Monday, July 31, 2006

Poole Speaks/Yellen Confirms/The Game Is Afoot

Poole has spoken -- he is officially 50/50 on whether the Fed should go or not. The remarks were made today, post a speech he made "Chinese Growth: A Source of U.S. Export Opportunities" in Lousiville, Ky. Poole pointed out that more incoming data between now and August 8 will be critical, such as Friday's employment report. Yellen gave a speech today at the Golden Gate University Speakers series and said the same -- 50/50. The game of managing the markets expectations as evidenced by the Fed funds futures market has begun.

The Fedspeak may be 50/50 , but the market remains at only a 26% likelihood they tighten in August and then nothing until they ease next year. The bond market, in its infinite wisdom and led by their chief spokesman Bill Gross, has voted that the bear market in bonds is over for this cycle. To give Bill his due, not that he needs it from me, he is a longer term bear for many of the same reasons I am -- the need to inflate is greater than not (opposite of 1979).

Strange, however, that the market is more certain than the Fed that August is a no-go, at least by virtue of public statements. If the Fed wants to move the market back to 50/50 look for an Ip article today or tomorrow.

To put the current market in expectations in some context let me trace today's comments from Yellen and Poole back to Bernanke's testimony on July 19, when he stated:
"In particular, we have imperfect knowledge about the effects of our own policy actions as well as of the many other factors that will shape economic developments during the forecast period. . . . . effects imply that we must be forward-looking, basing our policy choices on the longer-term outlook for both inflation and economic growth. In formulating that outlook, we must take account of the possible future effects of previous policy actions--that is, of policy effects still "in the pipeline." Finally, as I have noted, we must consider not only what appears to be the most likely outcome but also the risks to that outlook and the costs that would be incurred should any of those risks be realized.

At the same time, because economic forecasting is far from a precise science, we have no choice but to regard all our forecasts as provisional and subject to revision as the facts demand."

Which facts? Employment and CPI data? At this stage of the cycle greater import is given to anecdotal information than not -- the Beige Book. The reason to rely on anecdotal data was specifically laid out in Poole's speech at a Bank Of Korea Conference on June 16, "The Role of Anecdotal Information in Monetary Policy" If you want the academic model for how the FOMC should be analyzing the current environment read "Real-time Model Uncertainty in the United States: The Fed from 1996-2003" by Tetlow and Ironside.

The Fed is looking at the entrails of the data coming in. The Fed is making lots of phone calls to the business community. They are trying to figure out whether the economy is at the point where they should trust their forecast and believe the moderation story (see my last blog "White Kunckle Time for Bernanke").

There is another item that helps put today's comments into some context. Prof. Mishkin's paper "Can Central Bank Transparency Go Too Far?". If you can't wait for the movie, the essence of the paper is that at some stage policy is more effective if policy moves are unknown in the short-term against the market's understanding what the longer-term goal is, assuming that the central bank has established credibility -- through previous communication and action. Prof. Mishkin is now on the FOMC. The move from transparent communication to opaque has begun.

In sum, the market thinks it sees through the opaque policy statements to believe that the data and building anecdotal evidence (best shown in the beige book) mean that August is a no go. If the Fed does go, the markets will probably rally anyway, believing that they went too far. This is one case where I believe the market is right in anticipating a no-go. My impression is that the Fed is much less certain than the market than an ease next year is baked in the cake. Perhaps that is the message they are trying to get across.

Thursday, July 20, 2006

White Knuckle Time For Bernanke?

Every trader and investor that has been around for a while knows "white knuckle" time. For the uninitiated, white knuckle time comes when the market is against you more than anticipated, margin calls are coming and you have to decide whether you have the resolve to stick with your position or bail. White knuckle time. All the quant models in the world can't help, a combination of judgement and confidence is the hallmark of survivors.

Economists who earn their keep by the value of their opinions have their white knuckle time -- when inflection or turning points are forecast. Such forecasts, built on longer-term economic fundamentals, inevitably come up against a run of data suggesting the contrary. Data lag current conditions, everyone knows that, but sometimes the run is right and the forecast is wrong. Judgment and confidence are tested, stick with the view or do what Keynes did: "When I get new information I change my mind, what do you do?"

Bernanke's forecasts carry a bit more impact. His recent testimony suggests, at least to me, that his white knuckle time may be on the horizon if not already here. At some point, in the face of continued bad inflation news, he will stop tightening with the confidence that the Fed forecast for moderate growth based on weaker housing, high energy costs, and higher interest rates (finally!) will be right. Lack confidence in the outlook and keep tightening, risk recession. If he stops and the forecast is wrong, risk worsening inflation. White knuckle time. There is one thing in their forecast we don't know, where they set the funds rate. Is the next tightening in? Is the model using an endogenous equation for fund? If so, what level is the model coming up with.

Greenspan had his share of white knuckle periods and one fairly analagous to this one was 1995, when he stopped easing before growth turned back up. Then the economy accelerated and market calls for tightening through 1996 were met by a "no change in the funds rate" policy. Greenspan's response to the market was his new paradigm manifesto -- the economy can handle alot more growth without inflation because of technology and globalization. He was right. The market was wrong. How come that paradigm doesn't exist now? Topic for another blog.

Getting back to the current situation, the Fed always had a stated preference to err on the "too tight" side, believing it is easier to reverse downturns than inflation expectations. But Fed Chairmen, especially new ones, are also not immune to public opinion. I doubt Bernanke wants his first major accomplishment to be a recession.

He does, however, have a problem. Greenspan and his global counterparts left a mountain of liquidity that has been moving its inflation impact from financial assets to real ones.

His testimony gave us some Eco 101 -- the lead/lag relationship between interest rates (that is monetary policy) and the economy. He gave us that anecdotal information is more important than published data at turning points and surveys of inflation expectations are critical to read and contain. He didn't give us an explicit roadmap. That isn't necessary, from my vantage point, since the open mouth policy was meant to help the Fed wean the economy off of extraordinary accomodation and onto more realistic levels for the cost of credit. Now, as new FOMC member Mishkin has written, sometimes it is better for the Fed to say less.

In the end, Bernanke gave us a punt. Market reaction, one more tightening, most likely August, and then done. Of course the market did what a punt is supposed to do -- confuse (see Mishkin). On Friday, the market went from certain go to certain no go. A dizzying spin. The coming week suggests more of the same.

What will he do at the August meeting? I think he skips and hangs on with white knuckles, hoping he didn't stop too soon or go too far.

Tuesday, July 18, 2006

Where The Bond Market Is, It Can't Be On August 8, 2:15pm

The reaction to today's PPI data, along with recalibrated expectations for tomorrow's events, put back a reasonable sense of fear into investors that the Fed will raise rates another 25 basis points at the August meeting. The market went from a less than 50/50 chance of a tightening to a 60% chance of a 25bp hike. The congnoscente now wait for black or white smoke to rise from Capitol Hill at 10:01AM, with the outcome somehow dependant on the CPI data released that morning. Will core be .3 or higher? A lot of silliness to believe that Fed action in August depends on one data point or that Bernanke will do anything more than keep his options open while expressing optimism for the economy (good for stocks) and vigilance on inflation (good for bonds). More on this at the end of this posting.

The current pricing of the market embeds a pattern of expectations for Fed action that, when the time comes, the market won't be there. Fed funds and Eurodollar futures and their options are priced to an expectation that the Fed is August And Done. If you believe that to be the case and buy the two-year all you earn is the coupon -- nothing more when you bet with the forwards.

The August and Done scenario, however, can only be true retrospectively. Prospectively, if the Fed goes in August what are the odds that investors, advised by the same cognoscente who, last summer, were predicting Fed eases this summer, will hold September expectations to 0? Most likely we go to 50/50 at first, 25% at best if you are bullish.

Understand, however, that if the Fed goes in August and then the market prices in a 60% probability of going in September, 25% in Oct, 10% in Dec and 5% in Jan, the two-year goes up 22 basis points in yield (my guesstimate, certaintly no guarantee). If the market, after the Fed goes in August, expects a 6% funds rate, my guess is that the two-year moves 37 basis points higher. All the other maturities move the same in yield terms, more or less.

The only way to get a rally in the market is if the Fed SKIPS August and the market follows up with an expectation for no more tightenings, or perhaps even the potential for an ease. In that case, the market can rally anywhere from 15 to 25 basis points or more if the ease expectations creep into this calendar year.

The upshot is that if you own a two-year Treasury and want cap gains in the near term, your investment is a bet that the Fed skips August. If that makes you uncomfortable, change your investment.

I am not predicting what the Fed will do, I am just trying to define the risk.

Personally, 60/40 is about right for August and I really do not expect Bernanke to give us much more guidance outside of that. For those of you thinking he might do a rewrite after the CPI number (actually he will have it tonight, as will the White House) remember this -- the Fed understands the lead/lag relationship between inflation and growth. The worst inflation year in a business cycle is usually the first year of recession. What will, as a consequence, drive the Fed to act or not act is not the CPI data released tomorrow morning per se, but their internal forecast of the economy. IF they are confident that 5.25% is enough because the past tightenings plus high energy costs pull nominal GDP growth under 6%, then they are done. If not, they aren't. And if you own Treasurys, you've bet they're done.

Monday, July 17, 2006

Inflation, The Fed, and The Market: Where lies rationality?

7/17/06 8:14pm (Dow Jones) "Inflation is not the number-one threat to the US economy right now as much as the Fed's over-reaction to it," Merrill says. "The Fed's jawboning in recent months has been so intense that even with the turbulence in the markets, and the fact that two of every three economic indicators have come in below expected, that the futures market is still pricing in more than 50-50 probability that the Fed tightens yet again on 8 August," firm says. It's a "grim reality" that it probably comes down to Wednesday's June CPI number -- if it's 0.3% or higher month-over-month, the Fed has little choice but to tighten further, Merrill adds. (JHS)

Now that Merrill has said it, it must be true. Anyone who has been reading this blog knows that it has been my contention that the Fed will likely stop short of the number where money truly becomes expensive (6% or higher, based on nominal GDP growth) and keep some inflation bias in the system. The summation of what the Fed wants is a seamless turnover of the growth engine from housing to capital spending. No one, I repeat, NO ONE wants a recession.

Why the swap? Housing kept the economy going while business repaired balance sheets from the asset deflation that marked the past recession. Consumers didn't have to do as much since many more have homes as their number one asset as opposed to stocks. Capital spending improves the quality of growth over the long term. What helps spending today? Confidence in continued growth, weaker but not a collapsing dollar, cost of money below the expected return on physical capital to name a few.....and even a little inflation. Higher energy costs, as I have noted before, are also a boost to spending. In fact, now that everyone understands that $70 oil is here to stay and higher prices are likely, lots of opportunity for capital spending -- on the energy production and energy conservation sides of the broader equation.

Today we got industrial production and capacity utilization, this is from Bloomberg News as reported by Joe Richter

"Industrial production increased in the second quarter at an annual rate of 6.6 percent, the fastest since the final three months of 1997 and a sign corporate investment is sustaining growth as consumer spending slows. The inflation threat posed by higher energy costs and factories approaching production limits may prompt Fed policy makers to bump up interest rates again.

``Anything related to capital spending is strong and expected to stay strong,'' said Nariman Behravesh, chief economist at Global Insight Inc. in Lexington, Massachusetts. The rise in capacity utilization ``is one more indication that the Fed can't take its eye off of inflation. The Fed probably isn't finished raising rates.''"

Later in the article, Joe writes:

"Factories added 15,000 workers in June after shedding 8,000 in May, the Labor Department said July 7. The manufacturing workweek rose to 41.3 hours in June, the most since January 2000, from 41.2 hours in May.

A report from the Institute for Supply Management earlier this month showed that while manufacturing growth slowed in June, new orders rose to the highest in three months."

The swap is underway and so the Fed is writing and saying and looking for a place to stop and watch and wait. Markets have moved from certainty to uncertainty regarding the Fed in August. Thats okay, what still amazes is that EVERYONE assumes that the Fed will be easing next year (how else would you get the inverted curve from 2s to 5s).

Interestingly, if you play around with the Sep/Oct futures spread and its reaction to various events it could hedge up your downside risk in any Treasury -- even 30 year Zeros. Imagine that, if you run a pension fund you can buy an asset at 23 that is guaranteed to go to 100 in 30 years (400% return over 30 years?) with no downside risk with a costless hedge. Everyone still matching pension liabilities with equities?