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.