the year, partly reflecting a cooling of the housing market. Going forward, the economy seems likely to expand at moderate pace."

Last month's FOMC statement, the opening line was:

"The moderation in economic growth appears to be continuing, partly reflecting a cooling of the housing market."

Difference? Slowdown moves to the past tense and they add the expectation for growth. The Fed is saying that the housing slowdown has not broadened out to hurt the wider economy and has likely hit bottom.

Is there anything for them to worry about?

"Readings on core inflation have been elevated, and the high level of resource utilization has the potential to sustain inflation pressures"

The previous statement explicitly noted that energy and commodity prices were part of the parade of factors to sustain inflation, now no longer.

In sum?

Fed isn't worried about housing creating a broader slowdown. The Fed knows that the commodity push to headline inflation has subsided. The Fed has declared its concern about the old bugaboo, monetary inflation. They will watch and wait for now. No moves till Jan at the earliest. But they are poised to tighten in the face of stronger growth, more so than they are poised to ease. As Kohn told the Money Marketeers in the Q&A -- don't short the Fed's resolve to fight inflation.

More later today on where the market has priced this all out.

Pre-FOMC Is Said and Done, And To Be Said Again -- With A Twist

No sooner does the Fed get through telling the market it can't understand why the certainty of an ease is priced in for next year when the savants raise market yields to the point where they are pricing a small risk of a tightening in Jan -- but still expect 25bp of an ease by Sep 07 and 50/50 of another 25 in 08:1Q. Market opinions swing and generate trading, but in truth there isn't much to do except wait for the unexpected to move the Fed to ease or to tighten.

To sum up current pricing, before today's statement, the market is giving up a tiny risk premium, about 12%, that the Fed tightens by Jan. This is more insurance premium than anything else. The world is long cash and the risk of moving to "on hold" is at least 20 basis points in the 2-year.

After Jan, the expectation is that slower growth reduces inflationary pressures and, as such, gives the Fed leeway to drop funds 25 to 50 basis points.

Perhaps yes, perhaps no.

The market has to express some opinion but here is the Fed's (from my perspective): Everything is fine for now, when the unexpected occurs we will react, the longer time goes on the greater the possibility for the unexpected. Which way will it pull the Fed? They don't know. We don't know. The market really should have a flat curve. Anything else is a bet on a random event.

John Makin, an excellent economist (meaning that I agree with him more often than not), lays out the cross-currents that have the Fed waiting for events to unfold before doing anything. In his Economic Outlook column for the AEI. Lifting from piece, entitled "U.S. Slowdown Self-Correcting or Self-Reinforcing":

"The U.S. economy’s capacity for self-correction, whereby a slowdown of the real economy creates financial conditions that support an economic rebound, has been in no small part responsible for its remarkable resilience--especially over the last half-decade. .....

. . . . . As we enter the fourth quarter of 2006, the economy’s self-correcting mechanism is easing financial conditions and mitigating the drag from an intensifying slowdown in the housing sector, even though the Fed has signaled that it may continue to raise the fed funds rate if inflation persists. The operation of those opposing forces has created considerable uncertainty about the outlook for U.S. growth. . .

. . . . The notion that the slowdown may be self-reinforcing is underscored by the fact that actual weakness in the housing sector is probably more pronounced than the official data suggest. . .

. . . . .The balance between self-correcting and self-reinforcing slowdowns appears recently to have shifted slightly in the direction of self-correcting. . . . . .

. . . . . .What then is the likely outlook over the next year? Will self-correcting or self-reinforcing economic slowdown forces dominate? The two opposing forces have to remain about balanced with a tilt toward a self-reinforcing slowdown to validate the market’s current assessment that the Fed will start easing during the first half of 2007. Perhaps the most likely outcome will see growth oscillate gently around an underlying negative trend tied to a persistent drag from the housing sector. . . . . ."

This is what the Fed thinks, as Poole and Kohn and Yellen and everyone else has told us.

Thoughts for today's statement? A more balanced assessment of the risks going forward. The Fed likes the idea of keeping funds at 5.25% in the short run and letting the long end soften the blow to housing. Not too low, of course, and not too high (which is where the market might be going). So we get a responsible statement that lays out the risks and determines that there is nothing to do until the unexpected happens.

Bull Run In Bonds.......Incredibly In the Red Euros

One number (industrial production) and the market runs back towards the conclusion that recession or at least a Fed ease is on the way. While everyone is entitled to their opinion, market participants are, incredibly, betting that the Fed won't act until 2007:2Q at the earliest. Think about this. The grand poobahs of the market are looking at today's data, guessing on how weak the 3rd quarter was, adding to it forecasts for spreading weakness from housing and autos, and concluding that the Fed won't see what they do until next spring. You can't make this stuff up.

The table below, courtesy of my erstwhile partner Stan Jonas, is from his Bloomberg page (FFEP). It lays out where the market is betting and what happens if the bet shifts.



This morning's data helped to shift the market to the "Poole Scenario". This is based off of some of Poole's earlier comments that suggested (he would never tell, only suggest) that Fed funds were mildly restrictive and if inflation wanes and economic growth is comfortably in the 2.5% to 3.0% range, some give back is likely. He also let it be known that if the economy was starting to fall off a cliff, there would be no gradualism in the Fed's response.

That brings us back to today. IF you believe that the Fed will be easing because of a weak economy, an opinion based on recent data ..... Why believe that the Fed will wait until spring to ease?

There are plenty of Fed ease in January opportunities out there. The Jan digital is trading at 12, meaning you risk $120 to make $1000. Not a bad payoff. There is also the Jan/Feb Fed funds futures spread. Because of the Jan 31 FOMC date, any movement towards a Jan ease and the Feb contract will have all of the move -- by mathematical necessity. Of course a futures spread will hurt if the market switches to a tightening. In sum, its a bet on the Christmas season.

If you get a Fed ease in January, EIJ is the minimum move, a 17 basis point rally in the two-year Treasury. EJM is the more likely way the probabilities would line up if the Fed eases in Jan. That 100% in Mar can also be interpreted as 50/50 of a 50 basis point move. Remember, there will be no gradualism on the downside. In the EJM scenario, the two-year drops 44 basis points in yield and EDH7 is modeled to rally over 50 basis points. That Jan/Feb spread in Fed funds futures? You make 22 basis points, or thereabout.

Honing to the legalities of the day, these trades are mere suggestions, not suited for everyone, and the prices change minute to minute, and I am not guaranteeing anything other than that you will be paying your broker something if you put on a trade.

If the Fed is going to ease because the current spate of data indicates a rapidly weakening economy, they aren't going to wait until spring.

On Prices, Inflation and Why The Fed Is Concerned

Prices are supposed to change in a free market economy. Things, people, land, money, everything is supposed to go up and down to signal scarcity or abundance. Price changes create an income effect and a substitution effect for consumers. For investors, price changes are a signal for allocating capital. This isn't just theory. The communist economies eventually failed because of prices set by fiat rather than supply and demand.

A key to effective price signalling, however, is that prices are expected to move in both directions. Therein lies the difference between a change in price and inflation. Inflation is about seeing a price go up and then expecting the price to keep going up along with the price of everything else. The signals are more difficult to discern. In the 70s, consumption and investment decisions were driven by expectations that prices will be higher tomorrow. The cost and, yes, even benefits of that period are still with us. Volcker, knowing this was no way to run an economy, kick-started the disinflationary monetary policy that Greenspan continued. It eventually squeezed inflation expectations out of the system. This is one genie the Fed wants to keep in the bottle.

Here it is in Fedspeak, direct from Kohn's speech last week to the Money Marketeers (the boldface is mine):

"When we try to model energy pass-through econometrically, the results indicate that a break occurred in pricing patterns in the early 1980s: Pass-through is clearly evident before 1980 but it is difficult to find thereafter. I suspect this pattern has something to do with the monetary policy reaction to those shocks and its effect on inflation expectations. In the 1970s, monetary policy not only accommodated the initial shocks but also allowed second-round effects to become embedded in more persistent increases in inflation. Since the early 1980s, the pass-through to core prices has been limited or non-existent, at least in part because households and firms have expected the Federal Reserve to counter any lasting inflationary impulse that they might produce. This result reinforces the need today to keep inflation expectations well anchored."

Kohn is absolutely right in his assessment, though I suspect my view on this matters not at all to the Vice Chairman. The positive outlook on inflation, as per everyone's comments these past two weeks, comes from the abating price increases and even declines in the costs for energy and shelter. But, and there is always a but, Kohn sheds a bit of light on why the Fed remains concerned about inflation, beyond the required rhetoric. From the same speech (the boldface is once again mine):

"In sum, I think that the odds favor a gradual reduction in core inflation over the next year or so, but the risks around this outlook do not seem symmetric to me: Important upside risks to the outlook for inflation warrant continued vigilance on the part of the central bank. I say that not only because of the questions about underlying labor costs and about the future direction of energy and shelter prices but also because our understanding of the inflation process is limited, and I cannot rule out the possibility that the upward movement earlier this year reflected a more persistent impulse that I cannot now identify".

Where did this come from? Perhaps from the mountain of liquidity behind this expansion that helped to prevent a deflation that, thankfully, never arrived.

This first chart compares nominal GDP growth to the Fed funds rate as we came out of the 1990-91 recession.



Here is what they did this time around.



This chart compares the difference between GDP and Fed funds for each period. The higher the line, the easier the Fed.



To be fair, enough differences separate the periods to create different policy responses. This time around deflation was perceived as the credible risk to be tackled. Then, inflation was still the big risk and we did not yet full understand that the economy could grow faster without inflation because of technology and globalization.

There is one more difference. In the 90s, the Federal budget deficit was shrinking. Now it isn't. Then, alot was done beginning with Gramm-Rudman in 86 to put the structural deficit into balance. This time, the structural deficit is back.

Another difference? Japan wasn't growing and neither were China or India. As a consequence, the global demand for oil was not expanding as rapidly.

Enough caveats.

PCE year-over-year averaged around 2.3% during this period in the 90s and ran from 2.9% at the beginning to 1.8% by the end of 1996. This time, the average is the same and we are running at about the same pace, 2.3%, as when the recovery started (of course there was that scary dip in the middle).

So far so good. But lets take a look at the GDP deflator year-over-year, which includes energy and food and all the other non-core items that impact income and wage demands. In the 90s expansion, a 2.1% average and the pace dropped from 2.3% to 1.9%. This time, a 2.7% average and the pace has risen from 2.1% to 3.3%.

Uh-oh.

So Kohn is telling it like it is. They are hoping that a slowdown with rates at neutral and with its hard-won credibility, the Fed can get inflation down before it spills into the core. They have reason to be positive, and cause for concern.

No way to know now how it will turn out, as Poole keeps telling us. But there is more worry than they are letting on. After all, why else is Bernanke has recently been fronting a more open stance against the structural deficit in the Federal budget? Coincidence?

FOMC Minutes - It Can't Be Any More Clear

The FOMC minutes for the Sep 20 meeting were released today, and of course the market sold off. But it still isn't enough. In plain English, the crux of the problem is the view on housing. Here is what the Fed put into the minutes:

In their discussion of the economic situation and outlook, meeting participants noted that the pace of the expansion appeared to be continuing to moderate in the third quarter. In particular, activity in the housing market seemed to be cooling considerably, which would contribute to relatively subdued growth over the balance of the year. Growth was likely to strengthen next year as the housing correction abated, with activity also encouraged by the recent
decline in energy prices and still-supportive financial conditions. In the view of many participants, economic expansion would probably track close to the rate of growth of the economy's potential next year and in 2008. Many participants also noted that core inflation had been running at an undesirably high rate. Although most participants expected core inflation to decline gradually, substantial uncertainty attended this outlook.

The market savants, in their infinite wisdom, the very ones that a year ago were forecasting Fed eases this year, continue to press their view that the Fed is wrong, the housing contagion will spread and slow growth enough to create the need for a lower Federal funds rate.

What the Street arguments seem to lack, as opposed to the Fed argument, is that there are alot of other facets of the economy, unrelated to housing, that are growing. In addition, the drop in energy prices and bond yields are net adds to growth.

There is no way to know apriori who will turn out to be correct, but as evidence of growth sustaining itself continues, remember that the "Fed On Hold" scenario carries about a 40+ basis point move up in yield across the curve.

'nuff said.

Risks Realized As Market Hears The Fed, What's Next?

It has taken two weeks of speeches and conversations from Bernanke, Kohn, Yellen, and today Poole in the FT, plus last Friday's employment data to finally get the market to understand the risk inherent in utterly convincing itself that the Fed is going to ease in the coming year.

The risk, as I have written in this Blog before, is that when you own a security such as the 2-year Treasury, you own the market's expectations. Now that the market has finally caught on to what has been obvious, the yield on the 2-year has backed up about 25 basis points since last Wednesday. And the back up isn't finished.

Before looking ahead, lets look at what the array of speakers had to say;

• Don't short the Fed's resolve on fighting inflation
• Unless downturn in housing extends to broadly damage the economy, the Fed isn't stepping in
• If the Fed has to step in, it will ease aggressively to prevent recession
• Current Fed funds is high enough to bring down inflation over time -- and we can be patient
• At current market rates, the downturn in housing has probably plateaued
• If the Fed is uncertain as to how the economy unfolds, why is the market priced with such certainty?

The employment data was the final piece to crack the market's illusion of what will be to what is going on. Briefly put, the upward revision to August to 188,000 new jobs pushed growth above the 100,000-125,000 that the Fed feels is concurrent with trend growth. The earlier benchmark revisions are interesting for revising equations, but not so much for the market. Trading today on what employment growth actually was last April is a bit silly. The impact has long been seen in the growth data. All that has occurred is that we now know better why spending held up.

Looking ahead, the market is coming to an interesting pricing pattern, as seen below in the table lifted from my partner Stan Jonas's screen on the Bloomberg:

The table tells us that the market has shifted from the EIJ (Ease In January) to Poole (based on his and his compadre's comments). Should the market shift to HLD (Fed on hold forever), there is still a 46 basis point back-up in the yield on 2-year Treasurys. In other words, you are still buying the ease potential.

What are the odds? A careful look at Poole and I come away with the sense that the market is pricing for an impossible outcome. The outcome presumes that the longer the Fed goes with doing nothing, there is an ease out there, somewhere, sometime. Eventually, perhaps, but the longer the economy grows at trend, so the Fed doesn't have to ease, why would the economy suddenly weaken when the natural momentum in the economy is growth? In other words, barring the unpredictable, if the economy is on track next spring, forget about any ease. If there is going to be an ease, it will be by January the latest or not at all.

What does that mean? Simply that the HLD scenario is very much in play IF you believe the economy is not going to slink into recession. Remembering this economy ends with a bang and not a whimper, a recession bet is a bet on the unpredictable. As I have written before, understand the risk before you invest. If you buy a 2-year Treasury, there is a 45 basis point risk if the economy grows such that the Fed has nothing to do but watch.

If you are inclined to trade the market, the March 2007 Eurodollar contract has all the action and expectations. Not wanting to run afoul of any rules and regulations, I will let you figure out what you can do.

Poole Q&A -- A Gift To Those Looking For An Ease

In response to a question regarding the market's expectations of Fed policy next year, Poole gave an interesting resaponse. He noted that having the 10-year yielding 60 basis points under funds was not a tenable relationship for the long run. The trader, he added, is looking for less inflation and weaker growth and expecting the Fed to aggressively drop rates to a level below 4.65% (10-yr yield). Poole added that market forecasts, as honest and as good as they can be, do not have a good track record.

If inflation eases off, as the FOMC hopes, and real growth stays at or near potential, the Fed will not have to ease agressively and the 10-year yield would have to rise up to the funds rate or higher.

My italicized bold highlight informs us that IF the above scenario comes true, the FOMC is already set to give the market back the last 25 basis point hike.

In sum, if you think the Fed has done enough to quell inflation and not squash the economy, price in a 25bp cut for next year and short the 10-year. As for the timing of the move, considering that they want to see a solid pattern of data and are willing to wait until they get it, a March ease looks like the best bet.

Unless the unexpected occurs.

Neutral Is Neutral Is Neutral Until It Isn't

As I wrote last night, Bill Poole, President of the St. Louis Fed, was going to feed us what the Fed has been feeding us: The funds rate is at neutral until the data prove that it isn't. Between the lines, there is a bit of a wink to the expectations that an ease next year is not out of the question but he also lays out the parameters;

If incoming economic indicators show that both output and inflation are rising above these forecasts, then in the absence of any other information we can expect that the FOMC will increase its target fed funds rate. On the other hand, if both output and inflation come in weaker than expected, we are unlikely to see further increases in the federal funds target; indeed, if economic weakness is pervasive enough the FOMC will at some point reduce the target funds rate.

The italics are mine.

Where is the wink to an ease next year?

If the economy comes in below the baseline forecast in coming quarters, the FOMC will have room to act as aggressively as required. I have no idea what scale of easing might be appropriate, for that will depend on the nature of the incoming information. Still, I believe forecasters should assign a relatively low probability to deep recession precisely because of the FOMC's demonstrated willingness to act aggressively as necessary.

So the Fed isn't expecting an upturn anytime soon, and while they expect the economy to slow to a less than 3% real growth path (the new non-inflationary trend path), if the wheels come off the proverbial bus they will be on it quickly -- there is no gradualism on the downside

As for market thinking, Poole notes:

The market's evaluation of the prospects for policy is revealed in the futures markets for federal funds and Eurodollar deposits. Current futures prices predict that the fed funds target is expected to begin moving down. . . . the market's expectation of future policy easing has been taking hold gradually since late June, say, in response to data on the real economy suggesting that real growth is slowing and inflation data suggesting that the worst may be over on that front.

Is the market right?

I want to underscore my earlier point about the limited accuracy of those forecasts. Some of the forecast misses have been pretty dramatic.

When the market has been wrong, it is generally when:

Both the FOMC and the markets were surprised by incoming information . . .

According to Fed studies, 70% of the difference between the Eurodollar futures market forecast for rates six months out and where rates acutally end up is explained by "no one saw it coming". Remember that when street people write with rock-solid confidence what is going to happen next and what the Fed will do about it.

The market overreacts to every data point, it has to. The street only gets paid when money changes hands, so getting everyone on edge about the importance of the next data release is part of the drill. Remember when it was the money supply data on Thursday night? Remember money supply?

Anyway, the Fed, being professional has no panic, professionals never do, which is why Poole says:

. . .it is rare that a single data report is decisive. The economic outlook is determined by numerous pieces of information. Important data such as the inflation and the employment reports are cross checked against other information. . . .

. . . .Policymakers piece together a picture of the economy from a variety of data, including anecdotal observations. When the various observations fit together to provide a coherent picture, the Fed can adjust the intended rate with some confidence.

As for my neutral is neutral until it isn't, Poole closes with:

That the policy setting is data dependent is a good sign. It means that policy is in a range than can be considered neutral that is, thought to be consistent with the Fed's longer-run policy objectives. . . . I believe that is just about exactly where we are today.

That may be where the Fed is, but not the market. As I wrote yesterday, Poole was going to disappoint the market by telling the grand poobahs of market opinion that he isn't ready to ease. It was predictable, as is the market's reaction. The 2-year Treasury is currently up 3.5 basis points on the day, 5's are up 4.3bps, and 10s are 3.7bps. The movement reflects the red Euros being down 3 to 4 basis points.


Even with this back up, the market is still pricing in 25% chance of an ease in Jan, around 25% to 30% in Mar and 40% in May. Pretty high odds considering Poole's comments. If you own the 2-year Treasury you own those odds. To give a sense of the risk, if the expectations went to 0% the 2-yr would back up near 60 basis points in yield.

I am predicting nothing but expecting anything. Odds of an ease are better than they are for a tightening, but the market is just too sure for me that the economy will need lower rates to avoid recession. May turn out to be true, and the Giants might win the Super Bowl, but how much do you want to bet on the outcome?