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.