May And Done? Is the tightening cycle finished? The market, in its infinite wisdom is punting, stuck in the middle, sitting on the fence, waiting for the Fed while the Fed waits for the data, and otherwise acting in nervous fashion -- flitting about and reacting to data that shouldn’t even be released until its third revision. With market participants boldly pricing a 50% probability of the Fed going/not going in June, Fed funds futures and, in fact the whole curve, is, in turn, priced to an intrinsically impossible price point. Why impossible? Because 50/50 is the wrong answer.
The Fed raises or holds on June 29. When the uncertainty turns to certainty, when the Fed and its press agents let us know what’s next, the coupon curve should shift 25 to 30 basis points in one direction or the other.
Looking at the probability skew of the Fed going past June, the market diminishes the likelihood of Fed tightening as time goes on . . . . 34% in Aug, 6% in Sep, etc., till we effectively get to zero by yearend. This is another way of saying 100% certainty of 5.25% at some point before we put the tan suits away. After that the market is off to its next favorite parlor game – guess when the Fed eases. Of course the timing and shape of the whole expectation curve now starts with the impossible, 50/50. This is why the resolution of June is important. Once we know, the path will change and force yields to reprice.
Employment next week will be critical in the decision-making because of last month’s less than stellar number. If the May number under whelms again and April holds up, or down as the case may be, 50/50 drops to 30/70 odds of a Fed go in June. More than likely, soft numbers, now two months in a row, causes the Fed to put in a stop order.
The party line will be mixed signals -- fading rebound from Katrina, rising impact of past increases in the funds rate, rising energy prices, still strong lagging indicators such as inflation. Keep in mind that the Fed is accountable to Congress and public opinion, when things go awry. So weak employment and a weak stock market gets liberals and conservatives upset and the Fed pauses – at least at this stage of the cycle. More on this later (hold back on the political driven Fed stories for the moment).
There are some ways to try and make a bit of money on upcoming yield volatility. You can sell straddles in the 5-year note options and cover the wings with Augy options on Sep Euros, for a start. Or you might look at buying some call spreads in Augy Fed funds at a strike combo that only loses if the Fed goes in Jun and the market prices in the probability of Augy. You can cover the Augy position and still come out ahead with puts on Jul funds. Do the math and talk to your broker, its not calculus, just algebra.
But lets get back to the Fed and the confusion about where we are and what lies ahead. From here, much of this chatter is a full employment act for pundits. Does anyone out there think that money is tight or restrictive? Does anyone think that the economy is overheating? Does anyone think that the only thing that drives home values is interest rates? Does anyone think that a weakening dollar is bad for the economy? Does anyone understand the difference between rising oil prices that are caused when demand outstrips supply as opposed to when supply is artificially held below demand? Does anyone remember that the tougher the Fed talks the easier it is?
What does the economy need? Simple. Asset inflation. Why? What was the last recession? Asset deflation. Stocks, mostly. Everyone borrowed against them, one way or another. Are we still fighting that battle? In one arena, yes.
Housing bailed out the consumer and kept the economy afloat. Did such a good job that everyone thinks that housing is the economy. Housing does react to interest rates when nothing else on the right side of the equation is moving. But, folks, higher interest rates do not mean a housing collapse if rates are rising at a slower pace than the economy. If income and employment are growing faster than the interest rate input into the house price calculation is rising, the impact is not devastating. Rates are at 5% and nominal GDP growth is over 6% -- this is tight money! I think not.
At this level of rates, home price advances, on average, slow as will sales. The froth comes off, but no collapse. In other words, the house price/cpi ratio mean reverts -- slowly. From an economist’s perspective, as the interest rate subsidy to housing ends, capital gets reallocated to more productive ends.
So housing saved the day by keeping the consumer afloat, next up was the nonfinancial corporation (NFC). This is a bit trickier and it took a little longer. Overleveraged on an asset base of overvalued equity, over inventoried on high tech capital, and underfinanced in its pension funds, capex was guaranteed to lag. To remedy the problem, get the stock market up by cutting dividend and cap gain rates, drive interest rates to extraordinarily low levels, make the curve steep and try to hold things there long enough for debt to be refinanced, and put a little inflation into the tangibles held on the asset side of the balance sheet.
NFCs now can carry the debt at low cost and have lots of free cash flow. Two problems remain. The level of debt relative to asset levels remains high enough to crimp capital spending and the pension funding problem. What do we need? A strong equity market, some inflation to help boost the tangible assets on the balance sheet, interest rates approaching 6% and a positive yield curve. Pension reform is coming, why else bring back the 30-year.
From here the priority is still to keep NFCs going so that pensions can get funded without collapsing spending plans. In other words, keep capex growing apace so it makes up for the slowdown in housing. Strong equity markets and a weaker dollar help. The Fed will talk tough to keep the bond market in place but the equity guys will recognize that there is plenty of credit sloshing about.
You can look it up. This economy does not falter when the budget is in deficit, banks are flush, and the cost of money is below the nominal rate of GDP growth (year-over-year). Some hiccups, yes, and the Fed will continue to talk tough but this will be the pause that refreshes. A little inflation is still okay. When the Fed drives funds to 6%, then we will know they mean business. But to what purpose does it serve to drive U.S. into recession, in a politically uncertain world where economic shrinkage grows unrest.
The rate hikes are coming to an end. MADness probably not, JAD probably.