Tuesday, November 28, 2006

Bernanke Bias Shifts To Neutral; First Step To An Ease

Today's remarks by Chairman Ben S. Bernanke before the National Italian American Foundation in New York on "The Economic Outlook" told the audience that the bias shifts to neutral in the statement following the Dec 12 FOMC meeting. Beckner, a member of the Fed's favorite scribes, told us that the shift to netural is necessary before the Fed eases. It doesn't mean ease, the data has to conform, but the odds go to 50/50.

The link I give is to the audio/visual of the talk, courtesy of Bloomberg. Hearing the two paragraphs reprinted below is much more powerful. The italics and bolding are mine.

"Over the next year or so, the economy appears likely to expand at a moderate rate, close to or modestly below the economy's long-run sustainable pace. Core inflation is expected to slow gradually from its recent level, reflecting the reduced impetus from high prices of energy and other commodities, contained inflation expectations, and perhaps further reductions in the rate of increase of shelter costs and some easing in the pressures on capital and labor resources. However, substantial uncertainties surround this baseline forecast. The Federal Open Market Committee (FOMC), the committee that sets monetary policy, will continue to monitor the incoming data closely. In its latest statement, the FOMC reiterated its view that the upside risks to inflation are the predominant risks to the forecast and indicated that it is prepared to take action to address inflation if developments warrant.

As I have just noted, the pace of economic activity has moderated over the course of the year. According to the latest estimates by the U.S. Department of Commerce, real gross domestic product (GDP) increased at an annual rate of 2.6 percent in the second quarter of 2006 and at a rate of only 1.6 percent in the third quarter. These figures are down noticeably from the 3-1/2 percent average pace of growth of the preceding two years. We will receive an updated estimate of third-quarter GDP growth tomorrow. At this juncture, information about economic activity in the fourth quarter is limited, and the range of plausible outcomes remains wide. But the indicators in hand suggest that real GDP growth this quarter is likely to be in the same general range that it was in the second and third quarters."

Here is how I heard it: Bernanke says the economy has moderated, inflation risks have gone down BUT "substantial uncertainies surround this baseline forecast". In our last statement we told you that inflation was the big risk. Now, as I was saying, the economy has moderated, growth is down substantially from where it was, and it looks like the current quarter will come in at the same pace as the previous two BUT current information is limited so "plausible outcomes remain wide".

One mention of inflation, lots about the slowdown, and a pointed reference to the uncertainty of the coming quarter. When you expect the quarter to come in at the low pace of the previous two, seems to me the uncertainty lies with greater weakness rather than strength.

The market, in its infinite wisdom is placing the odds of an ease in Jan at around 10%. Bernanke just told us its 50/50. If the market shifts to those odds, the Jan/Feb funds spread I wrote about yesterday makes 12 on a 2 tic investment (caveats everyone, no guarantees, it might not be for you, and this is only explanatory not a direct recommendation, etc, etc, etc).

All is possible as far as the economy is concerned. After all, if the Fed thought the economy was going to weaken further they would ease now not in January. They certainly wouldn't wait till March. By Jan 31 they will know Q4 and Jan sales, which have become quite important. There is nothing earth shattering to learn in the following 6 weeks that lead into the Mar meeting.

The December shift to a neutral bias is necessary for the ease. From then on, the decks are clear for the data to lead the Fed.

Monday, November 27, 2006

Fed and Market Dancing Together For The Holidays

The Fed acts, the market reacts, the Fed reviews what the market does and speaks about it, the market reacts, perhaps something else in the world takes place, the market acts, the Fed reacts, the market reacts again, and the interest rate world converges to a single point. There is no arbitrary measure or guidepost to establish whether the point is too high or too low, for the short-term or the long haul. We just know that market and Fed have reached a conclusion that this is where rates should be for now. This is monetary policy today.

It would be nice to know why 5.25% is, as Poole noted in some q&a, "mildly restrictive" and how the FOMC came to that conclusion. We do know from that comment that once the economy slows to the point that inflation risk has lessened, rates will be pulled back to neutral. Before all that, the Fed will let us know whether the expectation in the market place for an ease is right or not.

Some insight to all this was given in remarks by Governor Kevin M. Warsh at the New York Stock Exchange, New York, New York on November 21, 2006 entitled "Financial Markets and the Federal Reserve"

"Today, I will discuss the role of financial markets in effective monetary, regulatory, and supervisory policy making by the Federal Reserve. In particular, I will discuss the potential for markets to inform the Fed's policy judgments--even as our policies also affect markets."

A good start. Later in his talk;

"Markets affect monetary policy predominantly through the information provided by asset prices. . . . At least as important, these prices also can provide some insight into the uncertainty surrounding likely outcomes. Monetary policy makers can use economic models and statistical techniques to extract the views of market participants about these key macroeconomic variables.

Let me cite a few simple examples of how we interpret asset prices. Through open market operations, the FOMC sets the target federal funds rate, . . . Interest rates for periods extending beyond that very short horizon, however, are established by market participants rather than the FOMC, although members of the Committee may be able to influence these longer-term rates somewhat through what is affectionately described as "open mouth operations." In this way, market-based interest rates reflect primarily the path investors expect for monetary policy. That expected path is of keen interest to us as policymakers."

Next, Warsh does my work for me by saying;

"Prices on federal funds futures and Eurodollar futures suggest that market participants expect the FOMC to cut the target federal funds rate about 50 basis points during 2007, a view consistent with expectations of a "soft landing." At the same time, market-based options prices on these interest rate futures indicate that implied volatilities are quite low, suggesting a surprising degree of certainty regarding policy expectations. Taken at face value, market participants appear to be reasonably certain of a benign outcome for both economic growth and inflation. In contrast, my own judgmental forecast includes a wider range of possible outcomes than is implicit in these market-based measures."

Now comes something interesting;

" . . . .Our own policies and actions affect market prices. As a result, when we look to financial markets for information, the information we seek may be shaped in part by our own views. The more that "market information" reflects our own actions, the less it is useful as a source of independent information to inform our policy judgments.

We need to be alert to this "mirror problem," in which markets can cease to provide independent information on current and prospective financial and economic developments. In the extreme case, financial markets keenly follow the Federal Reserve, the Federal Reserve is equally attuned to the latest financial quotes, and fundamentals of the economy are obscured. Under such circumstances, asset prices might teach us only about our skills as communicators. Fortunately, the prospect for profits--the critical underpinning of all markets--mitigates this problem."

Perhaps this is why Poole, after his talk to actuaries in Delaware, answered a question on the level of long-term yields with a question of why the bond market is a pessimist and equities an optimist.

Warsh, once again:

"Market-based information is surely important in determining good monetary policy. This does not mean, however, that the Fed's goal is to align its views with those of the markets or that it wants the markets' views to match its own. Instead, policymakers benefit greatly by listening to views expressed in markets that are at least somewhat independent of FOMC communications. We can further enhance the role of markets by enriching our understanding of the interplay between communication policies of central banks and market prices. Good communication by the Fed should help members of the FOMC interpret market prices. Unnecessary market uncertainty or misinterpretation of our assessments will only muddy the waters."

They will be making the waters still in the coming days as Feds speak and the November data start rolling in. Don't expect worried comments about the economy, but listen to what they are not saying. They have not said the market is wrong and they have not said anything about raising the funds rate. They have said the economy is cooling, housing isn't creating a recession, and inflation is cooling off nicely. Beckner, one of the Fed's chosen scribes, writes that the FOMC will shift its missive in the meeting prior to the ease.

What the market has priced in, and the Fed isn't telling us that the market is wrong, is an easing bias that starts with 10% chance of a 25bp cut in Jan, 30% for Mar, 30% for May, 40% for Jun and 40% for August (in round numbers). Since this all adds up to more than 100%, 50bp is in for next year -- see Warsh's comments above.

The odds of an ease have to rise as the year progresses, since the Fed has told us they will be easing but not when. The longer the time period, the greater the chance of capturing the ease. My guess, however, is that the ease, if it comes, comes in January. They will know everything they need to know. Watch the data, listen to the comments, read the Dec FOMC statement. The combination tells us Jan definitively.

The Jan/Feb spread in Fed funds futures closed today at 2. Earn 25 if the Fed goes, lose 2 if they don't. A pretty good risk/reward since Jan has the highest probability of getting Fed action and every other probability in 07 is contingent on what happens then. And given how policy is run, we will know Jan within the next 10 days or less.

Friday, November 17, 2006

Market Snaps Back Into Line

Yesterday's market was totally out of whack given the direction of data and Fedspeak. Forget Moskow's assertions to the otherwise, after all the Fed always wants us to know that they are vigiliant in their vigilance against the virus of rising inflation expectations. Poole has noted that a reason downturns in the economy aren't as deep or protracted is that the Fed eases and eases alot once it sees the economy heading south. This week, Poole let us know that the FOMC is ready to ease and ease alot if the data swing in that direction. Consequently, bets in the market today are a bet on data, not the Fed. The policy we know -- stay put or ease. As for the direction of the data? Its all a guess -- an educated guess perhaps, but still a guess.

Since today's swing was big enough, I have reproduced the Stan Jonas table of probabilities for your reference.

Thursday, November 16, 2006

Bonds Weaken With The Data . . . . . ?????

Earlier this week Poole let us know that everything is going according to plan and the funds rate is neither too hot nor too cold. Yet, he implies and has implied that the Fed eases and eases alot if the wheels are coming off. If the Fed thought that was happening don't expect it to be telegraphed like the march to 5.25%. They will just ease. After all, if they say they are worried it must be really bad. There is a limit to transparency in communications. January seems like perfect timing between enough data and enough suprise.

The market, in its infinite wisdom, ignores the softness that permeated the data this week and instead focused on the FOMC minutes. Minutes from a meeting that took place three weeks ago and made note of the important information coming out between then and the Dec meeting. Shouldn't Poole's comments these past several days have more impact than the minutes?

Apparently not. A week ago, the Mar 07 Eurodollar contract was priced to a 26% chance of an ease and now sits at 14%. Odds of a move in Jan is down to 6%. The Mar contract is interesting because it contains an expectation of what will have happened in Jan and what it thinks the market will think what will happen in the 3 months to follow. Below is how the probabilities shake out as of today's close (courtesy of Stan Jonas) and the impact of a shift in expectations on prices and yields. The later in the year we go, the odds of an ease move higher -- so says the market.

The pricing is skewed the wrong way, from my perspective. Odds of an ease in January is really quite high -- if the eco bears get the kind of 4th quarter economy they expect. The Fed will be sifting through 4th quarter data that are coming on the heels of a weak 3rd quarter. The cumulative impact of 5.25% funds will be obvious. On the other hand, if the Fed holds in Jan, that 4th quarter bounce the FOMC expects will have occurred. If we get the bounce, that market-determined cumulative probability of an ease in the spring and again later in the year will likely swing to a bias to tighten.

Right now, the 2-year has 23 basis points of risk should the probabilities swing back to 0% (on hold). On the other hand, a Jan ease gives the 2-year a 40 basis point rally. Pick your bias, know your risk, the tale will be told by Jan. And maybe, just maybe, hinted at in the Dec statement. Stay tuned.

Tuesday, November 14, 2006

Close To An Ease . . . . .But Based On What Policy?

After Bill Poole's talk "U.S. Labor Input in Coming Years" to the Chartered Financial Analysts Society of Philadelphia, the most interesting answer he gave was to the question on long term rates. Rather than take the conundrum path he jumped onto the yield curve. And rather than play the trader's growth expectations vs the Fed's, as he did several months ago, he contrasted the bond market's view (eco bears) with the equity market's (eco bulls). He doesn't understand why there is a difference in opinion, so the only thing to do is to wait. Wait and then what? If the equity market moves to share the bond market's view on things does the Fed ease? Poole's comments suggest to me they might.

In the Q&A to reporters, Bloomberg news headlines are (in my order): "inflation expectations are well controlled", "price movements tend to lag general economy", "can't rule out slower growth behind oil-price drop", "outlook for Fed policy is roughly symetrical" and "don't want to hold onto tight policy too long"

There you have it. Stop trading on employment data, retail sales or inflation indexes, so advises the President of the St. Louis Fed, one data point won't move the Fed and the value of the information in the first release is suspect to say the least. Watch the equity market instead.

If you are so certain that the Fed will ease, why bet on March? CBOT Fed funds digitals are trading at an 8%/11% chance of an ease in January with a tightening at, inexplicably, 4%/9%. Put up $11 to make $100 if the Fed eases, great odds in my view. Poole is telling you that the Fed is ready to ease if the data break that way or equity traders give up on the prospect for good earnings.

The Christmas selling season is upon us. By the end of January the current weakening trend in the data will be known as a blip or something more meaningful. They won't wait till March. And if they don't ease in January, why believe they ease in the Spring?

By the way, what is monetary policy? Not the object, the management.

We know and have confidence in the goal -- long-term price stability. But by what basis do they know what funds rate is right? Can they be certain that targetting 2% in the short term doesn't foster higher or lower inflation down the road? What benchmark best gauges policy, since we live in a series of short-term periods that only sees price stability looking backwards?

The other day Bernanke tells us that in this hi-tech, global world without borders, money is no longer a reliable indicator for monetary policy. Today, Poole tells us that labor can no longer be a reliable guidepost for policy.

Okay, I give up, what should we be looking at?

Friday, November 10, 2006

Market Wants Spring Break -- The Coming Week Will Tell

The market is hellbent on believing that by June of next year the first 25 will have been lopped off the funds rate. The Fed, erstwhile managers of market opinion, will let the market know whether to hold to this view on Tuesday. Poole gives a 12:30 talk in Philadelphia and then, as if he arranged a second chance for the market to get it right, he is to speak on Thursday at a CATO conference on the Fed. Other members of the Fed tribe will be out on the hustings as well, but Poole has been the best at setting the market straight.

Tuesday is also the date for the release of October PPI and Retail Sales. The October number will be used as an indicator of Christmas sales, as it comes on the heels of lower gas prices and some softening in consumer optimism. CPI is reported on Thursday.

Data plus the Fed means market volatility. Table below outlines the risks entailed. Market is pretty much set at the Poole scenario (things work out as we expect and we will give 25 back). But if we move back to 0%, there is 34 basis points of risk in the 2-year. To be forewarned . . . . . .

Money & Interest Rates ....Whose Money? Whose Interest Rates? What Policy?

Today's remarks by Chairman Bernanke at the Fourth ECB Central Banking Conference, Frankfurt, Germany entitled "Monetary Aggregates and Monetary Policy at the Federal Reserve: A Historical Perspective" gives light to the difficulty of a rules based monetary policy, or at least that the rules have changed. The upshot of his remarks:
"As I have already suggested, the rapid pace of financial innovation in the United States has been an important reason for the instability of the relationships between monetary aggregates and other macroeconomic variables.14 In response to regulatory changes and technological progress, U.S. banks have created new kinds of accounts and added features to existing accounts. More broadly, payments technologies and practices have changed substantially over the past few decades, and innovations (such as Internet banking) continue. As a result, patterns of usage of different types of transactions accounts have at times shifted rapidly and unpredictably.

Various special factors have also contributed to the observed instability. For example, between one-half and two-thirds of U.S. currency is held abroad. As a consequence, cross-border currency flows, which can be estimated only imprecisely, may lead to sharp changes in currency outstanding and in the monetary base that are largely unrelated to domestic conditions.15, 16"

As if to underscore this point, we got John Authers' Short View Column in today's Financial Times on "Tracking Bank of Japan"(subscription needed). Here he writes about the role of the yen-carry trade, the Japanese Central Bank and global liquidity.
"The question arises because much money is now riding on what is known as the “yen carry trade” – borrowing money in yen, where the BoJ’s base rates are still only 0.25 per cent, and placing it in a much higher yielding currency, such as the New Zealand and Australian dollars.

You lose money only if the yen suddenly appreciates. That could quickly wipe out all your gains. But the weight of money making this bet has helped to keep the yen relatively cheap. Volatility, which hurts the carry trade, has also been remarkably low. It may also have contributed to excess liquidity – or a “bubble” to some – elsewhere in world markets, by providing a source of cheap money.

Tim Lee of pi Economics says carry trades are “at the heart” of the “current bizarre economic cycle”, and that “carry trade mania is a key factor in the weak yen”. Stephen Jen of Morgan Stanley argues that the evidence does not support this, and points out that of all global cross-border loans, only 5 per cent are yen-denominated.

But there is circumstantial evidence that the yen carry trade matters a lot. During the sharp world equity market correction in May this year, traders complained of a liquidity crunch. That correction coincided directly with a sharp appreciation of the yen, which moved in days from Y118 to Y110 to the dollar. This temporarily removed the carry trade. Liquidity has returned, and equities rallied once more, as the yen has slipped back towards Y120. This is consistent with the belief that the yen carry trade is the source of a global liquidity bubble.

The BoJ has reason to dislike carry trade activity. If next week’s Japanese GDP figures are as bad as some expect, then it may be difficult for the BoJ to raise rates straight away. But it is well to pay a lot of attention: little or no risk of a tightening by the end of the year is priced into the market. Judging by May’s experience, a surprise from the BoJ could knock over a lot of dominoes."

So, what is U.S. monetary policy?

The globalization of money and credit has apparently confined policy to divining a rate that sustains the Fed's anti-inflation credibility yet maintains growth while letting everyone in on the plan. Policy has gone from a gold standard to monetary growth targets to "trust me, we know the right rate". The groundwork for this trust in today's Fed comes from when Volcker reestablished central bank credibility by essentially setting reserve growth and then allowing the market to decide the level of Fed funds. Believing we know the right rate to meet growth and inflation targets, especially in a world of free flowing capital and goods, is the kind of hubris that got us to needing Volcker in the first place.

Wednesday, November 08, 2006

Dems Win, Fed Concern -- Rolling Back Globalization?

The concern is not so much because Democrats are anti free trade, but because of the issue of income inequality. Class issues drive Democratic politics and policies. With the control of Congress and the start of the 2008 election campaign, you can bet that globalization and its effect on income distribution is front and center in the political landscape.

Why is the Fed talking about this? After all, income distribution is not in their policy agenda. Let's wind the calendar of events backwards to get a sense of the where and why of Fed concern.

We start with the November 6 speech by Janet Yellen, President of the San Francisco Fed, on "Income Inequality In The United States"
"However, there are signs that rising inequality is intensifying resistance to globalization, impairing social cohesion, and could, ultimately, undermine American democracy."

Lets go back to October 12, when Governor Mishkin gave a talk at Baruch College entitled "Globalization: A Force For Good?" From that speech:
"I will conclude by saying that those who oppose any and all globalization have it completely backward: Protectionism, not globalization, is the enemy. It is true that, by itself, globalization in both finance and trade is not enough to ensure economic development and that economies must position themselves to handle foreign capital flows. But as I said, to be against globalization as such is most assuredly to be against poor people, and this is presumably not the position antiglobalizers want to take. Developing countries cannot get rich unless they globalize in both trade and finance. Making financial flows truly worldwide and creating robust, efficient financial markets in developing countries is not optional: It needs to be the focus of the next great globalization."

Let's role back to Chairman Bernancke's talk at Jackson Hole, "Global Economic Intergration: What's New and What's Not?" on August 25 From that speech:
"The final item on my list of what is new about the current episode is that international capital markets have become substantially more mature. Although the net capital flows of a century ago, measured relative to global output, are comparable to those of the present, gross flows today are much larger. Moreover, capital flows now take many more forms than in the past . . . Today, international investors hold an array of debt instruments, equities, and derivatives, including claims on a broad range of sectors . . ."

Bernanke concludes with:
"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. Although this opposition has many sources, I have suggested that much of it arises because changes in the patterns of production are likely to threaten the livelihoods of some workers and the profits of some firms, even when these changes lead to greater productivity and output overall. . . . The challenge for policymakers is to ensure that the benefits of global economic integration are sufficiently widely shared . . . the effort is well worth making, as the potential benefits of increased global economic integration are large indeed."

Where is this interest in the topic coming from? In June of this year, an excellent book was published, "Polarized America: The Dance of Ideology and Unequal Riches" by Nolan McCarty, Keith T. Poole and Howard Rosenthal. It crystallized the political problem of income inequality.

It didn't take much to see, as Yellen did explicitly, that people see globalization as a key factor hollowing out the middle class. At the same time, it didn't take much imagination during these past few months to believe that the Democrats would regain some legislative power and bring the income issue to forefront.

Here is the abstract from the paper that predates the book:
"Since the early 1970s, American society has undergone two important parallel transformations, one political and one economic. Following a period with mild partisan divisions, post-1970s politics is increasingly characterized by an ideologically polarized party system. Similarly, the 1970s mark an end to several decades of increasing economic equality and the beginning of a trend towards greater inequality of wealth and income. While the literature on comparative political economy has focused on the links between economic inequality and political conflict, the relationship between these trends in the United States remains essentially unexplored. We explore the relationship between voter partisanship and income from 1956 to 1996. We find that over this period of time partisanship has become more stratified by income. We argue that this trend is the consequence both of polarization of the parties on economic issues and increased economic inequality"

The Fed is concerned, from my perspective, because any trade legislation that, going forward, has the impact of diminshing global capital flows will be particularly problematic for the U.S. First off, it would be a problem for financing the current account deficit and for financing the rolling over of the accumulated debt. Second, and I believe more important to the Fed, is the financing of social security.

The the social security trust fund has been using its current surplus to fund the current budget deficit by buying non-marketable Treasurys. Once the trust fund has to start paying out from the surplus it has been designed to build (talk to Greenspan, he helped design it), the fund will have to redeem these securities it accumulated to the Treasury in exchange for cash to make the required payments. Where will Treasury get the cash? By issuing debt that would be an addition to any debt raised to finance the budget deficit at that time. Any wonder why Greenspan in the 90s was so focused on maintaining budget surpluses?

If foreign flows aren't flowing at that time, the interest rate adjustment will not be pleasant.

Inflation anyone?

Tomorrow I go back to markets and probabilities and Fed action. I thought today should be about politics and economic policy and the long game.

Monday, November 06, 2006

Fed Fixes Market Focus . . . . . .Again

The monthly cycle to bring the market savants back to reality has begun. The Fed, again playing the role of responsible adult, is letting everyone know that the economy isn't tanking, the Fed isn't easing, and the risk of inflation is greater than that of a recession. The program to redjust attitudes and pricing began with the Beckner article on Friday (see my previous post) and Moskow's talk in Chicago this morning. Tonight (10pm est), Yellen speaks. Before the parade is over Poole will pop up to put the final coda on all of this.

The market, stubbornly holding to the view that its take on the economy is more correct than the Fed's (sometimes it is, this time it isn't), used Friday to push out the first ease to June. Apparently an ease delayed is not an ease to be denied. If anyone was really thinking, they might conclude that the tough Fed talk is masking an easy policy that is going to have to tighten late next year -- not ease. On that point, follow below through the highlights (as I picked them) from the Michael Moskow, President of the Chicago Fed, speech this morning to the Chicagoland Chamber of Commerce on the U.S. Economic Outlook.

Since so many are focused on a 5.25% funds rate demolishing the housing market and, in turn, the source of consumer spending, here is the Fed's take:

"A significant part, though, was due to developments in the housing sector. Residential investment has fallen 7-1/2 percent year-to-date, and in the third quarter it shaved 1.1 percentage points off of GDP growth. Additionally, home prices have been rising more slowly and by some measures have even declined. These developments raise important questions for the economy as a whole: Will there be further declines in housing markets? And will the current and any further declines in housing lead to more general economic weakness? . . . .

. . . . Nonetheless, with underlying housing demand growing 3 percent per year, the large gains in residential investment—which averaged 8-1/2 percent per year between 2001 and 2005—clearly could not continue indefinitely. Moreover, housing demand may slow to less than 3 percent, as demographics point to slower growth in household formation. As a result, we at the Chicago Fed expect some further weakness in residential construction.

.. . . . Currently, we do not see the slowing in housing markets spilling over into a more prolonged period of weakness in the U.S. economy overall. On balance, the 95 percent of the economy outside of housing remains on good footing. Employment has been increasing near its long-run sustainable pace. Productivity trends remain solid. Recent declines in oil prices should give household budgets a boost. Economic growth in other countries should increase demand for our exports. And current financial conditions are not very restrictive by historical norms."

Please note the phrase that I bolded and italicized. FINANCIAL CONDITIONS ARE NOT VERY RESTRICTIVE BY HISTORICAL NORMS. Ok then, if that is the case and the economy is expanding, what is the inflation view? From today's speech:

"Still, there is a risk that core inflation could run above 2 percent for some time. We could be wrong about reduced pressures from resource constraints, or we could see further cost shocks. And perhaps most importantly, if actual inflation continues at high levels, it could cause inflation expectations to run too high. If firms and workers expect inflation to be high, they will want to compensate by raising prices and wages or building in plans for automatic increases. In this way, high inflation expectations can lead to persistently high actual inflation."

Therefore, the conclusion on policy:

"Taking all of the factors on growth and inflation into account, my current assessment is that the risk of inflation remaining too high is greater than the risk of growth being too low. Thus, 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."

The Fed speaks, the market should listen. As for investors, 25bp in risk in the two-year Treasury if the market just goes back to pricing 0% odds of the Fed doing anything.

If, at the January meeting, the Fed holds because Christmas was good and the algebra of GDP growth makes for a stronger 4th quarter, those back Euros will be trading to a tightening instead. Just an opinion, but remember Moskow told us growth is fine and policy isn't particularly restrictive. Folks, the longer they stay on hold the less restrictive policy becomes. The nature of this economy is adapt and grow not shock and fold.

Friday, November 03, 2006

Employing Some Good Sense; The Fed Weighs In Just In Case We Missed The Point (Some Still Do)

Today's employment data and revisions snapped the market back to reality. The economy isn't falling off a cliff and the Fed is still on hold. Today's sharp move in bond prices underscores my oft made point: Investor risk lies not in fundamentals but in the volatility of opinion of what the Fed is thinking it should do next. Yesterday the market priced a 20% chance of an ease in January. Today its zero.

So much market opinion comes from savants proclaiming an inevitable recession because a 5.25% fund rate will dry up home equity lines as a source for spending. Here's a novel idea to these seers who take ceterus paribus to the extreme -- how about employment and income growth contributing to consumer well-being? Here is another novel thought, there is plenty room for the share of capital to flow back to labor before inflation becomes a problem, as this chart aptly illustrates:

In case you think this is the rant of an aging socialist, here are some words from today's Stephen Beckner article on what the Fed thinks of the data:
"The Fed is not alarmed by climbing labor costs at this stage. Officials have been expecting some increase in wages in the belief that they were due to "catch up" to past productivity gains which until recently served mainly to swell profits.. . . . .

. . . .It's possible that rising labor costs will just be part of a return to more historical norms on the labor share and the profit share, but that's not guaranteed," a senior Fed source said. "It's a rising cost pressure. It won't necessarily feed into inflation, but it's something that has to be taken into account."

That room for catch-up comes from the sharp dip in the blue line since 2000.

As for the ease potential priced into the Eurodollar contracts, beginning with Mar 07, understand what inflation the Fed is concerned about. They are not focused on price swings in energy and other commodities. That is the stuff that makes free market economies free. They instead focus on a broader increase in costs that gives truth to the Friedman view that inflation is a monetary phenomenon. This recovery sits on top of a mountain of liquidity. Hence the following from the same article:

"Comments by Fed sources suggest that, while labor compensation pressures are not worrisome enough in the current economic context to force a resumption of policy firming anytime soon, they are enough of a concern, together with other considerations, to reduce chances of Fed easing......

Echoing the FOMC minutes, a Fed official said, "trend might be a little lower than in recent years, in part because of slower productivity growth, in part because of slower labor force growth. Our bottom line expectation is not for a big output gap being opened up by slowing growth -- maybe something small."

"So that by itself isn't going to be a very strong disinflationary force," the official continued. "I don't think we can necessarily expect slower growth by itself to bring inflation down very rapidly from where it's been.""

Once again, if there is no ease in January why expect an ease by July? And if those back Eurodollar contracts return to pricing "no ease", there is a 25 basis point risk in the two-year (yesterday it was 40). Understand the risk to understand the reward.

I leave with where the market has priced the odds (they still believe 100% that there is a 25bp ease by next summer).

Thursday, November 02, 2006

Where Market Is Now -- The 170% Solution

It has been a week for bullish sentiment as far as bonds are concerned. The probability pricing for a Fed ease, diminished only a couple weeks ago by Fed speakers and then rekindled by the FOMC statement (go figure), has moved to a full flame-on frenzy based on ISM and other assorted just released data. Not even the first shot across the party boat's bow, Dallas Fed Chairman's chat today at the New York Association of Business Economists, could take the punch bowl away from this celebration of impending economic gloom (bond people are natural pessimists, if they were optimists they would've gone into equities).

Rather than opine on Mr. Fisher's comments and try to establish what is really meant by inflation (see my blog on the subject), I figured it was prudent to wait till after the big number is out tomorrow morning.

So in the interest of the public interest, or at least those that read my blog, I offer the table of market probabilities -- as compiled by my partner Stan Jonas.

Note that the Thursday column shows a cumulative probability of a 170% chance of a Fed ease by Aug 07. Meaning 25bp is baked in and there is a 70% chance for the next 50bp. Which, in our terms is pretty much 100%.

Once again, if the data continue to support the negative view on growth the Fed will ease in January (where the market is pricing in only a 1 in 5 chance of an ease) by 25b or even 50bp. Why anyone thinks they will wait til Mar is beyond me.

If the data stabilize, disappointing the gloomy ones, and the market prices to the "on hold" scenario (JHLD column), the two-year backs up approximately 40bp. Will that happen? No one knows for certain, but things always seem worse than they are when the economy is in the midst of a downshift. Still, it is always helpful to know the risk you are taking from what you are buying.

Wednesday, November 01, 2006

Rubin In The Times, Betting Against The Dollar

In today's New York Times the Economix column by David Leonhardt carries the title "A Gamble Bound to Win, Eventually". Its about Robert Rubin, now characterized as the "eminence grise at Citigroup", having lost money betting against the dollar. He isn't the only one to have wagered and lost on this bet. Of course the equally large book taking these bets wagered and won.

This from the article (the he is Rubin):
But when he talks about the dollar, you can see how hard it is, even for somebody with his self-assurance, to remain confident in the face of a failed prediction. “I think I was right, probabilistically,” he said recently, sitting in his Citigroup office overlooking Park Avenue. “But I don’t know. I really don’t. I don’t think anyone does. It’s also possible that none of this could happen. It’s possible that for reasons none of us can see that this will work itself out in a very copacetic way.”

Why bet against the dollar in the first place? The article explains:
The simplest way to explain the problem is to say that the United States has been living beyond its means.

Both the federal government and American families have been spending more money than they take in, leaving both in debt. To close the gap between our resources and our spending habits, we have borrowed from abroad. It’s the only option.

The net amount of money leaving the United States — that is, the amount of money we need to borrow back to support our lifestyle — has soared to $800 billion a year. “It’s just stunning,” said Kenneth S. Rogoff, former chief economist of the International Monetary Fund. “It’s unprecedented.”

As for how it can resolve itself, well it can be quick and dislocating or slow and relatively painless. One scenario noted in the column caught my attention:
The other possibility is that an unexpected event — a spike in oil prices, say — could cause foreign investors to cut their dollar purchases sharply, bringing all sorts of economic havoc.


Oil is priced in dollars. A spike raises global demand for dollars and then transfers all of it to OPEC. Petrodollar recycling ensues. Trust me on this one, they don't burn the dollars. They buy lots of things that are priced in dollars -- not all of which is sold by U.S. producers. By the way, know who the world's largest exporter is, in absolute terms? The United States, by a landslide.

The reason so many notables were wrong on the dollar, and this isn't to say that at some point they won't be right, is only one side of the equation is being examined. In other words, they are not open to the possibility that they have cause and effect reversed.

The demand for dollars is NOT something totally in our control. As the global currency, lots of people buy and sell dollars because of their own domestic needs and concerns and not because pricing of U.S. dollar assets are attractive. In fact, as I wrote about yesterday, the Warnock paper on the impact of dollar flows on U.S. interest ratees suggested that flows dropped the yield on ten-year Treasurys by about 90 basis points. Why would foreign capital keep following?

Herein lies the tale, from my perspective. We have, in some ways, become like any other emerging economy where foreign capital flows in and distorts domestic pricing and, in turn, domestic activity. It is not quite that bad, although 90bp is alot when you consider it took 4 Fed meetings to raise the funds rate 100 basis points, since the demand for dollars might reflect activity elsewhere in the world with little relevance to whether U.S. asseets are attractive. But the domestic impact is the same, regardless.

Rather that wring our hands about the profligacy of Amercian consumers and the Federal government, a worthy topic for another time, collective wisdom should focus on how to insulate asset prices here from being distorted by foreign flows. A distortion that, in turn, distorts domestic activity. Ideas?