Employment, Poole, and the Odds of A Move

Poole's speech today was interesting as it broke some new ground. In broad terms, he set the current Fed operating procedures firmly in the Mishkin camp -- leave 'em guessing in the short run, let 'em know for sure you are credible inflation fighters over time.

About the data coming in, Poole said:

It is rare that a single data report is decisive for the FOMC. 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. The FOMC is aware of possibility of data revisions and short-run anomalies.

My key point is that market commentary indicating that the FOMC is unpredictable is off base. Typically the FOMC cannot be predictable because new information driving policy adjustments is not predictable. All of us would like to be able to predict the future. We in the Fed do the best we can, but the markets should not complain that the FOMC lacks clairvoyance! What the FOMC strives to do is to respond systematically to the new information. There is considerable evidence that market does successfully predict FOMC responses to the available information at the time of regularly scheduled meetings

Followed by:

I myself do not finally make up my mind on my policy position until I’ve heard both staff presentations and the views of other FOMC participants. More accurately, I go into each FOMC meeting with a view on the appropriate policy action given my assessment of the economic outlook, but I try to be as open as I can to having my view altered by discussion at the FOMC meeting. There are certainly instances when I have changed the view I took into the meeting as a consequence of the discussion.

The employment number tomorrow will not push the Fed in one direction or the other. September is sit on your hands. The key aspect of tomorrow's employment report is that if the data are weak it sets up a probability that the Fed goes in October. If the data are neutral to strong, it will pretty much take October out of play as far any policy moves. Why? Because the Fed likes to have a few months of running data before declaring a trend change and reacting, barring some unforseen significant event (9/11 comes to mind). If Sep is weak and then Oct is weak, we have the beginning of something that the Fed might just react to.

Market pricing is interesting. For October the market is giving a cumulative 7% chance that they do something -- 3% for an ease, 4% for a tightening. Chances of a move in December (remember that these probabilities accumulate across the months) -- 37%, 24% of tightening and 13% of an ease. In other words, the Fed has done its job. They have brought us to neutral and the Fed has the market evenly divided on what they do next.

Moving into next year, the market swings into the higher likelihood of an ease. Looking at the 94.625 call option in Dec Euros, the pricing suggests that there is a 30% chance of a Fed ease. Market is more sure about the future course of the economy than the Fed seems to be. This is what Poole is telling us -- they don't make policy on one number and they don't know today what they are going to do at the next meeting. Everyone is just guessing.

The Coming Week and Market Probabilities

Incredibly, or perhaps not so incredible, the market has effectively moved to a small chance of one more tightening this year, in October or December, and then the eases come cascading down through the FOMC meetings in 2007.

The coming week, however, will decidedly push the market to where the Fed wants the market to be setting the odds. On Thursday, the Fed Chairman Ben Bernanke speaks on productivity at the Clemson Institute for Economic and Community Development, in Greenville, South Carolina at 12.30 PM ET. On the same day St. Louis Federal Reserve Bank President William Poole speaks about the Fed to the Dyer Co. Chamber of Commerce, in Dyersburg, Tennessee at 1 PM ET.

How they want to push market sentiment is anyone's guess.

What isn't a guess is that Bernanke will give us a reasonable clue of how the Fed forecast of moderate growth and moderating inflation is faring. Poole will tell us how the Fed goes about making and evaluating a forecast using published data and anecdotal information. The combined statements will give us a sense of what the FOMC is looking at and how they will be reacting in the near future.

My opinion is that it is still a no-go in September (Bernanke would look silly tightening so soon), but that the odds going forward are not as skewed to ease as the market is pricing.

In my days of learning the bond market the old adage was that the market moves in the direction that creates the most pain. A sell off with a steepening of the Euro curve in 2007 would be a major league pain.

Bernanke's Big Worry -- Not What You Think

Bernanke's talk in Jackson Hole told us his big concern -- that the current rise in protectionist sentiment, as reflected by the breakdown in the DOHA talks, could end up disrupting the international flow of capital. For this economy, that would be bad news indeed.

Everyone expected Benranke to note the slowdown in housing, believing that this is the bad news for a Fed chairman to address. Recent housing data have quite a few commentators worried that recession is around the corner. These everyones ignore a revived though not booming cap goods sector, the pick up in nonresidential construction, and the general good sense to recognize that the U.S. economy does not run on housing alone. At times, housing is admittedly more important than at other times. This is not one of those times. Speculative overshoot in home building is being hurt, no doubt, and the year-over-year construction and sales numbers will not be pretty for some time. But this is the froth coming off -- while the business side of the economy is doing well (including exports).

The sum of these crosscurrents for growth is not rapid, overheating growth to push the economy to 3% unemployment. The sum is that growth is now self sustaining to a pace that the economy does not need subsidized rates. Fear of a recession is overblown.

Tim Duy, however, seems to have it right. In his August 24 blog he wrote this on housing:

The recent spate of housing data confirms the anecdotal evidence – while there may be some pockets of resistance, the national housing market is quickly reversing course. Still, as I noted earlier this week, the Fed’s reaction to date appears to be muted. How long will they maintain such a complacent posture? In general, I think the answer is: Longer than you might expect.

The key, of course, is to what extent housing undermines the rest of the economy. I think there is little debate that the first impact (outside of residential investment) will be on the consumer, although the Wall Street Journal appears to believe we are still kicking this around:

A key concern, economists say, is whether the softening housing market will hurt consumer spending. In recent years, consumers have used extra cash from mortgage refinancing to fuel extra purchases, and the soaring value of their homes has given them a sense of wealth that could prove ephemeral if the decline in sales accelerates.

I believe it is more accurate to question the extent of the impact, not the impact itself. Two channels leap to mind, the impact of housing related employment and the impact via higher mortgages and reverse wealth effect. Presumably, both will be captured in consumer confidence, which took something of a drop in August, according to the University of Michigan.

He later writes:

Using the complex system of “eyeball” econometrics, the confidence data is pointing to year over year growth in spending of somewhere in the 2-3% range. Not exactly a disaster and necessary if you believe the US economy needs to undergo a rebalancing.

And then he picks up on the capex point I have been making in this blog --

The jump in capital goods shipments should pull the base for investment spending higher, reversing the decline signaled in the second quarter GDP report. In short, the durable goods report will support Moskow’s contention that the underlying trend in investment spending remains healthy, and help him dismiss the Eeyores.

He is kinder than me by calling these people "Eeyores", but then he is brighter than me as well.

Those Eurodollar contracts for 2007, the ones that are forecasting 50/50 of a 100 basis point ease in the funds rate next year seem ripe for disappointment. If you own the 2-year Treasury you are long those Euro contracts. Meaning that unless you think the odds of an ease next year is going to increase, owning this paper makes no sense. If you do think the odds will increase, more profit will come your way. My bias is that the 50/50 odds are too optimistic about the likelihood of an ease, but either way an investor should understand the risk and, hence, where the reward will come from.

Bernanke among the bears of Wyoming, at the base of the beautiful Grand Tetons, laid out his fears.

He starts off by noting:

One of the defining characteristics of the world in which we now live is that, by most economically relevant measures, distances are shrinking rapidly. The shrinking globe has been a major source of the powerful wave of worldwide economic integration and increased economic interdependence that we are currently experiencing.

Towards the end of the speech, he adds:

In the nineteenth century, international portfolio investments were concentrated in the finance of infrastructure projects (such as the American railroads) and in the purchase of government debt. Today, international investors hold an array of debt instruments, equities, and derivatives, including claims on a broad range of sectors. Flows of foreign direct investment are also much larger relative to output than they were fifty or a hundred years ago.6 As I noted earlier, the increase in capital flows owes much to capital-market liberalization and factors such as the greater standardization of accounting practices as well as to technological advances.

In his concluding paragraph:

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.

Then he wraps up with a decidedly non-Republican (my opinion) perscription :

The challenge for policymakers is to ensure that the benefits of global economic integration are sufficiently widely shared--for example, by helping displaced workers get the necessary training to take advantage of new opportunities--that a consensus for welfare-enhancing change can be obtained. Building such a consensus may be far from easy, at both the national and the global levels. However, the effort is well worth making, as the potential benefits of increased global economic integration are large indeed.

'nuff said.

Real Rates and Recession Risk

Yesterday I noted that the market was going a bit overboard in virtually eliminating the possibility of any more tightenings this year and increasing the odds for an ease for next year. While this skew in the probabilities may turn out to be leaning correct, it is still too soon to place the bets with certainty.

One key to the continued potential for growth, as I noted yesterday, is the credit creation process -- and it is alive and well. Yesterday's blog illustrated that commercial banks are still easing credit standards for commercial and household borrowers. This is not typical for a late cycle period with a marginally negative curve.

Add to the easy credit standards the fact that the cost of money is still low in real terms. The Federal Reserve of St. Louis just released its Monthly Monetary Trends. I have lifted from the publication their chart on real interest rates. Trust the calculation, this data find its way to the FOMC.



Most, however, are still nervous for the economy and believe that the Fed has gone too far. Some are even touting their higher odds for a recession next year. There is some reason to be nervous, but not because the Fed has been too restrictive. It is because of weakness in the demand for capital.

The Fed controls the cost of the supply (to an extent) but it can't make firms borrow. Firms aren't borrowing because money is too expensive, its because balance sheets are too leveraged. The economy is undergoing a hand off of growth leadership from housing to capex. Sometimes the ball gets dropped, sometimes not. Next several months tell the tale.

Sep Goes Off the Board, Market Goes Overboard

For a while after the Fed paused the market was inexplicably pricing in the probability that the Fed could tighten. As I wrote in the previous blog, the Fed was not going to go in September after having just paused. October was the first month where the data could dictate another tightening. That means, to me, October is effectively 50/50. The market thinks otherwise. My partner Stan Jonas has a spreadsheet mapping probabilities to prices. It is up on the Bloomberg and I have reprinted it below.



The WED column is the probabilities drawn from where the market closed. Note that there is still a cumulative 25% probability that the Fed tightens at some point this fall. Predictably, market sentiment has moved further by future eliminating tightenings and setting up the ease for next year. The cumulative ease is 50bp in 2007.

The other columns reflect different scenarios and the impact on Euros and coupon securities. For example, if we go back to where we were in probability space in the spring (GIS column), the 2-year would have a 49 basis point rise in yield. If we move toward a real ease scenario in term of expectations (MEO column), 2-year rallies 23 basis points. Once again, law being law, these are only references and guides and should not be taken as gospel truth, as the saying goes.

Where is the Fed as opposed to market sentiment? Steadier at the helm of expectations, for one thing. Market participants love to jump from one side of the boat to another with every data release. If the Fed acted that way the economy would be in real trouble. We have seen what happens when a fan (George Steinbrenner) runs a team as opposed to a professional (Brian Cashman/Joe Torre). There is no panic in professionals. Traders, like fans, are all about panic -- in the aggregate. To be fair it isn't really panic, it is the need to jump out ahead of everyone else in order to make money. The net effect, however, is that it looks like panic. The professionals, the Fed, will do nothing in Sep because it takes more than a data point or two to convince them that their expectations are wrong. Only possibility for Sep is if something implodes the economy in a way that an ease is necessary.

The economy is clearly moderating but, unlike some market seers, I do not see the wheels to coming off the U.S. economy. The next two charts from the Federal Reserve's Survey of Loan Officers reflects, in part, where my view is based. This chart below illustrates that commercial banks have been easing standards to their commercial borrowers. When the curve is inverted, lending standards tighten (the pattern of the line dovetails nicely with the slope of the Treasury curve). Now we have an inverted curve with more banks easing standards than tightening them. So when the Fed tells us that this time the curve's impact is different, the curve's impact IS different.





The chart below illustrates that with all the indebtedness of the household sector, banks aren't particularly concerned with household credit.



The point? Economies grow when credit expands. If the banking system shuts down, no country can grow -- be it Thailand, Zaire, England or the U.S. The U.S. banking system is healthy and willing to lend, more than willing as evidenced by their diminished credit standards. Further, the cost of money is still not high. U.S. growth is moderating, as the Fed noted. It is not heading into recession as long as this credit expansion is alive and well. The market pricing, especially for next year, is more bullish than it should be given the continued potential for growth. The market went overboard in its effective elimination of Fed tightenings past Sep and by emphatically pricing an ease in 2007. If you think I am wrong remember that the Fed likes to manage the fan's (er, market's) expectations. Read what just came out:


"If anybody tells you with absolute conviction that the Fed is done raising interest rates or with equal
conviction that they have only paused and will raise rates more starting
in September or October, remind yourself that at best -- and I'm being
generous here -- they are only guessing."
Fed's Fisher Sees'Definite Increase in Inflationary Momentum'>
2006-08-16 13:56 (New York)

What Is The Market Thinking Now

Based on the Fed funds digital options trading on the CBT, that collection of wisdom from the maelstrom of fear, greed, and uncertainty, is pricing a 20% probability of the Fed raising rates at the September meeting (Sep 20, for those of you planning any vacations). After that point, there is no sign of Fed activity until early next year when the collective wisdom is pricing in an ease. When all is said and done, it looks like 50 bp over the next year.

I am not sure whether market participants are thinking at all. THE FED WILL NOT TIGHTEN IN SEP. The only thing they will do aside from nothing is an ease if the data indicate an imploding economy. Once Bernanke put the Fed forecast on the line there is no way he can change direction with six more weeks of data. The October meeting, a different story but only marginally so.

The reason is that the Fed, like the Supreme Court, has its traditions, its playbook, its way of doing business (so to speak). An excellent read on this is A Term At The Fed by Laurence Meyers. The Fed doesn't flip flop like traders and commentators, they hold to their position for a while before shifting -- unless some major exogenous event (9/11 for example) takes place. Consequently, pricing in any chance of an ease after they just skipped is just silly.

There is yet one more reason why a skip is unlikely -- the dropping of the productivity reference. Productivity always falls late cycle because growth slows while employment, which lags, is still on the upswing. The dropped reference is not an attempt to say that productivity is no longer going to bail out price pressures, as some have suggested, but acceptance by the Fed that the economy is in a late cycle mode. This plus the skip is a bit disquieting if you are an economic bull.

The Fed has done research on what went wrong with policy in 2000. They came away with the idea that there are times, particularly turning points, when anecdotal information is of more value than the official data driving the model (see also the Poole speech that I am always referencing).

What is the upshot? Anecdotal information gave Bernanke confidence in his outlook to stop. Losing the productivity reference is his way of telling us that he believes we are in a late cycle. The Fed doesn't like what it sees as far as growth prospects are concerned, more than they are letting on (regardless of the dissenting vote, which suggests that he doesn't think slower growth will slow inflation). The equity market, picking up on this, has sold off. The geniuses in the bond market are still pricing a 20% probability that they tighten in September. Go figure.

Dog Bites Man . . . . . . As I was saying,

Those few of you who have been reading this blog know that the skip and the statement were in line with what I had written in my blog "White Knuckle Time for Bernanke" on July 20.

Reading a bit more into it, Bernanke must've gotten sobering anecdotal information on economic activity. This raised his confidence in the forecast from 50/50 to something high enough to give him confidence to stop.

Looking forward, the Fed will not go in Sep. The only Sep move they would make is a pause -- if the data collapsed. Market expectations, and lets wait till the day ends to see where that is, may price small odds for a tightening when the truer possibility is the opposite. This is one time where 0% could mean the market is 50/50 on tightening or easing or, if you will, equally divided into 3rds as to whether they tighten, ease, or do nothing.

Like the Fed, we sit and wait and watch the data roll in. Not something we are all comfortable doing, since we are programmed to do something, but there is no choice. Enjoy the rest of the summer, we will need the r&r to get ready for what promises to be a rollicking time for expectations.

Bernanke Tells Beckner: Too Soon To Flip The Game

Today's missive from Chairman Bernanke, via Beckner (look for Ip in the AM), had one major intent. It was to let everyone know that if they skip Augy don't get worked up into a lather handicapping the first ease. Stick with the current game -- setting odds on the next tightening. Don't flip the game, an Augy skip means wait and see not wait and ease.

Seems a shame that this missive came out before the Street could go full tilt into its data mining mode to forecast the ease based on average time span from stopping to dropping. Undaunted, most economists are out there raising their odds of a recession next year. My initial reaction to all this is to recognize how little impact economists have. When I first began working, in 1977 at Manufacturers Hanover Trust, there was a huge reluctance for bank economists to officially call a recession -- believing that it would become a self-fulfilling prophecy.

Today, these pronouncements seem more self-filling than not (kinda like a blog!). My second response to all this is that they are wrong. The economy is transitioning from housing to capex, where neutral rates (fed funds slightly less than nominal GDP growth) and a weaker but not plummeting dollar (central banks hate plummets) will help keep capex going. Even higher energy prices help since, as we all remember, when an important price shifts our budget line there is an income effect (where the economists are stuck today) and the substitution effect (cap spending, anyone?).

Lastly, this is an economy that, through financial innovation, floats on both side of the balance sheet. Further, the Fed moves have been so well telegraphed everyone has been adjusting accordingly. Obviously some housing stock cannot be sold at these rates, but then they probably shouldn't have been built in the first place. Yes, a reason to raise rates is to get a more efficient allocation of capital rather than too much flowing to a sector that is being subsidized (long term, an economy constructed on home building is not stable).


Back to Beckner, er Bernanke, the article touches on another theme that I have been touting, the Mishkin argument (see previous blogs) that a little less transparency will make the Fed more effective. The Chairman has taken it to heart, hence all the uncertainty regarding August 8 and what it means longer term.

I still believe the Fed skips, at some stage Bernanke needs to trust his forecast for moderating growth based on the lagged impact of past Fed hikes and higher energy costs -- and this is the best time. More interesting than the skip is what the Fed is saying going forward, their decisions will effectively be a roll of the dice. So those of you who own 2yr Treasurys understand the risks, you are betting that there will be eases next year. If there aren't, you lose. Are you being paid enough?

Market Reacts To The Yelling, But You Can't Make Money If They Stop

The other day the market was sticking with a 25% probability of a Fed tightening when Yellen and Poole came out and said they were 50/50. Today we got the Beckner underscore of the same point -- the odds of a 25bp tightening is closer to 50/50 than the market seems to be thinking.

Beckner also made the point that I discussed in my "White Knuckle" post -- is this the time where the Fed trusts its forecast and stops or they don't have the trust and tighten for insurance. Given what Poole and Yellen said, Bernanke has only a 50% confidence in their model's outlook. Hence the need for anecdotal info, etc. (see my previous blog).

Judging from how the market is priced, even if the Fed stops there is little upside for coupon securities. If the Fed stops and the market starts pricing in an ease for early next year, the two-year rallies about 7 bp. On the other hand, if the Fed tightens in August and then the market assumes no increases going forward (only likely in retrospect not likely in expectational terms) the 2-year would move back almost 20bp.

My own opinion is still that they skip, but the point is that unless there is the sudden belief that the economy is going to slip into recession, the upside is essentially priced in. And as far as the recession talk is concerned, it may or may not happen but it won't be because the funds rate is 5.25% or 5.50%. Remember, this economy goes into recession when the credit creation process comes to a halt, and we are far from that point.